FP513 Investing Flashcards

Question

A strategy where investors with relatively large amounts of money to invest purchase multiple certificates with varying terms to maturity is A) swapping. B) staging. C) laddering. D) bulleting.

Answer 1

Explanation C) Laddering is the process of purchasing multiple CDs with staggered maturities, that are equally spaced, and with varying interest rates. As each CD matures, a CD is purchased with a maturity equal to the longest in the ladder. This strategy is used to manage interest rate risk. LO 1.1.1

Answer 2

Explanation The answer is primary market. The purpose of the primary market is to facilitate the sale of initial public offerings (IPOs) of securities to the public. LO 1.2.1

Answer 3

Explanation D) The answer is short sale. A short sale involves the sale and subsequent repurchase of borrowed shares, allowing an investor to take advantage of falling stock prices. LO 1.2.1

Answer 4

Explanation B) The answer is good-til-canceled sell stop at $38. A good-til-canceled order is an order that will remain in effect until either it is executed or canceled. A good-til-canceled sell stop order becomes a market sell order when the market price drops below the stop price. LO 1.2.1

Answer 5

Explanation C) The answer is $30.77. Carly would receive a margin call when the stock fell to $30.77 per share. Margin call = [(1 − initial margin percentage) ÷ (1 − maintenance margin)] × purchase price of the stock = [(1 – 0.50) ÷ (1 – 0.35)] × 40 = 30.7692, or $30.77. LO 1.2.1

Answer 6

Explanation D) The answer is 2,500. Cosmo can purchase 2,500 shares calculated as follows: $50,000 ÷ 50% initial margin = $100,000 of buying power. $100,000 ÷ $40/share = 2,500 shares. LO 1.2.1

Answer 7

Explanation A) The answer is the amount of the discount as ordinary income. An investor holding a Treasury bill as of the date of maturity includes the amount of the discount as ordinary income. An investor who sells the bill before maturity includes as ordinary income only a portion of the acquisition discount based on the total time he held the bill. The remaining portion is capital gain income. LO 1.3.1

Answer 8

Explanation D) The answer is I, II, and III. T-bills are not subject to default risk and exhibit a high degree of marketability. As a result, the 90-day T-bill is often used as a proxy for the risk-free investment. LO 1.3.1

Answer 9

Explanation B) The answer is II and III. MMDAs provide limited check writing privileges and are offered by banks and savings and loans. MMDAs require a minimum balance. Unlike money market mutual funds, MMDAs are FDIC insured. LO 1.3.1

Answer 10

Explanation D) The answer is short-term drafts drawn by a private company on a major bank used to finance imports and exports. Banker's acceptances are typically traded at a discount from their face value in the secondary market. Eurodollars are U.S. dollar-denominated deposits at banks outside the United States. LO 1.3.1

Answer 11

Explanation C) The answer is they require a minimum balance of $500. Passbook savings accounts do not require a minimum balance. LO 1.3.1

Answer 12

Explanation C) The answer is repurchase agreement. Dealers in government securities use repurchase agreements, or repos, to satisfy short-term liquidity needs. LO 1.3.1

Answer 13

Explanation D) The answer is commercial paper. Commercial paper is usually issued in denominations of $100,000 or more and is a substitute for short-term bank financing. Commercial paper is normally sold at a discount and is rated for quality by a rating service. LO 1.3.1

Answer 14

Explanation A) The answer is I and III. Statements II and IV are incorrect. Eurodollar CDs are less liquid than domestic CDs and are used to settle international transactions. LO 1.3.1

Answer 15

Explanation C) The answer is issued by the U.S. Treasury. Eurodollars are issued by banks outside of the United States, not the U.S. Treasury. LO 1.3.1

Answer 16

Explanation D) The answer is all money market mutual funds are exempt from taxation on both the state and federal levels. Open-end investment companies offer both taxable and tax-exempt money market mutual funds. Only state specific money market mutual funds are exempt from taxation for the taxpayers in those specific states. LO 1.3.1

Answer 17

Explanation C) The answer is repurchase agreements. Repurchase agreements are used by dealers in government securities. Because of their low risk and short maturities, they are frequently found in money market mutual funds. LO 1.3.1

Answer 18

Explanation C) The answer is I, II, and III. All of these financial instruments would be held in a money market portfolio. LO 1.3.1

Answer 19

Explanation The answer is I, II, III, and IV. U.S. Treasury bills are short-term government securities. Because of their lack of default risk and high degree of marketability, T-bills are often used as the proxy for a risk-free investment, an asset having the lowest level of risk among all available assets, in modern portfolio management theory. LO 1.3.1

Answer 20

Explanation The answer is 61 days. 30 days before + date of sale + 30 days after = 61 total days. LO 1.4.1

Answer 21

Explanation The answer is both I and II. Both of these statements describe characteristics of wash sales. LO 1.4.1

Answer 22

Explanation The answer is I only. If the dividends and capital gains are reinvested, the individual receives an increased tax basis. If the distributions are made in cash, there is no increase in the tax basis of the underlying securities. LO 1.4.1

Answer 23

Explanation The answer is II only. Statement I is incorrect. Generally, income from U.S. government obligations is not taxable on state income tax returns. LO 1.4.1

Answer 24

Explanation The answer is both I and II. Both of these statements regarding net investment income are correct. LO 1.4.1

Answer 25

Explanation D) The answer is $0. After netting capital gain and losses, the client has a net capital loss of $3,000. Because $3,000 of net losses can be deducted during any one tax year, there is no carryforward. LO 1.4.1

Answer 26

Explanation The answer is $1,000. Only the dividends paid in cash to Galen that are reported as income. The stock dividends did not have a cash-dividend option and are not taxable. LO 1.4.1

Answer 27

A) Explanation The coupon rate on the convertible bond is usually greater than the stock's dividend yield because the stock usually pays little, if any dividends. This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate. LO 2.2.1

Answer 28

B) The answer is $1,150.

Answer 29

D) When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed. That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur. The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio. LO 2.3.1

Answer 30

A) First, determine what the current interest rate is, $1.50 ÷ $25 = 0.06. Now, determine the percentage price movement if interest rates climb 1%—$1.50 ÷ 0.07 = $21.43. This is a decline of $3.57, or 14.28%. LO 2.5.1

Answer 31

Explanation B) Option D At all other values, the bond's intrinsic value is greater than the conversion value; a conversion under those circumstances means that the investor is automatically losing money on the conversion, excluding the fact that the convertible bond sells at a premium to its intrinsic value as a bond. At a minimum, the conversion value should be greater than the bond intrinsic value for conversion to be considered. LO 2.2.1

Answer 32

B) General obligation bonds (GOs) are the most secure of all municipal debt because they are backed by the full faith and credit of the issuer. Municipalities may increase taxes to make principal and interest payments on any debt issue; therefore, a voter referendum is usually required to approve their issuance. LO 2.1.1

Answer 33

B) Neither Statement I nor II is correct. A bond portfolio is said to be immunized from interest rate risk and reinvestment rate risk when the duration of the portfolio is equal to the time horizon of the investor. If the time horizon of an investor is 10 years, a simple way to protect against interest rate risk and reinvestment rate risk would be to fund the portfolio only with zero-coupon bonds with a 10-year term to maturity. LO 2.3.1

Answer 34

Explanation B) For example, with a ladder bond strategy, instead of investing all money in a seven-year bond, an investor may divide the dollars among bonds with one, three, five, seven, and nine-year maturities. With this approach, instead of making a single bet on interest rates, the investor has both longer and shorter maturities, so that regardless of which way interest rates move the investor will not experience either great losses or great gains. LO 2.3.1

Answer 35

Explanation A bond's investment value is the same as its intrinsic value as a straight bond. Using an HP 10bII+ calculator, the bond price is determined by inputting the following keystrokes: (END mode) 10, N 7. 5 ÷, 2 I/YR 32. 5, PMT 1000, FV Solve for PV = –958.94, or $958.94. LO 2.2.1

Answer 36

A) The investor is long the straight bond (bought) and long the call option (bought). LO 2.2.1

Answer 37

Explanation A) Market interest rates have decreased from YC1 to YC2. When market rates decrease, duration increases, because market interest rates and duration are inversely related. Treasury bills are short-term debt and Treasury bonds are long-term debt. When an inverted yield curve changes to a normal yield curve, short-term rates will decline more than long-term rates. An inverted yield curve normally occurs when inflation is high and the Fed fights inflation by raising short-term interest rates above long-term interest rates. LO 2.4.1

Answer 38

Your primary objective is to match duration to the cash need of seven years. Treasury bills do not come close because the maturity of the bills is one year or less, meaning that the duration must be less than one year. A seven-year note must have a duration less than seven years because the note has a coupon; therefore, it is likely that the seven-year note duration will not be sufficient to match the duration of the need either. The duration of a 9 year bond with a coupon must be less than nine years. You can estimate that the duration of an intermediate-term bond might be about 80% of the bond's maturity, or, in this case, about seven years. That is a close enough estimate to arrive at the answer to this question. LO 2.3.1

Answer 39

Explanation B) The value of any convertible will rise with a rise in the underlying common stock into which it can be converted. The convertibles will not necessarily have the same gain; it will depend on their premium and conversion terms. LO 2.5.1

Answer 40

Explanation D) The purpose for using a barbell strategy in a bond portfolio is to offset the opposite effects of interest rates on bond prices. If rates rise, short-term bonds can be reinvested at higher rates. If rates drop, long-term bonds are used to lock in rates. LO 2.3.1

Answer 41

Explanation A) Because preferred stock does not have a maturity date, it is subject to more interest rate risk than bonds. LO 2.5.1

Answer 42

D) Explanation The interest on public purpose bonds is received tax-free by the holder. Only the capital gain realized on the sale is subject to income taxation. LO 2.1.1

Answer 43

Explanation C) Emily already owns higher-risk stocks and needs some additional income. As a retiree, she should not be invested in the higher-risk bonds in the other possible options. A high mortgage interest rate GNMA certificate selling at a premium, with a high prepayment experience is not a good choice because monthly cash flows are highly unpredictable, and principal is being returned at a high rate. A "Z" tranche CMO is not a good choice because it is similar to a zero-coupon bond. A 20-year, 8%, A rated income bond is not appropriate because it is an income bond that will only pay interest when and if earned, so it is not a dependable source of income. LO 2.3.2

Answer 44

Explanation A) The coupon rate is stated as a percentage of the par value. LO 2.1.1

Answer 45

Explanation The answer is I and II. Revenue bonds are not secured by property and are not a type of general obligation bond. They are only secured by user fees. LO 2.1.1

Answer 46

Explanation D) The answer is 3.26%. Because the corporate bond is taxable by the state and the federal government, its after-tax return is 3.5% [5% × (1 – 0.30)]. The State of Georgia municipal is not taxable by either government entity. The Treasury note is taxable by the federal government; therefore, its after-tax return is 2.28% [3% × (1 – 0.24)]. Averaging the three rates equals 3.26% [(3.5% + 4% + 2.28%) ÷ 3]. LO 2.1.1

Answer 47

Explanation D) The answer is the principal value is adjusted for inflation every six months based on the CPI, and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value. TIPS coupon rate stays the same for the life of the security, but the interest payment changes based on the inflation-adjusted principal or par value. LO 2.1.1

Answer 48

Explanation C) The answer is Louisiana resident, 6% state income tax bracket, 35% federal income tax bracket. The municipal bond interest is generally exempt from federal income tax, but is subject to both state and local taxes unless the bond is purchased by a resident of the issuing state. While the Florida resident is taxed at the highest federal tax rate and pays no state income tax, the overall tax savings is greatest for the Louisiana resident whose combined state and federal tax bracket is 41%. LO 2.1.1

Answer 49

Explanation A) The answer is Series EE bonds may no longer be exchanged for Series HH bonds. Until September 2004 (when Series HH bonds were no longer issued by the Treasury), the exchange of EE bonds for HH bonds was a popular way of continuing the income tax deferral on the accrued interest portion of the EE bonds. Such changes are no longer possible. LO 2.1.1

Answer 50

Explanation A) The answer is II only. Both Treasury notes and bonds are considered default risk free. Both obligations trade in the secondary market and pay interest, which is income tax free at both the state and local level, but taxed as ordinary income in the year earned at the federal level. LO 2.1.1

Answer 51

Explanation D) The answer is zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond. Although the securities underlying Treasury STRIPS are the U.S. government's direct obligation, major banks and dealers perform the actual separation and trading. LO 2.1.1

Answer 52

Explanation The answer is debenture risk. A coupon-paying bond is also subject to reinvestment rate risk. LO 2.1.1

Answer 53

Explanation The answer is 6.08%. The after-tax return is 8% × (1 − 0.24) = 6.08%. LO 2.1.1

Answer 54

Explanation B) The answer is market price is less than the conversion value. An investor would consider converting a convertible bond into common stock if the bond's conversion value exceeds its market price. LO 2.2.1

Answer 55

Explanation D) The answer is $781.25. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $32) × $25 = $781.25. LO 2.2.1

Answer 56

Explanation The answer is $180. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,120 - $940 = $180. LO 2.2.1

Answer 57

Explanation The answer is $190. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,080 - $890 = $190. LO 2.2.1

Answer 58

Explanation A) The answer is they offer a yield that is less than the yield on straight bonds with similar risk and maturities. Convertible bonds can be converted into a specified number of common shares at the option of the investor. Because of this option, they are sold at a premium over the price of comparable nonconvertible bonds. In other words, they offer a yield that is less than the yield on straight bonds with similar risk and maturities. When stocks sell for a price that is above the conversion price, convertible bonds sell for their stock values. However, convertible bonds have downside risk protection because they have the advantage of bonds. Most convertible bonds are converted. Also, most are callable, and companies often call their bonds to force conversion. LO 2.2.1

Answer 59

Explanation B) The answer is bond bullet. When using the bond bullet strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor. LO 2.3.1

Answer 60

Explanation B) The answer is shorter maturity bonds in a laddered portfolio are more subject to price fluctuations than the longer maturity bonds. The shorter maturity bonds in a laddered portfolio are less subject to price fluctuations than the longer maturity bonds because of their shorter duration. LO 2.3.1

Answer 61

Explanation The answer is a tax swap. A tax swap results in a tax savings generated by the realized loss. LO 2.3.1

Answer 62

Explanation A) The answer is the bond ladder strategy is used to immunize a portfolio against interest rate risk. It is an investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities. The barbell strategy involves the purchase of a mixture of very long-term and very short-term bonds. The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds. The barbell strategy is generally more aggressive than the ladder strategy because the barbell strategy only utilizes short-term and long-term bonds. LO 2.3.1

Answer 63

Explanation A) The answer is income from coupons reinvested over the investment horizon. By investing in bonds that have a duration equal to the investor's investment time horizon, any bond price/value changes caused by interest rate fluctuations will be approximately offset by changes in the interest earned on the reinvested coupons. LO 2.3.1

Answer 64

Explanation The answer is both I and II. The portfolio in Statement I will provide the investor with a portfolio that has the maximum interest rate sensitivity to take advantage of the capital gains experienced by bonds from the decrease in market interest rates. The portfolio in Statement II will provide the investor with a portfolio that has the minimum interest rate sensitivity to minimize the capital losses experienced by bonds from the increase in market interest rates. LO 2.3.2

