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Hock P2 2020Section B - Corporate Finance.
Answers
Section B - Corporate Finance.
1. Question ID: CIA 1191 IV.50 (Topic: Risk and Return)
From the viewpoint of the investor, which of the following securities provides the least
risk?
A. Income bond.
B. Mortgage bond.correct
C. Debenture.
D. Subordinated debenture.
Question was not answered
Correct Answer Explanation:
A mortgage bond is secured with specific fixed assets, usually real property. Thus,
under the rights enumerated in the bond indenture, creditors will be able to receive
payments from liquidation of the property in case of default. In a bankruptcy proceeding,
these amounts are paid before any transfers are made to other creditors, including
those preferences. Hence, mortgage bonds are less risky than the others listed.
Explanation for Choice A:
An income bond pays interest only if the issuer achieves a certain level of income. Such
bonds are riskier than