Answer 65

Explanation C) The answer is preferred stock's value is based on prevailing interest rates. The value for a preferred stock is its dividend divided by prevailing interest rates. LO 2.5.1

Answer 66

Explanation C) The answer is short-term bonds. Long-term bonds are affected by interest rate changes more than short-term bonds. If interest rates are expected to rise, an investor should invest in short-term bonds until rates peak. Risk of default of high-yield bonds increases when rates rise. LO 2.3.2

Answer 67

Explanation The answer is government bonds. Unlike corporate, revenue, and municipal bonds, government bonds are free from default risk. LO 2.3.2

Answer 68

Explanation A) The answer is sell short-term bonds and buy long-term bonds. If interest rates are expected to fall soon, an investor should sell short-term bonds and buy long-term bonds to lock in the current higher interest rates offered by the long-term bonds. LO 2.4.1

Answer 69

Explanation The answer is all of these statements are correct. The term structure of interest rates theory has several iterations. Although unbiased expectations theory and market segmentation theory may be used to explain any shaped yield curve, the liquidity preference theory only explains a normal, upward-sloping yield curve. LO 2.3.2

Answer 70

Explanation The answer is a positive yield curve can signal an upcoming economic recession. A positive (or normal) yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise. LO 2.4.1

Answer 71

Explanation The answer is the current long-term rate is the average of today's short-term rate and expected future short-term rates. The other statements relate to the liquidity premium theory and the market segmentation theory. Under the unbiased expectations theory, an upward sloping yield curve indicates increasing inflation expectations. LO 2.4.1

Answer 72

Explanation B) The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates. LO 2.5.1

Answer 73

Explanation B) The answer is I and IV. Preferred stock is considered a hybrid security. This type of stock has an infinite life span and pays dividends like an equity instrument. Similar to a debt security, the dividend amount is fixed and known in advance. Preferred stock may be cumulative. LO 2.5.1

Answer 74

Explanation C) The answer is II and III. Both preferred stock and long-term bonds generally pay a fixed periodic payment, and both preferred dividends and interest must be paid before common stock cash dividends are paid. LO 2.5.1

Answer 75

Explanation A) The answer is if Max does not sell the stock this year, he will not have to pay taxes on the difference between the amount he paid for the stock and the current market price this year. If Max sells the stock today, he realizes the gain in the value of the stock and must pay taxes on the gain. The gain would equal the price at which Max sells the stock minus the original purchase price, or $40 per share. If the gain is not realized, Max has no tax liability for the increase in the value of the stock. Capital gains are only taxable when they are realized at the time of the sale. LO 3.1.1

Answer 76

Explanation The answer is I and IV. Warrants typically have a maturity date of several years, not months, and are customized to fit the needs of the issuing corporation. LO 3.1.1

Answer 77

Explanation The answer is rights. Rights are a purchase option for stock that allows a shareholder the opportunity to buy shares of the new stock issue, thereby maintaining the overall percentage ownership in the corporation. LO 3.1.1

Answer 78

Explanation B) The answer is I only. Stocks generally are considered an inflation hedge; in periods of hyper-inflation, this may not be true, but the question does not ask about periods of hyper-inflation. FNMA securities are not backed by the full faith of the government (the government did step in as a result of the credit crisis of 2008, but there has not been a commitment to permanently back FNMAs in the same way that GNMAs (Government National Mortgage Association) have historically been backed). LO 3.1.1

Answer 79

Explanation The answer is III and IV. A stock split is not a taxable event to the investor. Following a stock split, the investor owns the same percentage of the company as before, but each share now represents a correspondingly smaller percentage. LO 3.2.1

Answer 80

Explanation D) The answer is II and III. In a 2-for-1 stock split, the number of outstanding shares is doubles and the share price is reduced by one-half. The total market value of the company's stock and the shareholder's interest remains the same. LO 3.2.1

Answer 81

Explanation C) The answer is 200. John will acquire 200 additional shares and therefore, will own a total of 400 shares of XYZ stock. In a stock split, the par value of each share of stock is reduced, and the number of shares is increased proportionately. LO 3.2.1

Answer 82

Explanation The answer is I, II, and III. Only statement IV is incorrect. The IRS treats reinvested dividends the same as cash dividends for tax purposes. LO 3.2.1

Answer 83

Explanation The answer is II only. Cash dividends paid by a corporation to the shareholders are not tax deductible. Qualifying (or qualified) dividend income may be treated at favorable long-term capital gain rates (0%, 15%, or 20%) if it meets certain criteria. LO 3.2.1

Answer 84

Explanation The answer is RNO shares are priced at $49.33 per share. Because RNO invests in both bonds and equities, it is not a money market mutual fund. RNO's shares are valued at NAV, calculated as follows: ($63 million + $85 million) ÷ 3 million shares = $49.33 per share. Mutual fund shares are sold and redeemed directly by the mutual fund company and do not trade on the major exchanges. RNO is an example of an open-end investment company. LO 3.3.1

Answer 85

Explanation A) The answer is II only. Statement I is incorrect. An open-end investment company can raise an unlimited amount of capital by continuously issuing new shares. After the initial public offering, a closed-end fund will generally not issue additional shares. LO 3.3.1

Answer 86

Explanation The answer is I and IV. Adding foreign investments could reduce her portfolio's level of risk and possibly improve return. Foreign investments have a low correlation with U.S. securities and thus provide diversification benefits. Additional investment in U.S. equities or bonds will not provide as much diversification as international investing. LO 3.3.1

Answer 87

Explanation The answer is an open-end investment company is categorized as open-end because it is limited in the number of shares that are sold. An open-end investment company is the most popular form of investment for the small or individual investor. The investment company is categorized as open-end because it is not limited in the number of shares sold. LO 3.3.1

Answer 88

Explanation The answer is unit investment trust. A unit investment trust (UIT) is an investment company whose units are sold in the secondary market and is generally unmanaged, or passively managed as the money manager initially selects the securities to be included in the portfolio and then holds those securities until they mature or the UIT terminates. LO 3.3.1

Answer 89

Explanation The answer is sector funds. Sector funds tend to limit their investments to one sector of the economy, such as natural resources, technology, or health care. LO 3.3.1

Answer 90

Explanation D) The answer is a separately managed account is a privately offered pool of capital for wealthy, sophisticated investors. In a separately managed account, the money manager purchases securities on behalf of the individual investor, not as a pool of capital for numerous investors. LO 3.3.1

Answer 91

Explanation The answer is closed-end investment company. A closed-end investment company (closed-end fund) is a type of company whose shares trade in the secondary market. LO 3.3.1

Answer 92

Explanation The answer is $4,475 cost basis, $2,425 gain on sale. The highest cost shares are as follows: (100 × $17) + (100 × $15) + (75 × $13) + (25 × $12) = $4,475. The gain is $2,425 ($6,900 − $4,475). LO 3.3.1

Answer 93

Explanation The answer is I, II, and III. All of these can be used to make this determination. LO 3.3.1

Answer 94

Explanation The answer is a closed-end fund typically redeems its shares as a courtesy to all shareholders. Generally, a closed-end investment company does not redeem its own shares. Closed-end fund shares trade in the same manner as publicly traded stocks, either on a stock exchange or over the counter. LO 3.3.1

Answer 95

Explanation The answer is II, III, and IV. Because they mimic indexes, ETFs typically have lower annual expenses than mutual funds. Most ETFs permit in-kind redemptions, and such transactions are income tax free. Hedge funds rely heavily on borrowing strategies in an attempt to accomplish superior returns. LO 3.4.1

Answer 96

Explanation The answer is purchasers of hedge funds are required to be accredited investors. A hedge fund is an unregistered, privately offered, managed pool of capital for wealthy investors. In addition to short selling, a hedge fund will implement a wide array of risky trading strategies in order to exploit market inefficiencies. Hedge fund managers are paid based on fund performance. LO 3.4.1

Answer 97

Explanation The answer is I, II, III, and IV. A hedge fund is subject to all these risks. In addition, hedge funds are usually subject to higher investment risk than other types of funds. LO 3.4.1

Answer 98

Explanation The answer is insurance companies. GICs are issued by insurance companies. They are called guaranteed investment contracts because their rate of return is guaranteed by the insurance company for a fixed period. They are not guaranteed by the FDIC. LO 3.4.1

Answer 99

Explanation The answer is a passive investment strategy. Index funds are used in a passive investment strategy. The purpose of an indexed portfolio is not to beat the targeted index (e.g., S&P 500 Index) but merely to match its long-term performance, less any management fees and administrative costs. LO 3.4.1

Answer 100

Explanation The answer is I, II, and III. Only statement IV is incorrect. If prices rise, the fixed investment amount will purchase a lower amount of the security. The effect of dollar cost averaging is to increase the number of shares gradually over a long period. Because more shares are acquired when the price of the stock or mutual fund declines, the average cost per share is reduced. LO 3.5.1

Answer 101

Explanation The answer is two business days before the record date. Under the T+2 rules in effect, ex-dividend date is one day business prior to the record date. A trade made on the ex-dividend date will clear in two business days, one day after the record date. The investor will not be on the corporation's record book as a shareholder unless the purchase is made at least two days before the record date. LO 3.5.1

Answer 102

Explanation The answer is I and III. Dollar cost averaging benefits the investor if the same amount is invested on a regular basis over a substantial period, during which the price of the stock fluctuates. A constant dollar plan is one in which the investor maintains a constant dollar value of securities in the investment portfolio. LO 3.5.1

Answer 103

Explanation C) The answer is the difference between a fund's realized return and its risk-adjusted expected return. Alpha does not compare directly to the S&P 500, but rather to the fund's expected return, which is risk-adjusted for the fund's beta. The total return, not just the capital appreciation component, is used in the Jensen formula. The risk-adjusted required return is the risk-free rate plus the risk premium multiplied by the fund's beta. LO 3.6.1

Answer 104

Explanation The answer is Fund F, because its alpha is higher. In this case, the investor should choose the fund with the higher alpha. With an alpha of 1.6, Fund F exhibits the best risk-adjusted performance. LO 3.6.1

Answer 105

Explanation Interest rate risk, market risk, business risk, and financial risk are all risks that impact equity investments. Reinvestment rate risk is a primary consideration for fixed-income investments. LO 3.1.1

Answer 106

Explanation D) Fund B can be expected to do as well as the overall market, will have a low expense ratio, and is less risk, as measured by beta, than Fund A. LO 3.6.1

Answer 107

Explanation B) Rather than buy every security in an index, some ETFs only sample the index, called representative sampling, especially when the index contains a very large number of issues. LO 3.4.1

Answer 108

Explanation D) Option IV is an incorrect statement because dividends are not tax deferred. They are taxable (potentially at preferential rates) as income at the time they are received. Option I is incorrect because cost basis is needed to compute taxable income when the shares are sold in the future. LO 3.2.1

Answer 109

Explanation A) Statements II and IV are incorrect. Reinvested dividends are treated the same as dividends received in cash for tax purposes. The term dividend reinvestment refers to dividends that are reinvested directly into the investment from which they were initially earned. LO 3.2.1

Answer 110

Explanation A) An index fund would match the market's performance. In a poor market, the technology fund would have even greater losses and the balanced fund should do better because of the bond mix. LO 3.6.1

Answer 111

Explanation An asset allocation fund is a type of growth fund. The other options are all considered income funds. LO 3.3.1

Answer 112

Explanation | A global fund invests in U.S. stocks and in international stocks.

Answer 113

Explanation D) Balanced funds can be securities that produce both income (dividends and interest) and capital gains. Income securities can be high-dividend paying stocks or bonds. Capital gains securities generally are stocks. Most balanced funds contain some combination of both stocks and bonds (often 60% stocks and 40% bonds). LO 3.3.1

Answer 114

Explanation A) Only statement IV is incorrect. If prices rise, the fixed investment amount will purchase a lower amount of the security. LO 3.5.1

Answer 115

Explanation A) ETFs trade like stock and can be sold short. They are tax-efficient, generally low cost, and large investors conduct trades by making in-kind exchanges, whereby they give or receive shares of stock that are in the fund. Generally ETFs trade near net asset value (NAV), if not at NAV.

Answer 116

Explanation C) The investor will purchase more shares when the NAV falls because the dollar amount invested remains the same. LO 3.5.1

Answer 117

Explanation D) profit = (gain on stock – cost of warrant) × number of shares; ($5/share – $2/share) × 80 shares = $240 LO 3.1.1

Answer 118

Explanation D) An equity income fund would fit these criteria by owning stocks of companies paying above-average dividends. A stock index fund is too general a description in that it could own small company stocks that pay little, if any, dividends, and are more volatile than large company stocks. An asset allocation fund would own stocks, bonds, cash equivalents, precious metal stocks, and even currencies, so income would not necessarily be above-average. LO 3.3.1

Answer 119

Explanation C) Hedge funds have few public disclosure requirements, may lack marketability, and use leverage. LO 3.4.1

Answer 120

Explanation Investments II and IV are the only two that will provide current income for the couple. LO 3.6.1

Answer 121

Explanation A) The best choice for this couple would be a semiconductor stock; as a competitive and high-growth sector, semiconductors should add the appropriate degree of risk and return for this couple's conservative portfolio. A big box store stock would be considered defensive, a waste management stock would be an income stock, and a domestic airline stock would be considered a cyclical stock. LO 3.1.1

Answer 122

Explanation Long-term bonds have greater purchasing power risk than short-term bonds. LO 3.3.1

Answer 123

Explanation B) The P/E ratio is 20, calculated as follows: $48 ÷ $2.40 = 20. When a stock exhibits a P/E ratio below the historical range, this could indicate the stock is undervalued in the market. LO 4.3.2

Answer 124

Explanation A) The rule-of-thumb approach to measuring the estimated price change of a bond is to multiply the bond's duration by the estimated change in interest rates (for small rate changes—less than 1% or 100 basis points—only). Therefore, longer-term bonds have the greatest duration and the most price volatility. LO 4.1.1

Answer 125

Explanation B) Option I is not a factor used for industry analysis, but rather for company analysis.

Answer 126

Explanation D) Both depreciation expense and S, G & A expenses are used to obtain operating income, which is the same for both companies. Generally, the most significant factor in raising one company's ROE above another company's is the greater use of debt. The company having the greater percentage of debt, assuming the cost of the debt is less than the return earned from the debt proceeds, will have the highest ROE. LO 4.2.2

Answer 127

Explanation A) In a bull market, there is less fear so there is a lower spread between high-quality and lower-quality bonds. LO 4.2.1

Answer 128

A) Explanation Because Al and Stacy are in the top tax bracket, they do not qualify for a Roth IRA, therefore eliminating portfolios 1 and 4. Portfolio 2 is too conservative for their risk tolerance and long-term goals. LO 4.1.1

Answer 129

Explanation B) The growth rate cannot be equal to or greater than the investor's required rate of return or the denominator becomes meaningless. The model assumes the required rate of return is constant. LO 4.3.1

Answer 130

B)Explanation Technical analysis is not considered valid under any of the three forms of the EMH. Ratio analysis fits with fundamental analysis techniques. Bottom-up analysis begins with identifying attractive individual companies for investment. Fundamental analysis may indeed allow for an investor to outperform the market, but only under the weak form of the EMH. LO 4.2.1

Answer 131

A) Explanation Because interest rates are expected to increase, the percentage change in price will be negative. Because semiannual compounding was used to compute duration, modified duration must be computed by using one-half the current YTM (3.1%). The computation using the formula is as follows. ``` ΔP P= −D×Δy 1+y = −12×0.005 1.031=−0.0582=−5.82% LO 4.1.2 ```

Answer 132

Explanation D) Financial statement ratios are part of fundamental analysis. LO 4.2.1

Answer 133

B) Explanation This is correct, as any form of EMH does not coexist with technical analysis. LO 4.2.1

Answer 134

B) Explanation Determine the duration of the bond. Year. Cash Flow(CF) (PV) of CF PV × Year 1. $45 $43.37 $43.37 2. $45 $41.81 $83.62 3. $1,045 $935.73 $2,807.19 $1,020.91 $2,934.18 Divide the sum in the last column ($2,934.18) by the total PV/market price of the bond ($1,020.91) to derive the duration of 2.8741 years. For year 1, FV = 45, I/YR = 3.75, N = 1, solve for PV. For year 2, change N to 2 without clearing your calculator and solve for PV. For year 3, FV = 1,045, I/YR = 3.75, N = 3, solve for PV. LO 4.1.2

Answer 135

Explanation The new price of the bond should be $1,041.23. FV = 1,000 PMT = 60 I/YR = 4.5 N = 3 Solve for PV = –1,041.2345, or $1,041.23 LO 4.1.1

Answer 136

A) Explanation All else being equal, a profitable company with a higher debt level will have a higher return on equity. If income is the same for both companies, then the only difference is the percentage of equity. With a lower equity, Company B will have a higher return on equity. EBITDA and ROA would be equal, and Company B has a higher debt-to-equity ratio. LO 4.2.2

Answer 137

A) Explanation The determinants of both duration's and convexity's direction of impact is the same (maturity [direct relationship], coupon rate, and yield [both inverse relationships]). Therefore, high-duration bonds also have high convexity. LO 4.1.2

Answer 138

C) Explanation The dividend growth model is just one of many models that investment analysts use to estimate the intrinsic value of a company. Other models can be used if a company does not pay a dividend. Determining intrinsic value by comparing relative P/E ratios compared to relative market prices is not a valid approach to valuation. LO 4.3.2

Answer 139

B) Explanation Bonds with longer durations have greater volatility than bonds with shorter durations. The time horizon of a goal should be matched with a bond's duration rather than with its maturity. Duration does take into account all interest and principal payments, not just the final payment at maturity. LO 4.1.2

Answer 140

D) Explanation Victor's bond portfolio is properly immunized to reach financial goals or pay liabilities when the goals' time horizon matches the portfolio's duration (8.6 years). Portfolio immunization balances reinvestment rate risk with interest rate risk. Because zero-coupon bonds' durations are equal to their time to maturity and portfolio duration is a weighted average, Victor's portfolio could consist of $2,000 worth of 3-year zero-coupon bonds and $8,000 worth of 10-year duration bonds, calculated as follows: (20% × 3 years) + (80% × 10 years) = 8.6 years. LO 4.1.2

Answer 141

C) Explanation Because the bond is a zero-coupon bond, the duration must be 10 years. LO 4.1.2

Answer 142

Explanation B) When interest rates change by 1%, the approximate price change of a bond will be the bond's duration multiplied by the rate change. The bond's duration can be seven years only if it is a zero-coupon bond. No information in the facts states that it is a zero-coupon bond. The facts do state that the bond has a coupon. Therefore, its duration will be less than seven years. The only other indicated possibility is a five-year duration. So, a five-year duration multiplied by an interest rate change of 1% results in a price change of 5%. Because rates rose, the price of the bond must decrease. LO 4.1.2

Answer 143

Explanation D) The answer is $1,051.18. The present value of the bond is $1,051.18, calculated as follows: N = 10 (5 × 2); I/YR = 2.175 (4.35% ÷ 2); PMT = 27.50 (5.50% × 1,000 ÷ 2); FV = 1,000; solve for PV = 1,051.18, or $1,051.18. LO 4.1.1

Answer 144

B) The answer is $901.01. The intrinsic value of LJM's bond is $901.01, calculated as follows: N = 14 (7 × 2); I/YR = 5 (10% ÷ 2); PMT = 40 (8% × $1,000 ÷ 2); FV = 1,000; solve for PV = 901.01, or $901.01. LO 4.1.1

Answer 145

Explanation C) The answer is for a discount bond: coupon rate < current yield < yield to maturity. When a bond trades at a discount, its yield to maturity will be greater than its current yield, which will be greater than its coupon rate. LO 4.1.1

Answer 146

C) The answer is II, III, and IV. Only statement I is incorrect. If a bond's coupon rate is greater than the market yield, the bond will sell for more (at a premium) than its par value.

Answer 147

Explanation D) The answer is $1,079.93. Using the 3-year rate of 7% for the calculation: FV = 1,000 I/YR = 3.5 (7 ÷ 2) PMT = 50 (100 ÷ 2) N = 6 (3 × 2) PV = 1,079.9283, or $1,079.93 LO 4.1.1

Answer 148

A) Explanation The answer is II and IV. Convexity has an inverse relationship with coupon rate and a direct relationship with term to maturity. The higher the coupon, the lower the convexity. The longer the maturity the greater the convexity. LO 4.1.2

Answer 149

C) Explanation The answer is +4.49%. Given the inverse relationship between bond prices and market interest rates, the price of the bond must increase by 4.49%, calculated as follows: ΔP/P = –4.8 × [(0.06 – 0.07) ÷ (1 + 0.07)] = 0.0449, or 4.49%. LO 4.1.2

Answer 150

Explanation C) The answer is duration is the average weighted time it takes the bondholder to receive the interest and principal payments from a bond in present value dollars. Covariance measures the extent to which two variables move together, either positively (together) or negatively (opposite). Duration is a measure of the sensitivity of a bond's price to changes in interest rates. LO 4.1.2

Answer 151

D). Explanation The answer is weighted average time to maturity of bonds is 10 years with coupon of 5%. To immunize the portfolio, the duration of the portfolio should match the investor's time horizon. Coupon-paying bonds have durations that are less than their time to maturity. Zero-coupon bonds have durations equal to their time to maturity. LO 4.1.2

Answer 152

B) Explanation The answer is 2.8835 years. The duration for this bond is 2.8835 years, calculated as follows: Year Cash Flow(CF) (PV) of CF PV × Year 1 40.00 37.91 37.91 2 40.00 35.94 71.88 3 1,040.00 885.68 2,657.04 959.53 2,766.83 To solve for the PV of a given CF (example Year 1): FV = 40, N = 1, PMT = 0, 5.5 = I/YR, solve for PV. Divide the sum in the last column (2,766.83) by the total PV/market price of the bond (959.53) to derive the duration of 2.8835 years. LO 4.1.2

Answer 153

Explanation A) The answer is I and IV. Cash and accounts receivable are current assets. Taxes payable is a liability and goodwill is generally considered an intangible asset. LO 4.2.1

Answer 154

A) Explanation The answer is technical analysts rely heavily on financial ratios in their analysis of stocks. Analysts do not rely on financial ratios in their analysis of stocks. Instead, they rely on charts of past price history and volume to predict future price movements. LO 4.2.1

Answer 155

Explanation C) The answer is none of these. The efficient market hypothesis is in direct contradiction to technical analysis because the efficient market hypothesis is founded on the notion that all historical price and volume data, which is used by technical analysts, is already accounted for in the current stock price. LO 4.2.1

Answer 156

Explanation C) The answer is return on equity, earnings per share, and risk to stockholders. ROE and earnings per share are magnified with leverage, and the risk to stockholders increases as a firm's leverage increases. LO 4.2.2

Answer 157

Explanation D) The answer is 28%. $500,000,000 – $50,000,000 = $450,000,000 in equity. $125,000,000 profit ÷ $450,000,000 equity = 0.2778, or 28% ROE. LO 4.2.2

Answer 158

Explanation D) The answer is II and IV only. To increase ROE, the company would want to issue debt instead of equity. Warrants are an option to purchase additional equity that would increase the denominator of the equation. The issuance of additional shares of common stock does the same. Debt in place of equity can increase ROE, as can the reduction of interest expense, which increases the numerator of the equation. LO 4.2.2

Answer 159

B) Explanation The answer is $45.00. The intrinsic value of the stock is $45, using the perpetuity dividend discount model, calculated as follows: $4.50 ÷ 0.10 = $45. LO 4.3.1

Answer 160

B) The answer is $27.41. Using the constant growth dividend discount model, the stock has an intrinsic value of $27.41, calculated as follows: [$2.15 × (1 + 0.02)] ÷ (0.10 – 0.02) = $2.1930 ÷ 0.08 = $27.41. LO 4.3.1

Answer 161

A) Explanation The answer is $56.67. The formula for the discounted free cash-flow model: V = FCFE1 ÷ (r – g) = ($2.50 × 1.02) ÷ (0.065 - 0.02) = 2.55 ÷ 0.045 = 56.6667, or $56.67 LO 4.3.1

Answer 162

D) Explanation The answer is no, the stock is overvalued based on the constant growth dividend discount model. Based on the constant growth dividend discount model, the intrinsic value of the stock is $5.52, calculated as follows: [0.75 × (1 + 0.0125)] ÷ (0.15 – 0.0125) = 0.7594 ÷ 0.1375 = 5.5227, or $5.52. Because FER is currently trading at a price of $6.34 per share, it is overvalued, and the investor should not buy the stock. LO 4.3.1

Answer 163

Explanation C) The answer is $7.70. Calculate the intrinsic value of the stock using EPS and the P/E ratio, which is $7.70 ($3.50 × 2.2). LO 4.3.1

Answer 164

Explanation B) The answer is $35.00. The present (intrinsic) value of this investment is $35 ($3.50 ÷ 0.10) using the no-growth (perpetuity) dividend discount model. LO 4.3.1

Answer 165

Explanation D) The answer is yes, the stock is undervalued based on an intrinsic value of $39.82. Using the constant growth dividend discount model, the intrinsic value of the stock is $39.82. V = ($1.85 × 1.0225) ÷ (0.07 – 0.0225) V = 1.8916 ÷ 0.04750 V = 39.8232, or $39.82 Based on this value, the stock is undervalued relative to its price in the secondary market. LO 4.3.1

Answer 166

Explanation B) The answer is with an intrinsic value of $27.13, the stock is undervalued and should be added to the portfolio. The intrinsic value of the stock using the multistage growth dividend discount model is $27.13. Because the intrinsic value is greater than the fair market value, the stock is considered undervalued by the market and should be purchased for the portfolio. Compute the value of each future dividend until the growth rate stabilizes (Years 1-3). D1 = $1.35 × 1.02 = $1.38 D2 = $1.38 × 1.02 = $1.41 D3 = $1.41 × 1.02 = $1.44 Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes (Year 4). D4 = $1.44 × 1.03 = $1.48 V = $1.48 ÷ (0.08 – 0.03) = $29.60 Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock. CF0 = $0 CF1 = $1.38 CF2 = $1.41 CF3 = $1.44 + $29.60 = $31.04 I/YR = 8% Solve for NPV = 27.1272, or $27.13 LO 4.3.1

Answer 167

B) The answer is $187,500,000. The formula for the discounted earnings model: V = E ÷ RD = 15,000,000 ÷ 0.08 = 187,500,000 Using the discounted earnings method produces a current corporate valuation of $187,500,000. LO 4.3.1

Answer 168

C) Explanation The answer is 0.5263. Calculate the firm's PEG ratio as follows: 5.00 ÷ (0.095 × 100) = 0.5263. After calculating this ratio, it then would be compared to ABC Corporation's peers to determine whether a purchase is warranted. LO 4.3.2

Answer 169

Explanation C) The answer is 37.00. The firm's P/FCF ratio is 37.00, calculated as follows: (1 + 0.11) ÷ (0.14 – 0.11) = 37.00. After calculating this ratio, an investor would compare the result with the stock's peers to determine if a purchase is warranted. LO 4.3.2

Answer 170

Explanation The answer is Stock 2, because the return on investment is greater than Al's required rate of return. The intrinsic value of Stock 1 = $33 [($1.20 x 1.10) ÷ (0.14 - 0.10)]. Because $33 is less than $38, the stock is overvalued and would return less than his required return. The intrinsic value of Stock 2 = $36.67 [($1.00 x 1.11) ÷ (0.14 - 0.11)]. Because $36.67 is more than $30, the stock is undervalued and would return more than his required return. LO 4.3.2

Answer 171

Explanation D) The answer is 15.36. The formula for the price-to-sales (P/S) ratio: P/S = market price per share ÷ sales per share P/S = $25.65 ÷ $1.67 = 15.3592, or 15.36 This ratio would then be compared to its industry peers to determine whether the stock appears to be overvalued or undervalued. LO 4.3.2

Answer 172

Explanation D) The answer is a stock should be purchased if it is selling near its historic low P/E. While purchasing stocks near their historically high P/E ratio could continue to represent value, a much better time would be to purchase stocks that are at their historic low ratios. LO 4.3.2

Answer 173

D) Explanation | Near the money is not a term concerning option valuation.

Answer 174

B) Explanation Foreign markets have fewer analysts following stocks than do U.S. markets, and the information available from many foreign companies is minimal, making these markets less efficient than U.S. markets. The covariance of foreign stocks, especially small-cap and emerging market stocks, with U.S. stocks is relatively low, serving to lower the standard deviation of the portfolio in which such stocks are placed. Exchange rate risk is a systematic risk with foreign investments. Foreign income is taxed first in the country of origin and then again in the United States; U.S. taxpayers can take a foreign tax credit for taxes paid to other countries. LO 5.5.1

Answer 175

B) Explanation Most real estate investments are not readily marketable. Therefore, an investor in real estate can generally expect some difficulty in converting a property to cash if cash is needed quickly. However, a REIT securitizes real estate properties, thereby allowing REIT investors to easily sell REIT shares in the open market. REITs must flow through at least 90% their income to investors; therefore the investors and not the REITs pay tax on these distributions. LO 5.1.1

Answer 176

B) Explanation The antique/collectibles markets are inefficient, where supply is frequently limited, making supply an important consideration. Some rare and famous antiques may be in great demand and be marketable; for many, however, no, or a limited, market and demand may exist. Rising inflation generally encourages investors to purchase tangibles. Dealer reputation is important in the collectibles market to minimize fraud. LO 5.4.1

Answer 177

C) Explanation Government intervention has always been an issue for gold. The price was fixed for years and Americans were forbidden from owning gold. Although this has changed, the possibility of government intervention does exist. These positions are very speculative and are highly leveraged and risky. LO 5.4.1

Answer 178

B) Explanation Generally, collectibles do not provide an investor with predictable cash flows. Therefore, they would not be suitable for an income-seeking investor. LO 5.4.1

Answer 179

Explanation A) Buying an index option means the risk associated with any one company (business risk) is avoided. An index option can be used to participate in a broad market advance, but still has systematic risk. One would buy a put to hedge against a market decline. LO 5.2.2

Answer 180

D) Explanation From the statement of facts, the client wishes to continue holding the current portfolio but wants to hedge. Because the client is long stocks, the appropriate hedge is a short position, which is obtained by purchasing a put option. Because the portfolio is well diversified, an index put option will be an excellent choice. Selling an index put option provides more limited hedging than does buying a put option, as the loss is shielding only to the extent of the income per share received by the option seller. LO 5.2.2

Answer 181

A) Explanation This is known as the covered call strategy and is used to increase the income of the portfolio when the price of the underlying stock is expected to remain flat for a period of time. Assuming the price of the underlying stock continues to remain flat, there is little chance of the option being exercised and the stock being called away. LO 5.2.2

Answer 182

D) Explanation A short hedge is a transaction involving the sale of futures (a short position) while holding the asset (a long position); whereas, a long hedge is a transaction where the asset is not currently held but futures are purchased to lock in current prices. LO 5.3.1

Answer 183

D) Explanation intrinsic value of a put option = (exercise price − market price) = ($45 − $40) = $5 LO 5.2.1

Answer 184

D) Explanation A CMO differs from mortgage-backed securities in that the cash flows associated with the CMO's pool of underlying mortgages are divided into repayment periods known as tranches. LO 5.1.1

Answer 185

``` A) Explanation As risk (volatility) increases so does the value of an option. As an option approaches expiration there is less time for the option to be profitable, so the value decreases. An increase in rates lowers the present value of the funds needed to exercise, which in effect lowers the present value of the strike price, so the value of the option increases. ``` LO 5.2.1

Answer 186

C) Explanation The collectibles market is inefficient, with large spreads between bid and ask prices and untimely information on trades. Collectibles must be stored and insured, and their prices normally rise and fall with inflation to a greater extent than do financial asset prices. LO 5.4.1

Answer 187

C) Explanation ADRs are priced in U.S. dollars and therefore have exchange rate risk. LO 5.5.1

Answer 188

B) Explanation A revaluation occurs to a U.S. investor when the U.S. dollar can buy more of a particular foreign currency today than it could buy last year. A devaluation occurs when the U.S. dollar can buy less of a particular foreign currency today than it could buy last year. LO 5.5.2

Answer 189

B) Explanation The calculation is as follows: Potential gross income (PGI) of $1,500,000 less vacancy losses of $120,000 equals effective gross income of $1,380,000. Subtract operating expenses of $450,000, resulting in net operating income (NOI) of $930,000. Value = $930,000 ÷ 0.09 = $10,333,333. LO 5.1.1

Answer 190

D) Derivatives give the holder certain rights and options under certain specific conditions. They represent neither an equity (ownership) nor a debt (credit) interest in a corporation. LO 5.2.1

Answer 191

C) Explanation Futures contracts are standardized contracts for delivery, whereas a forward contract is custom made. LO 5.3.1

Answer 192

C) Explanation The answer is income attributed to limited partners is considered passive income for income tax purposes. Real estate limited partnerships (RELPs) are composed of at least two partners. Limited partners do not have any management responsibilities, and income attributed to them is treated as passive income by the IRS. RELPs are not publicly traded. LO 5.1.1

Answer 193

Explanation C) The answer is I, II, III, and IV. All of these statements are correct. A popular form of indirect ownership of real estate is to invest as a limited partner, usually through a non-publicly traded real estate limited partnership (RELP) or syndication. A real estate investment trust (REIT) serves as a source of long-term financing for real estate projects by investing in real estate, short-term construction loans, and mortgages. LO 5.1.1

Answer 194

Explanation B) The answer is mortgage REITs. Mortgage REITs are in the business of financing real estate ventures. They make loans to develop property or finance construction. LO 5.1.1

Answer 195

Explanation D) The answer is tranches. A CMO differs from mortgage-backed securities in that the cash flows associated with the CMO's pool of underlying mortgages are divided into repayment periods structured as tranches. LO 5.1.1

Answer 196

Explanation D) The answer is $4,045,333. First, calculate the net operating income for the Prairie View Apartments as follows: Gross rents (60 X $500 X 12) + (20 X $600 X 12) $504,000 Other income +15,000 Potential gross income (PGI) 519,000 Vacancy losses (8% of PGI) −41,520 Effective gross income 477,480 Operating expenses ($44,000 + 18,600 + 19,800 + 31,000) −113,400 Net operating income (NOI) $364,080 Value = NOI ÷ capitalization rate = $364,080 ÷ 0.09 = $4,045,333 LO 5.1.1

Answer 197

Explanation B) The answer is liquidity. Real estate is an illiquid investment. Real estate offers the ability to shelter an investment's cash flow. Income real estate provides a relatively dependable source of cash flow. Real estate offers investors an excellent source of long-term capital appreciation. LO 5.1.1

Answer 198

Explanation D) The answer is an investor who is bullish is likely to write a call. An investor who is bullish is likely to either purchase a call or write a put. An investor will write a call if he or she believes market prices will decline. LO 5.2.1

Answer 199

Explanation D) The answer is IV only. The Black-Scholes option valuation model assumes that the price of the option will change constantly because the market price of the underlying security also changes constantly and is designed to determine the price of a European call option. The binomial option pricing model assumes that the price of the option will change in discrete increments on the basis of movements (up or down) in the price of the underlying stock. LO 5.2.1

Answer 200

Explanation A) The answer is the maximum gain to the purchaser of a put option is the amount of premium received from the writer. The maximum gain to the purchaser of a put option is the exercise price less the amount of premium paid to the writer. The maximum loss to the purchaser of a put option is the amount of premium paid to the writer. LO 5.2.1

Answer 201

Explanation C) The answer is neither I nor II. A bullish investor will either purchase a call or write a put. A bearish investor will either write a call or purchase a put. LO 5.2.1

Answer 202

A) Explanation The answer is the option is out-of-the-money. The option is in-the-money because the option has a positive intrinsic value. The option has an intrinsic value of $0.33 ($20.00 – $19.67) and a time value of $0.20 ($0.53 – $0.33). LO 5.2.1

Answer 203

B) Explanation The answer is John's maximum gain is $3. John's maximum loss is unlimited. Because the call option was written as a naked call option, the seller (John) will have to buy the stock at the prevailing market price if the call option is exercised by the buyer. The buyer would exercise the call option when the stock price exceeds $20. Any price level over $20 begins to reduce the call option buyer's potential loss, and at $23 the seller and buyer break even. LO 5.2.1

Answer 204

Explanation B) The answer is purchasing a call option on the stock. To create a zero-cost collar, the investor will not purchase a call option on the stock. Rather, the investor will use the premium received from writing the call option to subsequently purchase the put option on the underlying stock, thereby creating a cashless collar and protection from downside risk. LO 5.2.2

Answer 205

Explanation C) The answer is purchase a put option. Danielle should purchase a put option (referred to as protective put or portfolio insurance) to protect herself from possible loss. Thereby, the portfolio is protected and the investor's loss on the option is limited to the amount of the premium paid for the put. LO 5.2.2

Answer 206

Explanation C) The answer is buying a put option on a stock already owned. A protective strategy limits downside risk. The purchase of a put option on a stock that is already owned reduces downside risk. If the price of a stock declines, the value of the put option increases and protects an investor holding a long position in the underlying stock. LO 5.2.2

Answer 207

A) Explanation The answer is increase in volatility. Long straddle profits if the volatility of the underlying security increases more than is reflected in current option prices, which would increase the value of both the call option and the put option. Either a significant increase or a significant decrease in the underlying price would benefit the holder of a long straddle. If the investor was expecting only an increase in price, long call would be a better choice of investment (as the premium paid on the long put would be a waste). LO 5.2.2

Answer 208

Explanation D) The answer is I only. Statement II is incorrect. At the end of the year, net gains on futures contracts are treated as 60% long-term and 40% short-term. LO 5.3.1

Answer 209

Explanation D) The answer is a futures contract is an agreement between two parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price. To complete the futures contract, delivery of the commodity or asset may be made, but more often, the buyer (or holder) simply purchases an offsetting contract and cancels the original position. LO 5.3.1

Answer 210

Explanation C) The answer is a long hedge; Jim should buy lumber futures contracts to protect against rising lumber prices. A long hedge uses a long futures position to hedge a short position (purchasing lumber). LO 5.3.1

Answer 211

Explanation B) The answer is the number of futures contracts outstanding for a commodity on any given trading day. Open interest is reported daily in the financial press. Traders like to be in the most active months of a contract for liquidity purposes. LO 5.3.1

Answer 212

Explanation B) The answer is I and IV. Statements II and III are incorrect. Investments in natural resources offer investors a high degree of risk and a negative correlation with other financial assets. LO 5.4.1

Answer 213

Explanation C) The answer is specialize in a type of collectibles. Specializing in a type of collectible would give an investor a better knowledge of that collectible and its market direction and worth. LO 5.4.1

Answer 214

Explanation D) The answer is economic or political uncertainty. Economic or political uncertainty causes the demand for gold to grow. LO 5.4.1

Answer 215

Explanation B) The answer is an emerging market is a market in a highly developed foreign economy with stable political and social institutions. Emerging markets are markets in lesser developed countries. LO 5.5.1

Answer 216

C) Explanation The answer is foreign taxes paid on income earned from an ADR are eligible for the foreign tax credit. Although ADRs are dollar denominated, they are still subject to exchange rate risk because the dividends are declared in the local currency and converted to U.S. dollars. ADRs are receipts for shares of a foreign company, not shares of a mutual fund. Because ADRs are traded in the secondary market, they are relatively liquid and marketable investments. Foreign taxes paid are eligible for the foreign income tax credit. LO 5.5.1

Answer 217

Explanation C) The answer is information is not as readily available on foreign investments. Foreign markets offer economies of scale and growth opportunities. Investors may earn higher returns in foreign markets, particularly if they are less efficient than U.S. markets. Including foreign securities in an investment portfolio may lower risk through greater diversification. LO 5.5.1

Answer 218

Explanation The answer is 900. Determine the cost in U.S. dollars to purchase one euro. Using the HP 10bII+: 0.90, SHIFT, 1/x = $1.1111 Then, $1,000 ÷ $1.1111 = 900 euros or $1,000 × 0.90 = 900 euros LO 5.5.2

Answer 219

Explanation C) The answer is I, II, and IV. When an investor has money invested in a foreign stock, the investor should want the dollar to decline relative to the foreign currency so that a currency gain occurs in addition to the security gain. Currencies are subject to the same supply/demand rules that apply to goods and services and to the money supply. Increasing supply results in decreasing price of the currency. LO 5.5.2

Answer 220

Explanation A) The answer is the yen would have to depreciate or remain steady relative to the dollar during the holding period of the bond. When an investor in Country A invests in a security in Country B, the investor benefits if Country A's currency depreciates relative to Country B (or Country B's currency appreciates relative to Country A). Because rising interest rates cause bond prices to decline, the best possible scenario would be for the yen to depreciate and for U.S. interest rates to fall. This would give both a capital gain and a currency gain. LO 5.5.2

Answer 221

D) Explanation Asset B is highly correlated with the S&P 500, and its beta is 1.0, indicating an expected increase similar to that of the S&P 500. Asset B has a correlation with the S&P 500 of 0.98 and a correlation with Frank's portfolio of only 0.03. Thus, Frank's portfolio is not highly correlated with the S&P 500. Asset A's coefficient of determination with respect to the S&P 500 is –0.72 × –0.72 = 0.52, or 52%, indicating that beta is a poor measure of risk for Asset A. LO 6.2.5

Answer 222

``` C) Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. ``` LO 6.1.1

Answer 223

A) Explanation Unsystematic (diversifiable) risk may be effectively managed through portfolio diversification. LO 6.1.1

Answer 224

Explanation A) All other things being equal, security prices move inversely to interest rate changes. LO 6.1.1

Answer 225

C) Explanation A beta of 1 represents the risk of the market. A beta of less than 1 represents risk less than the market's risk, and a beta of greater than 1 represents risk greater than that of the market. LO 6.2.1

Answer 226

B) Explanation A stock with a standard deviation of 20 will deviate from the mean by one standard deviation 68% of the time, two standard deviations 95% of the time, and three standard deviations 99% of the time. So for this stock, plus or minus 40 from the mean of 14% would be –26% and +54%. LO 6.2.2

Answer 227

C)Explanation By definition, an investment's return will be within one standard deviation of the mean return 68% of the time. The mean return of 18% plus or minus one standard deviation is 18% – 21% (–3%) and 18% + 21% (39%). LO 6.2.2

Answer 228

D)Explanation Chances are that past relative relationships will continue into the future. The smaller the dispersion of returns, the lower the risk associated with a particular investment. LO 6.1.1

Answer 229

B)Explanation J's coefficient of variation is 8% ÷ 13% = 0.615. I's coefficient of variation = 4% ÷ 10% = 0.40. I is less risky, on a risk-adjusted basis, than J. Because I and J are perfectly negatively correlated (correlation coefficient of –1.0), there exists a combination of I and J such that the standard deviation is zero. The expected return of a portfolio is the weighted average, which cannot be less than the lowest expected return of the portfolio components. LO 6.2.4

Answer 230

C) Explanation R-squared gives us the amount of systematic risk, and we have been given R (correlation coefficient). So, we square 0.85 to come up with an R-squared of 0.7225, or 72%. LO 6.2.5

Answer 231

C). Explanation All of these statements are correct. Investment risk may broadly be categorized as either unsystematic or systematic risk; both types of risk together constitute total, or absolute, risk. LO 6.1.2

Answer 232

C) Fixed-income securities are subject to a number of risks including purchasing power, liquidity, default, and reinvestment rate risk. LO 6.1.2

Answer 233

C) A standard deviation of 14% means an investor can expect a return on an investment to vary ±14 from the average return approximately 68% of the time. LO 6.2.2

Answer 234

D) Explanation Beta is a measure of systematic risk, not unsystematic risk. The beta coefficient may be used to help select a portfolio that is consistent with an investor's willingness to assume systematic risk. LO 6.2.1

Answer 235

D) Explanation Holding stocks that have a low correlation coefficient between them will result in a diversified portfolio that reduces and virtually eliminates the degree of unsystematic (business) risk in the portfolio. Buying stocks in international companies and stocks with low betas can help to reduce systematic risk, but only if they have low correlations with other stocks. Buying stocks in companies with strong revenue and earnings growth often results in acquiring significant company-specific risk that is attributable to the underlying business. LO 6.2.4

Answer 236

D) Explanation R-squared gives us the amount of systematic risk, and we have been given R (correlation coefficient). So we square 0.77 to come up with an R-squared of 0.5929, or 59%. LO 6.2.5

Answer 237

C) Explanation The answer is by increasing the number of securities in a portfolio, the total risk would be expected to fall at a decreasing rate. As more and more securities are added to a portfolio, diversification benefits begin to diminish. The main attraction of diversification is the reduction of risk without an accompanying loss of return. LO 6.1.1

Answer 238

C) Explanation The answer is unsystematic risk. Unsystematic risk can be diversified away by investing in approximately 10–15 large company stocks in different industries and 25–30 small company stocks in different industries. Systematic risk cannot be reduced by diversification. LO 6.1.1

Answer 239

Explanation D) The answer is neither I nor II. Realizing the greatest amount of return per unit of risk may be pursued by 1) having a longer (not shorter) investment time horizon, 2) structuring a portfolio that contains assets with low (not high) correlation to each other, or both. LO 6.1.1

Answer 240

C)Explanation The answer is default risk. Default risk is the risk that a business will be unable to service its debt obligations. LO 6.1.2

Answer 241

Explanation D) The answer is II, III, and IV. Business risk is a type of diversifiable, or unsystematic, risk. LO 6.1.1

Answer 242

Explanation A) The answer is business risk. Also known as nondiversifiable risk, systematic risk reflects the uncertainty of returns associated with an investment in any type of asset. Business risk is an example of an unsystematic risk. LO 6.1.2

Answer 243

Explanation D) The answer is default risk. Treasuries are considered default risk-free. Financial risk is the uncertainty introduced from the method by which a firm finances its assets (i.e., debt versus equity financing). Reinvestment rate risk is the risk that as cash flows are received they will be reinvested at lower rates of return than the investment that generated the cash flows. Systematic risk is the risk that all securities are subject to and typically cannot be eliminated through diversification. LO 6.1.2

Answer 244

Explanation B) The answer is I, II, and III. Their investment portfolio is subject to all of these risks except default risk. Investment manager risk is associated with the skills and philosophy of their mutual fund portfolio managers. Financial risk is the risk that a company's financial structure may negatively affect the value of an equity investment. By holding investments in international stock mutual funds, they are subject to exchange rate risk. LO 6.1.2

Answer 245

B) Explanation The answer is II, III, and IV. Only statement I is incorrect. A firm's decision to buy back some of its own stock in the open market by borrowing funds through a new bond issue is an example of financial risk. LO 6.1.2

Answer 246

A) Explanation The answer is the price of one currency relative to other currencies. Relative currency prices and changes to them are the basis of exchange rate risk. LO 6.1.2

Answer 247

D) The answer is financial risk. Financial risk is associated with the degree to which a company utilizes debt to finance its operations. LO 6.1.2

Answer 248

A) Explanation The answer is the weighed beta for the portfolio is 0.9340. Calculated as follows: (0.50 × 0.80) + (0.10 × 1.54) + (0.15 × 0.60) + (0.25 × 1.16) = 0.40 + 0.154 + 0.09 + 0.29 = 0.9340. With a beta of 1.54, Stock B is the riskiest; whereas Stock C, with a beta of 0.60, is the least risky. LO 6.2.1

Answer 249

D) Explanation The answer is less than 0.5. When seeking investments having the least amount of risk, the lowest beta should be selected. LO 6.2.1

Answer 250

Explanation C) The answer is that the stock is more volatile than the market. A beta that is higher than 1.0 indicates that the stock's volatility and risk are higher than that of the market. LO 6.2.1

Answer 251

Explanation D) The answer is 1.11. Keystrokes are 0.9, INPUT, 20, ∑+, 1.2, INPUT, 50, ∑+, 1.1, INPUT, 30, ∑+, SHIFT, 6 (alternate function is weighted average) = 1.11. LO 6.2.1

Answer 252

Explanation D) The answer is an investment exhibiting a high positive skewness and a leptokurtic distribution. Investments exhibiting high positive skewness have a larger than average number of positive price movements. Also, investments exhibiting a leptokurtic distribution have more observations clustered closely around the mean, resulting in a lower variance. Investors prefer a large number of positive returns with low risk. LO 6.2.2

Answer 253

Explanation The answer is 16%. The standard deviation of the returns is 16.98% and the arithmetic mean is 4.65%. One standard deviation to the right of 4.65% is 21.63%. Fifty percent of returns lie below 4.65% and an additional 34% of returns fall between 4.65% and 21.63% resulting in 16% of returns falling above 21.63%. Calculations: Arithmetic mean (18.5 − 14.3 + 9.75) ÷ 3 = 4.65% Standard deviation (keystrokes are shown for the HP 10bII+) 18. 5 [Σ+] 14. 3 [+/−][Σ+] 9. 75 [Σ+] [SHIFT] [Sx,Sy] (8 key) 16.9843, or 16.98% LO 6.2.2

Answer 254

Explanation The answer is 97.5%. The probability of a return above 24% is 50%. The probability of a return between 4% and 24% is 47.5% (95% ÷ 2). Therefore, the probability of a return above 4% is 97.5% (50% + 47.5%). LO 6.2.2

Answer 255

Explanation A) The answer is that the distribution is negatively skewed. A distribution with a mean that is less than its median is a negatively skewed distribution. A negatively skewed distribution is characterized by many small gains and a few extreme losses. Note that kurtosis is a measure of the peakedness of a return distribution. In a symmetrical distribution, the mean, median, and mode are all equal. LO 6.2.2

Answer 256

B) Explanation The answer is the security's returns can be expected to be between 5.8% and 22.6% approximately 68% of the time. This security can be expected to have a return that does not range beyond one standard deviation on either side of its average return approximately 68% of the time. LO 6.2.2

Answer 257

C). Explanation The answer is Stock J because it has the lowest coefficient of variation. The stock with the lower coefficient of variation (CV) provides the least amount of risk for a given level of return. CV = standard deviation of asset ÷ expected return of asset. Stock J: CV = 0.08 ÷ 0.115 = 0.6957 Stock K: CV = 0.06 ÷ 0.082 = 0.7317 LO 6.2.3

Answer 258

A) Explanation The answer is I only. The standard deviation is divided by the total return to obtain the coefficient of variation. A beta is higher does not mean that any higher return is acceptable. The client's fund has higher risk as measured by both standard deviation and beta, but taking this higher risk does not provide sufficient return based on the coefficient of variation calculation. LO 6.2.3

Answer 259

D) Explanation The answer is Stock B. The coefficient of variation is a measure of the degree of variation of returns compared with the expected mean return. The security with the lowest coefficient of variation is the one most likely to deliver periodic returns closest to its expected return. The coefficients of variation of the three securities are 1.47 for Stock A, 1.18 for Stock B, and 1.33 for Stock C. Stock B should be recommended. LO 6.2.3

Answer 260

B) Explanation The answer is 7.88%. To determine the standard deviation of a two-asset portfolio, use this formula: [W2Aσ2A + W2Bσ2B + 2WAWB(COVAB)]1/2 [(0.72 × 9.052) + (0.32 × 12.32) + (2 × 0.7 × 0.3 × 19.86)]1/2 [(0.49 × 81.90) + (0.09 × 151.29) + (8.3412)]1/2 [40.1310 + 13.6161 + 8.3412]1/2 62.08831/2 = 7.8796, or 7.88% Note the standard deviation for the portfolio is lower than the standard deviations for each security. This result directly supports the low correlation between the returns of ABC and MEJ. LO 6.2.4

Answer 261

D) Explanation The answer is combining two securities with perfect negative correlation provides no portfolio risk reduction. Combining two securities with perfect negative correlation could eliminate risk altogether. This is the principle behind hedging strategies. LO 6.2.4

Answer 262

Explanation C) The answer is covariance. Covariance is the most important variable in minimizing the standard deviation of a portfolio. The weight and standard deviation are not as critical as the covariance of the two securities. Beta is not used in the formula to compute a portfolio's standard deviation. LO 6.2.4

Answer 263

Explanation The answer is 14.66%. The covariance may be calculated first: COV = (23) × (16) × (0.25) COV = 92

Answer 264

Explanation The answer is 75%. The coefficient of determination explains the percentage of change in the dependent variable that can be explained by changes in the independent variable. Therefore, 25% (0.50 × 0.50) of returns are explained by changes in the market. To determine the percentage of returns that are explained by unsystematic risk, subtract the systematic risk from 1. Therefore, the return explained by unsystematic risk is (1 − 0.25) = 0.75, or 75%. LO 6.2.5

Answer 265

Explanation D) The answer is 64%. The correlation coefficient (R) has been given, so it needs to be squared (R2) in order to come up with the coefficient of determination (0.802 = 0.64). LO 6.2.5

Answer 266

B) Explanation The answer is 6.25%. The coefficient of determination is the square of the correlation coefficient (0.25)2 = 0.25 × 0.25 = 0.0625, or 6.25%. LO 6.2.5

Answer 267

D) Explanation HPR =750−470/ 470=0.596=59.6% LO 7.1.1

Answer 268

C) Explanation Sharpe uses standard deviation and assumes the portfolio is not well diversified and measures total risk. LO 7.2.1

Answer 269

C) Explanation The call premium is 3%, which would be a price of $1,030. The keystrokes are as follows: ``` HP 10bII+ (1040) PV 1030 FV 35 PMT 18 N I/YR = 3.3255 × 2 = 6.65% ``` LO 7.4.1

Answer 270

C) Explanation The $13.16 has grown to $14.78 over a three-year period, so ($13.16) is the PV: $14.78 FV, 3 N, and solve for I/YR, which equals 3.95%. LO 7.1.1

Answer 271

D) Explanation The simplest way to do this problem is to see how much $1 would have grown to over the four years, and then do a simple time value of money calculation. $1.00 × 1.12 × 1.18 × 1.22 × 0.87 = $1.4027. (1) PV, 1.4027 FV, 4 N, I/YR = 8.8281%. LO 7.1.1

Answer 272

A) Explanation For a price-weighted index, higher priced stocks have more influence on the overall movement of this index than lower priced stocks. For a market capitalization weighted index, such as the S&P 500, a stock with a market capitalization value of $25 million will have 10 times the impact of a stock with a market capitalization value of a $2.5 million company. LO 7.3.1

Answer 273

A) Explanation The formula for solving this problem is 8.75% ÷ (1 – 0.24) = 8.75% ÷ 0.76 = 11.51%. LO 7.4.1

Answer 274

D) Explanation Beta is the risk measure for alpha, but Sharpe uses standard deviation as its risk measure. Therefore, the reliability of beta is relevant for alpha. Jensen's alpha can be used by itself to judge an investment; the Sharpe ratio must be used in comparison with another Sharpe ratio in judging an investment. A negative alpha indicates the investment did not perform as well as expected given the risk taken. For example, an alpha of –1 means the investment underperformed by 1% compared to what it was expected to return. Accordingly, a negative alpha does not necessarily mean the investment lost money. LO 7.2.1

Answer 275

C) Explanation Janice should purchase the municipal bond based on the following after-tax yield calculations: U.S. Treasury bond [2.75% × (1 − 0.35)] 1.79% Corporate bond [5.25% × (1 − 0.35)] 3.41% Municipal bond (tax-free) 3.55% U.S Treasury note [2.25% × (1 − 0.35)] 1.46% LO 7.4.1

Answer 276

C) Explanation Higher priced stocks within this index have more influence on the overall movement of this index than lower priced stocks. That is, a $25 stock has five times the impact of a $5 stock. LO 7.3.1

Answer 277

C) Explanation The R-squared for all four funds is greater than 0.70, meaning beta is reliable. Alpha uses beta, and is a measure of absolute return, and the best measure to use if beta is reliable. The fund with the highest alpha is the Z fund. LO 7.2.1

Answer 278

``` D) Explanation HPR=sale price − purchase price / purchase price = 1 , 250 − 800 800 = 56.25 % LO 7.1.1 ```

Answer 279

C) Explanation This question can be answered with or without a calculation. We have nothing to compare Quest Mutual Fund to, and both Sharpe and Treynor are comparative measures, so neither can be used to evaluate the fund. The answer "Yes, because the fund has an 11% return" just restates the return of the fund without taking risk into account.

Answer 280

A) Explanation taxable equivalent yield = tax-exempt yield ÷ (1 − marginal tax rate) = 4.75% ÷ (1 − 0.32) = 6.99% LO 7.4.1

Answer 281

Explanation C) Because the portfolio is not fully diversified (only five stocks), the Sharpe ratio is the only one that can be used. This ratio uses standard deviation in its formula. Beta, which measures only systematic risk, assumes a diversified portfolio, and it is used in the Treynor ratio and Jensen's alpha. LO 7.2.1

Answer 282

D) Explanation This is a false statement. A bond is selling at par when the current yield equals the YTM. LO 7.4.1

Answer 283

C) Explanation CR = coupon rate CY = current yield YTM = yield to maturity Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate. LO 7.4.1

Answer 284

D) Explanation The simplest way to do this problem is to see how much $1 would have grown to over the four years, and then do a simple time value of money calculation. $1.00 × 1.19 × 1.12 × .92 × 1.14 = $1.3978. (1) PV, 1.3978 FV, 4 N, solve for I/YR = 8.73%. LO 7.1.1

Answer 285

D) Explanation The answer is 5.68%. The bond's yield to call is calculated as follows: Note: XYZ Company has the option to call the issue in five years. PV = (990) N = 10 (5 × 2) PMT = 23.75 (47.50 ÷ 2) FV = 1,040 (1,000 × 1.04) Solve for I/YR = 2.84 × 2 = 5.68% LO 7.4.1

Answer 286

B) Explanation The answer is Arithmetic mean = 8.50%; geometric mean = 7.80%. Arithmetic mean: [(2% + 5.5% − 9% + 18% + 26%) ÷ 5] = 8.50%. Geometric mean: PV = –1; FV = (1 + 0.02)(1 + 0.055)(1 – 0.09)(1 + 0.18)(1 + 0.26) = 1.4559; N = 5; solve for I/YR = 7.80%. LO 7.1.1

Answer 287

B) Explanation The answer is 14%. Total return on a stock or mutual fund may be thought of as the sum of the capital appreciation/depreciation on the underlying principal of the investment and any income or earnings generated from that investment. Therefore, Mary's total return equals 14% (3% + 2% + 9%). LO 7.1.1

Answer 288

C) Explanation The answer is 2.56%. Johnny realized a real rate of return of 2.56%. Real rate of return = {[(1 + 0.0425) ÷ (1 + 0.0165)] – 1} × 100 = 2.5578, or 2.56%. LO 7.1.1

Answer 289

C) Explanation The answer is 16.12%. The effective annual rate on his credit card is 16.12%, calculated as follows: EAR = [1 + (0.1495 ÷ 365)]365 – 1 = 0.1612, or 16.12%. LO 7.1.1

Answer 290

D) The answer is 17.46%. Jonathan earned a dollar-weighted rate of return of 17.46% on CPM stock over the three-year period, calculated as follows: CF0 = −12 × 500 = −6,000 CF1 = (−12 × 500) + (0.35 × 500) = −5,825 CF2 = (0.35 × 1,000) = 350 CF3 = (0.35 × 1,000) + (17 × 1,000) = 17,350 Solve for the internal rate of return (IRR/YR) = 17.4626, or 17.46% LO 7.1.1

Answer 291

C) Explanation The answer is 4.85%. The inflation-adjusted return (IAR) is computed as: IAR = [((1 + nominal rate of return) ÷ (1 + inflation rate)) − 1] × 100 = ((1.08 ÷ 1.03) − 1) × 100 = 4.8544, or 4.85% LO 7.1.1

Answer 292

A) Explanation The answer is 42.9%. This is calculated as: [($60 - $45) + $2 + $2.30] ÷ $45 = 42.9%. LO 7.1.1

Answer 293

D) Explanation The answer is 19.21%. Calculation follows: ``` HP 10bIi+ 4,300 +/–, CFj 180 CFj 180 CFj 200 CFj 225 CFj 230 + 8,900 =, CFj SHIFT, IRR/YR (answer = 19.21%) LO 7.1.1 ```

Answer 294

Explanation B) The answer is 4.45%. Keystrokes: ``` HP 10BII+ (set for 4 P/YR) 4000, +/–, CFj 30, CFj, 4, SHIFT, Nj 35, CFj, 3, SHIFT, Nj 4100, +, 35, =, CFj SHIFT, IRR/YR LO 7.1.1 ``` PreviousNextGo to Summary

Answer 295

Explanation A) The answer is all of the statements are correct. When compared with another investment, the higher the Treynor ratio, the better the risk-adjusted performance of the asset. Therefore, ABC Fund with a Treynor ratio of 0.0487 has a better risk-adjusted performance than XYZ Fund. XYZ Fund has a beta greater than ABC Fund, indicating a higher level of systematic risk. Calculations: Treynor ratio for ABC Fund is 0.0487 [(0.0865 – 0.05) ÷ 0.75] Treynor ratio for XYZ Fund is 0.0178 [(0.0678 – 0.05) ÷ 1.00] Sharpe ratio for ABC Fund is 0.6229 [(0.0865 – 0.05) ÷ 0.0586] Sharpe ratio for XYZ Fund is 0.1784 [(0.0678 – 0.05) ÷ 0.0998] LO 7.2.1

Answer 296

Explanation B) The answer is the Treynor ratio for the fund is 0.0400. Based on the information provided, the Treynor ratio for the fund is 0.0316, calculated as follows: Sharpe ratio = (0.0745 – 0.0350) ÷ 0.0455 = 0.8681 Treynor ratio = (0.0745 – 0.0350) ÷ 1.25 = 0.0316 Jensen's alpha = 7.45% – [3.50% + (8.50% – 3.50%) 1.25] = –2.30% When Jensen's alpha is positive, the fund manager outperformed the overall market. In this case, alpha indicates that the fund manager has underperformed. LO 7.2.1

Answer 297

Explanation A) The answer is 0.0538; 0.0400. Calculations are as follows. Trace's Treynor = (0.12 – 0.05) ÷ 1.3 = 0.0538 Market's Treynor = (0.09 – 0.05) ÷ 1 = 0.0400. The market has a beta of 1.0. LO 7.2.1

Answer 298

D) Explanation The answer is QUE over POI because QUE's Sharpe ratio is 2.38. QUE's alpha = 13% – [3.5% + (12% – 3.5%) 1.05] = 0.58% QUE's Treynor ratio = (0.13 – 0.035) ÷ 1.05 = 0.09 QUE's Sharpe ratio = (0.13 – 0.035) ÷ 0.04 = 2.38 QUE's coefficient of variation = 4% ÷ 13% = 0.31 Because QUE's R2 equals 67% (0.82 × 0.82), alpha and Treynor are not appropriate performance measures for comparison purposes. Because we do not know POI's coefficient of variation, we must use the Sharpe ratio to select the better risk-adjusted return. LO 7.2.1 PreviousNextGo to Summary

Answer 299

A) Explanation The answer is Option D. A decrease in the risk level decreases the denominator of the Sharpe ratio, while the numerator stays constant, thereby increasing the Sharpe ratio. The decreased risk level, as measured by beta, decreases the expected return for the fund, while the actual portfolio return remains constant, thereby increasing the alpha. LO 7.2.1

Answer 300

Explanation The answer is Jensen's alpha. The indicator that measures performance in relation to what was expected on a risk-adjusted basis is Jensen's alpha. A positive number (alpha) indicates that the manager performed better than expected on a risk-adjusted basis. LO 7.2.1

Answer 301

Explanation The answer is should be purchased, because the rate of return is high in relation to risk. A positive alpha indicates the fund performed better than it should have on a risk-adjusted basis. Also, an alpha of +4, which is very high, means it performed 4% better than expected. LO 7.2.1

Answer 302

Explanation D) The answer is Fund A, because it has a higher alpha. Alpha is a measure of risk-adjusted performance. Because it was given in the problem, no calculation is required. Alpha and the alpha can be used to determine which fund has the best risk-adjusted performance. LO 7.2.1

Answer 303

Explanation D) The answer is all of these statements are correct. Averages and indexes are constructed to inform investors about changes in the market. They also serve as benchmarks for the performance of investors' portfolios and the performance of money managers. LO 7.3.1

Answer 304

Explanation B) The answer is the S&P 500 Index automatically adjusts for stock splits and dividends by focusing on market value instead of price. The Russell 2000 Index is a well-known index used to benchmark small capitalization companies. A market average, not a market index, reflects the average price behavior of a group of stocks at a given point in time. An index measures the current price behavior of a group of stocks in relation to a base value. The Wilshire 5000 index is used as a measure of the U.S. broad market. LO 7.3.1

Answer 305

``` Explanation B) The answer is the percent change in the index value. Percentage changes in the value of a security market index over time represent the performance of the market, segment, or asset class from which the securities are chosen. ``` LO 7.3.1

Answer 306

Explanation The answer is 31%. The basic formula must be rearranged: ``` Tax equivalent yield = Tax-exempt yield 1 − Marginal tax rate (federal + state) ``` So, ``` Marginal tax rate = 1 − Tax-exempt yield Tax equivalent yield ``` Using this formula, we get: ``` 1 − 0.052 0.075 = 0.3067 ``` The closest answer, rounded, is 31%. At the 15% combined marginal bracket, the tax-equivalent yield is 6.12%; at the 28% combined marginal bracket, the tax-equivalent yield is 7.22%; and at the 35% combined marginal bracket, the tax-equivalent yield is 8%. But at the 31% combined marginal bracket, the tax-equivalent yield is 7.54%, which is the first bracket where the yield on the taxable bond (at 7.5%) is not high enough to justify purchasing it instead of the tax-exempt bond. LO 7.4.1

Answer 307

Explanation C) The answer is 5.51%. YTM: PV = –1,075, FV = 1,000, PMT = 32.50 (6.5% × 1,000 ÷ 2), N = 20 (10 × 2), solve for I/YR = 2.757 × 2 = 5.51%. The YTM on the bond is 5.51%, which is lower than the coupon rate of 6.5%, further validating that the bond is trading at a premium. LO 7.4.1

Answer 308

Explanation C) The answer is 8.06%. The note's YTM is computed as follows: PV = −938.12 PMT = 35 FV = 1,000 N = 8 × 2 = 16 Solve for I/YR = 4.03 × 2 = 8.06% LO 7.4.1

Answer 309

Explanation C) The answer is 6.78%. The bond's YTM is calculated as follows: PV = –1,025; FV = 1,000; PMT = 37.50 (1,000 × 7.5% ÷ 2); N = 8 (4 × 2); solve for I/YR = 3.388 × 2 = 6.78%. LO 7.4.1

Answer 310

D) Explanation The answer is 4.04%. The bond's TEY is calculated as follows: 2.75% ÷ (1 – 0.32). LO 7.4.1

Answer 311

Explanation A) The answer is 5.81%. The current yield is calculated as follows: $57.50 ÷ $989.50 = 0.05811, or 5.81%. LO 7.4.1

Answer 312

Explanation B) The answer is 8.33%. The current yield is calculated by dividing the bond's annual interest payment by the bond's current market price. Therefore, the current yield of this bond is 8.33% ($80 ÷ $960). LO 7.4.1

Answer 313

D) Explanation The answer is 5.68%. The bond's yield to call is calculated as follows: Note: XYZ Company has the option to call the issue in five years. PV = (990) N = 10 (5 × 2) PMT = 23.75 (47.50 ÷ 2) FV = 1,040 (1,000 × 1.04) Solve for I/YR = 2.84 × 2 = 5.68% LO 7.4.1

Answer 314

Explanation C) The answer is Bond A, AA rated municipal bond with a 3.5% coupon rate. Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Jane based on her desire for an investment-grade bond. Therefore, Bond A would be the best choice. Calculations: Bond A: 3.5% Bond B: 4.75% × (1 – 0.35) = 3.0875% Bond C: 6% × (1 – 0.35) = 3.90% Bond D: 1.5% × (1 – 0.35) = 0.9750% LO 7.4.1

Answer 315

``` D) Explanation Tactical asset allocation continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions and overall investor sentiment. ``` LO 8.5.2

Answer 316

A) Explanation Real assets, which includes gold and real estate, should do well in inflationary times. Bonds do poorly because interest rates will increase to fight inflation, and increases in interest rates cause bond prices to fall. LO 8.5.1

Answer 317

B) Explanation In general, rising interest rates result in falling stock and bond prices. LO 8.5.1

Answer 318

B) Explanation According to modern portfolio theory, the CML defines performance of a portfolio. All portfolios should plot on the CML in proportion to the risk of the portfolio. The Y axis is return and the X axis is the risk level. If a fund has superior performance, its return will be above the return level for the given risk level; if inferior, its return will be below the return level for the given risk level; and if it is in equilibrium, then it will plot exactly on the CML. LO 8.2.1

Answer 319

D) Explanation A properly crafted IPS will keep both the client and the advisor on track, and minimize any disagreements or confusion. LO 8.4.1

Answer 320

B) Explanation If information is generated randomly and information announcements are independent, prices will tend to fully reflect all available information. In addition, price changes will be independent of one another and tend to occur random patterns. LO 8.1.1

Answer 321

D) Explanation At any point along the efficient frontier the highest return for a given level of risk is present. The optimal portfolio is the point on the efficient frontier that intersects with the investor's indifference curve. LO 8.1.1

Answer 322

A) Explanation Investments purchased years ago will probably have a low tax basis, which could affect decisions to sell them, or they may have become worthless, in which case they can be used as a tax deduction. Likewise, the risk level of the investment is probably unknown and may not be compatible with the client's risk tolerance level and goals. LO 8.4.1

Answer 323

A) Explanation Required rate of return is 5.75% + (7.5%)1.25 = 15.13%. The fact that Roger believes 11% would be a good return is not relevant for computation of the required rate of return—only the computed market risk premium is relevant. The market return is computed as 7.5% + 5.75% = 13.25%. Roger will invest in an above-average risk stock (beta = 1.3) if he can be rewarded for taking the extra risk. The reward is the greater-than-market return of 15.13%. LO 8.2.1

Answer 324

A) Explanation Inside information may help in the semistrong form; fundamental analysis may help in the weak form; there is no hypothesis under which security prices are considered to be randomly determined. LO 8.3.1

Answer 325

B) Explanation One who believes that fundamental analysis can result in superior performance believes in the weak form of the EMH. The weak form states that all historical price information is fully reflected in the stock price, therefore technical analysis will not produce superior results. The semistrong hypothesis states that neither fundamental nor technical analyses deliver superior performance. The strong form states that all information, including insider knowledge, is already reflected in the stock price. LO 8.3.1

Answer 326

A)Explanation Technical analysis is not considered valuable under any of the forms of the EMH; fundamental analysis is considered valuable under the weak form only. LO 8.3.1

Answer 327

C) Explanation Neglected firms are those that are neglected (not followed) by many financial analysts. When such companies can be found, the market for those companies may not be efficient, and investors who can take the time to analyze these companies may be able to take advantage of undervalued situations. LO 8.3.1

Answer 328

D) Explanation If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns. LO 8.3.2

Answer 329

D) Explanation As an investor's required rate of return decreases, the present value of future benefits of the stock increases, and therefore the value of the stock increases. Investors will probably buy stocks because they perceive that interest rates are stabilizing. LO 8.5.1

Answer 330

C) Explanation Options III and IV are correct because beta, used in the CAPM formula to compute required return, is a measure of systematic risk. Option I is incorrect because the SML plots only risk/return relationships; it does not determine which is optimal. Option II is incorrect because beta is used on the SML, and standard deviation on the CML. LO 8.2.1

Answer 331

A) Explanation Long-term bonds decrease in value in a rising interest rate environment. Stock in public utilities and durable goods firms does not benefit from a rising interest rate environment. LO 8.5.1

Answer 332

A) Explanation Investors who follow an active approach to portfolio management will benefit most from a portfolio containing emerging market equities and U.S. small-cap stocks, which tend to be more volatile investments. LO 8.5.2

Answer 333

Explanation A) The answer is Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. Harry Markowitz's theory uses standard deviation as a measure of portfolio risk. LO 8.1.1

Answer 334

D) Explanation The answer is I, II, and III. The portfolio that lies at the point of tangency of an indifference curve and the efficient frontier is the optimal portfolio for the investor. LO 8.1.1

Answer 335

A)Explanation The answer is I, II, and IV. Efficient markets will not allow investors to consistently outperform the market. LO 8.1.1

Answer 336

Explanation C) The answer is represent all points where an investor is equally satisfied with the risk/return trade-off. Indifference curves express an individual's preference regarding two items - risk and return. The more risk averse an investor is, the steeper the slope is for that investor's indifference curve. Conversely, the less risk averse an investor is, the flatter the slope for that investor's indifference curve. LO 8.1.1

Answer 337

B) Explanation The answer is shows all portfolios that offer the highest expected returns for each level of risk. Efficient frontiers take all of the possible combinations of assets that can be held in a portfolio into account in order to represent the set of portfolios that offer the highest expected return for a given amount of risk. LO 8.1.1

Answer 338

A) Explanation The answer is both I and II. The development of the capital market line allows investors to see that the risk and the potential return of various asset classes do increase along a relatively straight line. LO 8.2.1

Answer 339

Explanation C) The answer is an increase in beta. All other factors remaining equal, an increase in beta will cause the risk premium to increase. In addition, the resultant expected rate of return will increase. LO 8.2.1

Answer 340

B) Explanation The answer is CAPM uses standard deviation as a measure of market risk. CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away. LO 8.2.1

Answer 341

B) Explanation The answer is beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. Beta is a measure of relative systematic risk for stock or portfolio returns. LO 8.2.1

Answer 342

Explanation C) The answer is expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return. LO 8.2.1

Answer 343

Explanation B) The answer is shows a security's expected return as a function of its systematic risk. The security market line (SML) shows the relationship between the rate of return and systematic risk (beta). Thus, the SML depicts a security's expected return as a function of its systematic risk. The intersection between the efficient frontier and a line from the risk-free rate depicts all the optimal portfolios composed of a combination of the market portfolio and the risk-free asset. The market portfolio is the only optimal portfolio comprised solely of risky securities. LO 8.2.1

Answer 344

Explanation D) The answer is provides a direct relationship between the risk and return for a well-diversified portfolio. The capital market line (CML) graphically depicts the relationship of risk and return for efficient well-diversified portfolios. The CML uses standard deviation as a risk measure. LO 8.2.1

Answer 345

B) Explanation The answer is semistrong. The semistrong form suggests that fundamental analysis is of no value and only through the use of insider information can an investor achieve above-market returns. LO 8.3.1

Answer 346

B) Explanation The answer is II and III. The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios. Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information and does not believe that the markets are efficient in the strong form. Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information. An investor studying annual reports and analysts' reports to make stock selections indicates that the person is conducting fundamental analysis, because the investor believes that the markets are weak-form efficient. LO 8.3.1

Answer 347

A) Explanation The answer is both I and II. The semistrong form states that all publicly available information, including past stock price history, is reflected in current stock prices.

Answer 348

C) Explanation The answer is index funds. An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques. The remaining choices all incorporate an active portfolio management philosophy. LO 8.3.2

Answer 349

B) Explanation The answer is the goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. This is net of transaction costs. Such a strategy also involves higher transaction costs and, usually, risk. LO 8.3.2

Answer 350

Explanation D) The answer is I and IV. In actuality, the investor is following a passive portfolio management style. The purpose of indexing is not to beat the market, but merely match its long-term performance. LO 8.3.2

Answer 351

Explanation A) The answer is with this analysis, the user is attempting to predict the variability of an option contract. A Monte Carlo simulation provides insight into the range of outcomes. With this analysis, the user gets a best-case and a worst-case scenario. LO 8.4.1

Answer 352

D) Explanation The answer is investment policy statement. The investment policy statement sets forth a client's objectives, sets limitations on the portfolio manager, provides guidance to the portfolio manager, and provides a means for evaluating performance. LO 8.4.1

Answer 353

B) Explanation The answer is II, III, and IV. The statement of financial position provides the planner with a list of assets stated at fair market value and any corresponding debt. Subsequently, the planner can analyze income-producing assets to determine whether they are generating income or growth at optimum levels or if there might be better alternatives for these assets. LO 8.4.1

Answer 354

A) Explanation The answer is tax bracket. Tax concerns play an important role in investment planning; however, these constitute an investment constraint, not an investment objective (i.e., risk tolerance). LO 8.4.1

Answer 355

A) Explanation The answer is provides for short-term strategy shifts in response to short-term dramatic value declines. The investment policy statement does not provide for shifts in strategy due to short-term value declines. LO 8.4.1

Answer 356

Explanation B) The answer is expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible. LO 8.5.1

Answer 357

A) Explanation The answer is I, II, III, and IV. In order to do an effective job of investment counseling, the adviser should examine and review the client's financial goals, risk tolerance and risk exposure, tax situation, liquidity and marketability needs, and financial statements. LO 8.5.1

Answer 358

D) Explanation The answer is changing market conditions play a large role in determining the proper asset allocation. With strategic asset allocation, periodic rebalancing is necessary to bring the portfolio back in line with the strategic mix, but changing market conditions play a very small role in determining the actual mix of the portfolio. LO 8.5.2

Answer 359

Explanation C) The answer is allows the investment manager to charge any fee possible to reach the client's financial goals. An investment policy statement may or may not address the fees and commissions due to the investment manager for handling the investment process for the client. However, the investment manager is restricted by contract on how the fee charged to a client for services rendered is calculated. LO 8.5.2

Answer 360

C) Explanation The answer is tactical asset allocation. Tactical asset allocation continuously adjusts the asset allocation in an attempt to take advantage of changing market conditions. LO 8.5.2

Answer 361

C) Explanation The answer is both I and II. Statements I and II are both correct. Asset allocation is the process of apportioning an investor's wealth among different countries and asset classes for investment purposes. LO 8.5.2

Answer 362

B) Explanation The answer is both I and II. Both of these statements are correct. LO 8.5.2

Answer 363

Explanation The answer is weak form. Frank is subscribing to the weak form of the EMH because he believes fundamental analysis and insider information will yield superior performance. LO 9.2.2

Answer 364

Explanation A) The answer is the 30-year, $50,000, zero-coupon Cooper Co. bond. If held to maturity, this bond provides the highest YTM. Calculations are shown using the HP 10bII+. 25-year, $15,000, 6% coupon U.S. Treasury bond: 13,138.64 [+/–] [PV] 15,000 [FV] 50 [N] 450 [PMT] Solve for [I/YR] 3.5321 (semiannual) × 2 = 7.06% YTM 30-year, $50,000, zero-coupon Cooper Co. bond: 4,093.40 [+/–] [PV] 50,000 [FV] 60 [N] 0 [PMT] Solve for [I/YR] 4.2593 (semiannual) × 2 = 8.52% YTM 5-year, $10,000, 7.5% coupon U.S. Treasury note: 10,351.18 [+/–] [PV] 10,000 [FV] 10 [N] 375 [PMT] Solve for [I/YR] 3.3313 (semiannual) × 2 = 6.66% YTM LO 9.2.1

Answer 365

Explanation D) The answer is as a result of the stock dividend, the fair market value (FMV) per share of Stock B will be approximately $72.73. A stock dividend is generally not taxable. As a result of the stock dividend, Frank will own 1,595 shares of Stock B, with a FMV of $116,000. The FMV per share and Frank's basis per share are both reduced proportionately to reflect the stock dividend. FMV: $116,000 ÷ 1,595 = $72.73; Basis: $114,000 ÷ 1,595 = $71.47. LO 9.1.2

Answer 366

Explanation D) The answer is JEM stock with a beta of 0.98. Because she considers herself to be a moderate risk investor, Julie would prefer a stock with a low beta. Investments exhibiting a platykurtic distribution have more observations dispersed further from the mean, resulting in a higher standard deviation. LO 9.2.1

Answer 367

B) Explanation The answer is both I and II. You must communicate any limitations on the scope of the engagement and your recommendations must be written and prepared in a clear, understandable manner. LO 9.3.2

Answer 368

D) Explanation The answer is II, III, and IV. UITs are considered unmanaged or passively managed because the initial securities (usually bonds) included in the portfolio are typically held until maturity. UIT units are sold at NAV plus a commission. Units are sold in the secondary market but not on the major exchanges. LO 3.3.1

Answer 369

Explanation B) The answer is low coupon and long maturity. Price volatility is measured by duration. Duration is inversely related to the bond's coupon rate and directly related to the bond's term to maturity. LO 4.1.2

Answer 370

D) Explanation The answer is tax deferral. Tax deferral is not an advantage of investing in REITs. REITs are professionally managed assets investing in a diversified portfolio of real estate holdings. Many REITs trade on the exchanges and over the counter, thereby providing investors with liquidity. LO 5.1.1

Answer 371

Explanation B) The answer is 4.67%. The real rate of return is 4.67%, calculated as follows: {[(1 + 0.065) ÷ (1 + 0.0175)] –1} × 100 = 0.0467, or 4.67%. LO 7.1.1

Answer 372

A) Explanation The answer is highest indifference curve is tangent to the efficient frontier. The optimal portfolio for an investor is determined as the point when the investor's highest indifference curve is tangent to the efficient frontier. LO 8.1.1

Answer 373

Explanation D) The answer is 13.30%. Using the capital asset pricing model, the expected rate of return is 13.30% [6.5% + (15% – 6.5%)0.80].

Answer 374

D) Explanation The answer is I and III. Startup capital is typically available at commercial banks and from investment bankers. It is not available through credit unions, which typically provide only consumer loans. Mutual funds invest in stocks or bonds on secondary markets. LO 1.1.1

Answer 375

B) Explanation The answer is daily pricing. ETFs are continually priced during a trading day, just like stocks. LO 3.4.1

Answer 376

A) Explanation The answer is 2.95%. The dollar-weighted return is calculated as follows: CF0 (2,500) [50 × $50] CF1 (520) [10 × $52] CF2 (530) [10 × $53] CF3 (450) [10 × $45] CF4 4,400 [80 × $55] Solve for IRR/YR = 2.95% LO 7.1.1

Answer 377

Explanation B) The answer is 12.25%. The bond's yield to maturity is calculated as follows: PV = –711.74 FV = 1,000 PMT = 6% × $1,000 ÷ 2 = 30 N = 7 × 2 = 14 (number of periods until maturity) I/YR = 6.1254 × 2 = 12.2508, or 12.25% LO 7.4.1

Answer 378

B) Explanation The answer is $66.37. Using the multistage growth dividend discount model, calculate JKL stock's intrinsic value: Step 1: Compute the value of each future dividend until the growth rate stabilizes (Years 1–2). D1 = $2.50 × 1.08 = $2.70 D2 = $2.70 × 1.08 = $2.92 Step 2: Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes (Year 3). D3 = $2.92 × 1.10 = $3.21 V = $3.21 ÷ (0.14 – 0.10) = $80.25 Step 3: Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock. CF0= $0 CF1= $2.70 CF2 = $2.92 + $80.25 I/YR= 14% Solve for NPV = $66.37 LO 9.2.2

Answer 379

Achieved D) Explanation Income from rental property is not subject to Social Security tax, nor are dividends to S corporation shareholders/employees as long as the employees' compensation is considered reasonable. LO 5.3.1

Answer 380

B) Explanation Christopher's self-employment income is $90,000. The dividends, interest, and K-1 distributions from the S corporation are not self-employment income. The self-employment tax is calculated as follows: $90,000 × 0.9235 = $83,115 net self-employment earnings. Total self-employment tax is $12,717 ($83,115 × 0.1530). LO 5.3.1

Answer 381

``` D) Explanation Taxable income $300,000 Federal income tax (80,000) Dividends paid (all in current year) (40,000) Accumulated earnings credit ($250,000 – $160,000)1 (90,000) Accumulated taxable income $90,000 20% Accumulated earnings tax $18,000 ``` 1The accumulated earnings credit is the $250,000 accumulation limit minus accumulated earnings and profits at the end of the preceding tax year. LO 5.2.1

Answer 382

B) Explanation A sole proprietorship is owned by one individual who is personally liable for the business and all its operations. Therefore, the business depends solely on the owner. LO 5.2.3

Answer 383

B) Explanation No deduction is allowed because the office is not used regularly and exclusively as a principal place of business for Jessica's insurance business, as required by the Internal Revenue Code to qualify as a deductible office expense. LO 5.4.1

Answer 384

A) Explanation Schedule C of Form 1040 (Profit or Loss From Business) would be used to report the income from a sole proprietorship. If it were a farm, the taxpayer would use Schedule F. LO 5.2.2

Answer 385

C) Explanation The accrual method of accounting is required when the sale of merchandise is an income-producing factor. LO 5.1.1

Answer 386

D) Explanation Because Yetunde had a profit in Years 3, 5, and 6, the hobby rules do not apply and Yetunde can use Schedule C to report income and expenses from her business. LO 5.4.2

Answer 387

``` B) Explanation IRS Form 2553—Election by a Small Business Corporation has to be filed by the 15th day of the 3rd month of the tax year. The shareholders must secure the consent of the IRS to be taxed as an S corporation. In general, only one class of stock is allowed in an S corporation. ``` LO 5.2.2

Answer 388

A) Explanation NOLs cannot be carried back but can be carried forward indefinitely years following the loss year. The loss is limited in amount to 80% of the total of taxable income reported for the carryforward years. In this case, the original 2019 $25,000 loss was carried forward and applied to the 2020 taxable income, reducing it to $3,000. The NOL in 2019 is then applied to the 2021 taxable income of $15,000, reducing it to $3,000. The balance of the NOL ($1,000) is a carryforward. LO 5.1.1

Answer 389

C) Explanation Gordon and his spouse have a $95,000 Section 1244 loss ($110,000 purchase price − $15,000 sale price) against ordinary income in the year the stock is sold. If a married investor sells Section 1244 at a loss (or if the stock becomes worthless), up to $100,000 of the loss may be deducted as an ordinary loss and is not subject to the $3,000 loss limitation. Any amount over the $100,000 will be treated as a capital loss subject to the $3,000 annual limitation ($1,500 if married filing separately) under the capital loss rule. LO 5.2.1

Answer 390

A) Explanation Statement III is incorrect. If Landry has not previously reported the hobby income and expenses, Richard should advise him to file amended returns, reporting the income on the front of the Form 1040. Hobby expenses are not deductible except for allocated property taxes and mortgage interest. LO 5.4.2

Answer 391

A) Explanation One similarity of a partnership and a C corporation is that they may both have more than one owner. However, only a C corporation is regarded as a distinct, separate entity for tax purposes. Partnerships are flow-through entities. C corporations may retain profits. Partnerships are not required to distribute profits equally. C corporations pay tax on income. LO 5.2.3

Answer 392

C) Explanation Tom can deduct 10% of all the expenses. The calculation is $9,000 × 10% = $900. A 10% depreciation deduction is also allowed based on the cost of the home. It should be noted that in order to take this deduction, Tom's gross income from the business must be sufficient to cover all of his other operating expenses in addition to the home office deduction. The deduction for home office expenses cannot create a loss from the business for the taxpayer. LO 5.4.1

Answer 393

A) Explanation Multiple ownership of an unincorporated business is characteristic of a general partnership. More than one owner personally liable indicates a general partnership business form. Common shareholders, preferred shareholders, and limited partners do not have personal property at risk; only their investment in the company is at risk. LO 5.2.3

Answer 394

B) Explanation Statements II, III, and IV are correct. Statement I is incorrect. Stock issued in exchange for services rendered to the issuing corporation does not qualify as Section 1244 stock. LO 5.2.1

Answer 395

A) Explanation The loss on the sale, exchange, or worthlessness of Section 1244 stock may be treated as an ordinary loss up to $100,000 annually on a joint return or $50,000 annually on any other return. Thus, as a single taxpayer, Jim has a $50,000 ordinary loss. Any excess loss is a capital loss—short- or long-term depending on the holding period. LO 5.1.1

Answer 396

A) Explanation Every regular corporation can accumulate up to $250,000 in retained earnings without having to prove a reasonable business need. LO 5.2.1

Answer 397

D) Explanation Both statements are correct. LO 5.3.1

Answer 398

D) Explanation All of these factors are strengths of the partnership form of business entity. LO 5.2.3

Answer 399

C) Explanation The cash method may be used because average annual gross receipts are under $26 million for the prior tax years. (This limit was increased by the Tax Cuts and Jobs Act, or TCJA.) The accrual method may always be used. The hybrid method may be used because the business involves both inventory and service. The installment method may not be used, as dealers are not allowed to use the installment method. LO 5.1.1

Answer 400

A) Explanation The accrual method of accounting generally is mandatory when inventory constitutes a significant income-producing factor. Thus, the cash method is incorrect. The hybrid method is incorrect because there is no indication that service constitutes a significant portion of the business. Also, the installment sale method is not available for sales of inventory, or sales with revolving credit terms. With annual sales of $30 million, the accrual method exception does not apply. If she had annual sales of under $26 (2020) million, she could still use the cash method, even though she has inventory. LO 5.1.1

Answer 401

B) Explanation A typical small business would use the cash method of accounting. Due to cost and complexity, the accrual and hybrid methods would NOT be recommended. A business is not required to use the accrual method until it has at least $26 million in gross receipts (2020). A business that has no inventory would not use LIFO. LO 5.1.1

Answer 402

B) Explanation Under the cash method of accounting, a taxpayer generally reports income when any cash is collected (or the constructive receipt income tax doctrine applies) and reports expenses when any cash payment is made. The accrual method is the conceptual opposite of the cash method and requires recognition of taxable income in the same tax year it is reported on the taxpayer's financial statements; it is mandatory for businesses maintaining inventory and have gross receipts in excess of $26 million. The hybrid method of accounting is a combination of the accrual method and the cash method of accounting. There is no IRS method of accounting. LO 5.1.1

Answer 403

C) Explanation Constructive receipt, which serves to accelerate income, is not considered an advantage of the cash method of accounting. LO 5.1.1

Answer 404

A) Explanation Because 50% of the preferred dividends received by a corporation are exempt from federal income taxes, a corporation gains a tax advantage. The government and nonprofit organizations pay no income taxes. Mutual funds are also exempt from taxation. (The Tax Cuts and Jobs Act, or TCJA, reduced the dividend-received deduction to 50%.) LO 5.2.1

Answer 405

Explanation Loss on the sale of Section 1244 stock is deductible as an ordinary loss up to $100,000 per year on a jointly filed return, or $50,000 on any other return (which applies to Jim as a single taxpayer). Any Section 1244 loss in excess of the annual limits is treated as a capital loss—long term or short term, depending on the holding period. The $100,000/$150,000 option would be correct if Jim were a married taxpayer filing jointly. LO 5.2.1

Answer 406

D) Explanation The accumulated earnings tax applies to corporate accumulated earnings in excess of $250,000, generally, for which there is no valid business reason for accumulating the funds. For a personal service corporation (PSC), the accumulations limit is $150,000. Engineering is one of the personal services specifically listed for determining a PSC. Expenses otherwise not allowed in computing the corporate income tax are allowed in computing the accumulated earnings tax, as is summarized here. (Note that the accumulated earnings credit of $60,000 is the difference between the $150,000 safe harbor and the $90,000 of accumulations at the beginning of the year.) The accumulated earnings tax rate is 20%, the highest rate that may apply to qualified dividends. ``` Taxable income $310,000 Federal income tax (80,000) Dividends paid (20,000) $210,000 Less: accumulated earnings credit (60,000) Excess accumulations $150,000 × 20% $30,000 LO 5.2.1 ```

Answer 407

B) Explanation The C corporation files a tax return with the IRS—this is the Form 1120. LO 5.2.1

Answer 408

A) Explanation The personal service corporation (PSC) classification for a C corporation was effectively repealed with the Tax Cuts and Jobs Act (TCJA). S corporations do not have corporate income tax rates. As an S corporation, all income would flow through to John to be taxed at his individual rates. LO 5.2.2

Answer 409

B) Explanation The S corporation form is similar to the partnership in operating as a conduit for tax purposes. It also is similar to a C corporation, since it features limited liability for shareholders. In addition, the death of a shareholder in an S corporation does not create a need to reorganize the business. Finally, unlike a C corporation, an S corporation may have no more than 100 shareholders. LO 5.2.2

Answer 410

C) Explanation All of the statements are correct. The fact that the shareholder has a minority interest in the corporation has no bearing on the correct answers. The flow-through of a proportionate share of net income is reported on the K-1. The shareholder is allowed to vote for the board. LO 5.2.2

Answer 411

A) Explanation An SSB is any trade or business involving the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; or, any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Thus, the medical practice would be an SSB, but none of the other businesses would. Engineering and architecture are specifically excluded from the definition of SSB. LO 5.2.2

Answer 412

``` C) Explanation An S corporation may have only one class of stock, although differences in voting rights are allowed within that one class of stock. An S corporation may have no more than 100 shareholders; however, the corporation must elect S status by filing a Form 2553—the treatment is not automatic. An S corporation may have passive income, although excess passive income may trigger the sting tax if the corporation had been a C corporation with earnings & profits (E&P). Nonresident aliens may not be shareholders in an S corporation. ``` LO 5.2.2

Answer 413

C) Explanation The investment planning fees are not deductible (the Tax Cuts and Jobs Act, or TCJA, repealed the Tier II miscellaneous itemized deductions). This expense may not be added to the basis of securities. The tax preparation fee is partly nondeductible (the portion attributable to the individual return), and the portion of the fee for completing the Schedule C is a business expense that would be deducted on the Schedule C. LO 5.2.3

Answer 414

D) Explanation The S corporation (and the partnership entities) are conduits, and would cause the income to be added to their other significant individual income. The use of the C corporation would allow for protection from lawsuits or business failure. Also, the general partnership and the limited partnership both would cause a flow-through of the income, and the general partnership would not provide protection from personal liability. There is no indication that either party wants to be a general partner in a limited partnership. The use of a C corporation would be appropriate since it is a separate taxable entity, and the profits would not flow through. They could receive a reasonable salary, and the qualified dividends that are paid out would be subject to long-term capital gain rates. LO 5.2.3

Answer 415

D) Explanation For a specified service business (SSB), if the taxpayer's taxable income is below the phaseout range of $163,300 to $213,300 (single 2020), the QBI deduction is fully available. An SSB involves performance of services in the fields of health, law, accounting, actuarial science, performing arts, veterinary services, consulting, athletics, financial services, or brokerage services. For pass-through entities, the owner/taxpayer may be allowed a deduction equal to 20% of the lesser of the QBI, or 20% of the taxpayer's taxable income (reduced by net capital gain). Thus, the available deduction is 20% of the QBI of $100,000, or $20,000. LO 5.2.3

Answer 416

D) Explanation The sole proprietorship is the business that files a Schedule C with the individual's Form 1040. The limited partnership files a Form 1065, and the C corporation files a Form 1120. The S corporation files an 1120-S. Note that a single-member LLC would also file a Schedule C, as it would be treated as a disregarded entity for income tax purposes. LO 5.2.3

Answer 417

A) Explanation The steps to calculate self-employment tax for 2020 where net income from self-employment is above the taxable wage base are as follows: Step 1: Calculate self-employment income. Step 2: Subtract 7.65% or multiply by 0.9235 (1 − 0.0765). Step 3: From Step 2, subtract the taxable wage base and multiply the excess over the taxable wage base by 2.9% (Medicare portion of the tax). Step 4: Multiply the taxable wage base by 15.3%. Step 5: Add the results of Steps 3 and 4 together to arrive at the total self-employment tax. LO 5.3.1

Answer 418

``` A) Explanation Only half (50%) of a taxpayer's self-employment tax liability is deductible as an adjustment to income. ``` LO 5.3.1

Answer 419

C) Explanation Bobby's total self-employment tax is $7,065 ($50,000 × 0.9235 = $46,175; $46,175 × 0.1530 = $7,065). LO 5.3.1

Answer 420

A) Explanation The items included in the computation of self-employment income are the Schedule C income and the flow-through of general partnership operating income. The total of these items is $27,000. This is then reduced by 7.65% of this amount, and then multiplied by 15.3% to give us $3,815. Remember, the 7.65% subtraction always applies. Because the total of the self-employment income and the wages received are less than the wage base, no special computation is necessary. LO 5.3.1

Answer 421

D) Explanation The general partnership operating income is self-employment income. By definition, the other items of income are not subject to the self-employment tax. LO 5.3.1

Answer 422

D) Explanation The distributive share of income from an S corporation is not subject to the self-employment tax. ``` Actual earnings $60,000 Less: 7.65% – (4,590) Net earnings from self-employment $55,410 Multiply by × 15.3% Self-employment tax $8,478 LO 5.3.1 ```

Answer 423

C) Explanation Wages and salary paid to an S corporation shareholder are not self-employment income. LO 5.3.1

Answer 424

B) Explanation Both the relative square footage of the home office area and the relative number of rooms may be used in determining the business part of a home. The amount of utility use can be a deduction, but is not used in determining the business part of a home. There is no recognized method known as the relative use method of allocation. LO 5.4.1

Answer 425

C) Explanation The home office expense deduction is limited to the earned income from the business. In other words, the home office expense deduction can generally neither create nor add to a loss. In this situation, the $61,000 of gross income is reduced by the $63,000 of business expenses not associated with the home office, to leave no earned income. Thus, of the $4,200 of home office expenses, none would be deductible in the current year. Note that the entire $4,200 of home office expenses would be subject to a carryforward. LO 5.4.1

Answer 426

C) Explanation Because Sandy is self-employed, she can deduct her qualifying home office expenses when calculating AGI (as a line item on Schedule C). The amount of her home office expense deduction this year is limited to the net income from her business. A profit from the business is not one of the tests for qualification of a home office for tax deduction purposes. Rather, it is one of the limitations on the deductible amount after it qualifies. LO 5.4.1

Answer 427

B) Explanation The fact that this business has not been profitable and is merely a side business increases the likelihood it could be reclassified as a hobby loss. Mike has operated the business only part time, and he has not demonstrated that he is attempting to make it a profitable business. The fact that huge losses have occurred every year overrides the presumption that Mike is in the business to make a profit. LO 5.4.2

Answer 428

A) Explanation Starting in 2018, due to the passage of the Tax Cuts and Jobs Act (TCJA), most hobby expenses are no longer deductible with the notable exception of cost of goods sold. LO 5.4.2

Answer 429

C) Explanation The deduction is based on the lesser of basis or the decrease in FMV—reduced by the insurance, the $100 floor per occurrence, and 10% of AGI. Lesser of decrease in FMV ($22,000) or adjusted basis ($17,000) ``` $17,000 Less insurance coverage (12,000) $5,000 Less $100 floor (100) $4,900 Less 10% of AGI (3,500) Deductible loss on Schedule A $1,400 ``` LO 6.2.3

Answer 430

D) Explanation An exchange of an apartment building for commercial rental property may be a like-kind exchange. As long as qualifying real property (property used in a trade or business or held for investment purposes) is exchanged for qualifying real property, the exchange is like-kind. LO 6.2.2

Answer 431

A) Explanation Use of the once-in-a-lifetime exclusion prior to May 7, 1997, does not preclude use of the full Section 121 exclusion for sales after that date. Thus, Lawrence may exclude the entire gain of $200,000. His gain recognized (the taxable gain) would be $0. LO 6.2.5

Answer 432

B) Explanation The cost basis of the property, $12,000, would be reduced by the cost recovery deductions taken ($7,392). This leaves an adjusted basis of $4,608. When the property subsequently sold for $13,000, the difference between the sales price ($13,000) and the adjusted basis of $4,608 was the gain realized ($8,392). The recapture is the lesser of the gain realized ($8,392) or the cost recovery deductions taken ($7,392). The remaining $1,000 gain is Section 1231 gain. LO 6.1.3

Answer 433

D) Explanation The substitute basis of a qualifying asset received in a like-kind exchange is the asset's fair market value reduced by the gain realized but not recognized. The deferred gain reduces the basis of the acquired asset, such that when that asset is sold, there is a larger gain recognized. LO 6.2.2

Answer 434

D) Achieved Explanation The Section 179 expense is first limited by the amount of qualifying property placed in service during the tax year. To the extent that the taxpayer purchases and places into service more than $2.59 million of qualifying property during the tax year, the benefit of the Section 179 election is reduced on a dollar-for-dollar basis. In this situation, Stanton placed an excess $120,000 of property into service. This reduces the maximum election from $1.04 million to $920,000—this is the maximum Section 179 expense of $1.04 million reduced by the dollar amount of property placed into service in excess of $2.59 million. The Section 179 expense election is then limited to the taxpayer's taxable, or earned, income. Because the business is a sole proprietorship, for purposes of Section 179, salary or wages received as an employee are considered to be from the active conduct of a trade or business. Thus, the total earned income in this situation is $415,000. The maximum Section 179 expense election is $920,000, but for Stanton, the current year deduction is limited to his earned income of $415,000. LO 6.1.5

Answer 435

D) Explanation Remember that the commission paid reduces the gain realized. The gain realized from the sale is $300,000 ($380,000 sale price, reduced by the $20,000 commission and the basis of $60,000). After subtracting the $250,000 Section 121 exclusion, the gain recognized is $50,000. LO 6.2.5

Answer 436

B) Explanation The profit on the sale of $17,000 divided by the $22,000 contract price equals a 77.27% gross profit percentage. This is multiplied by the $6,000 of payments received during the year to calculate the amount of gain recognized ($4,636): ``` $ 17,000 profit $ 22,000 contract price = 77.27 % × $ 6,000 payments = $ 4,636 recognized LO 6.2.4 ```

Answer 437

C) Explanation The gain realized is $604,000. This is the difference between the sales price of the residence—$916,000—and the basis of $312,000. They lived in the new home for only 19 months before the old home sold. Thus, for the previous home, they meet the two-out-of-five-year rule allowing for up to a $500,000 exclusion of gain on the sale of a principal residence under Section 121. The realized gain of $604,000, reduced by the $500,000 exclusion, leaves a gain recognized (subject to tax) of $104,000. LO 6.2.5

Answer 438

C) Explanation The Section 179 deduction is subject to a taxable (earned) income limitation. Because the business is a sole proprietorship, wages received (even from a completely unrelated source) are considered to be from the active conduct of a trade or business. With only $20,000 of earned income, only $20,000 may be used. LO 6.1.5

Answer 439

D) Explanation The maximum Section 179 election amount available to VUE Corp. is $25,000. The election is limited to the lesser of the cost of the asset, the amount of business taxable income, or the annual Section 179 election amount for 2020 ($1,040,000). LO 6.1.5

Answer 440

A) Explanation Of the current year's $11,000 Section 1231 gain, $7,000 is treated as ordinary income. This is due to the $7,000 of unrecaptured Section 1231 losses during the five-year lookback period. The remaining $4,000 of current Section 1231 gain is treated as long-term capital gain. LO 6.1.4

Answer 441

A) Explanation There is $114,000 of unrecaptured Section 1250 income, creating 25% long-term capital gain; and $100,000 of regular long-term capital gain (at taxable income of $190,000, it is 15% rate). Calculate the gain realized and recognized: Amount realized $400,000 Less adjusted basis (186,000) Gain realized and recognized $214,000 Calculate the unrecaptured Section 1250 (25% LTCG) income: Lesser of: (a) Straight-line depreciation taken $114,000 (b) Gain realized and recognized $214,000 Lesser of these two amounts $114,000 Calculate the regular long-term capital gain: Gain recognized $214,000 Less unrecaptured Section 1250 income (25% long-term capital gain) (114,000) Regular long-term capital gain $100,000 In this example, we have total gain recognized (Section 1231 gain) of $214,000, comprised of $114,000 of unrecaptured Section 1250 income and taxed at a maximum rate of 25%, and $100,000 of regular long-term capital gain, eligible for the maximum 15% or 20% long-term capital gain rates. The gain created by the straight-line depreciation on realty is unrecaptured Section 1250 income, subject to a maximum rate of 25%. The gain created by actual appreciation of the asset is regular long-term capital gain under Section 1231. LO 6.1.4

Answer 442

D) Explanation The basis of property acquired by inheritance where the administrator elects the alternate valuation date is the fair market value on that alternate valuation date. Thus, in this situation, the fair market value of $10 as of the alternate valuation date would be Frank's basis in the inherited property. LO 6.1.1

Answer 443

B) Explanation The net debt relief is considered to be boot, as is the cash received. The net debt relief of $11,000 plus the cash received of $7,000 equals $18,000. LO 6.2.2

Answer 444

``` C) Explanation Section 1231 gains $8,000 Less Section 1231 losses (1,000) Current year net Section 1231 gain $7,000 Lesser of: (a) Unrecaptured net Section 1231 ``` losses claimed during the lookback period $2,000 (b) Current year's net Section 1231 gain $7,000 Current year's net Section 1231 gain characterized as ordinary income $2,000 LO 6.1.4

Answer 445

C) Explanation The cost of the duplex of $79,500 is increased by the capitalized costs (i.e., $800 for the attorney's fees and $7,500 for improvements). This amount would be reduced by the cost recovery deduction of $3,000, leaving an adjusted basis of $84,800. The repairs of $1,900 represent a current deduction and therefore do not impact the basis of the property. LO 6.1.2

Answer 446

C) Explanation When using the specific identification method of computing basis in the sale of mutual fund shares, it is necessary to identify the shares being sold based on their purchase date. The documented basis of those shares is then used to compute the gain (or loss) realized. LO 6.2.1

Answer 447

C) Explanation The freight and setup charges of $600 must be capitalized—that is, added to the cost of the computer—to give a total basis of $4,900. The first-year deduction using the MACRS table is 20%. Thus, 20% times $4,900 equals $980. Please note that the MACRS table has all applicable conventions already built into the table; therefore, no adjustment is necessary for the half-year convention. Note that bonus depreciation is not used, as the fact pattern states to use the MACRS table. LO 6.1.3

Answer 448

D) Explanation The basis of property acquired by inheritance is simply the fair market value on the date of the decedent's death. In this case, that value was $9 per share. LO 6.1.2

FP513 Investing Flashcards

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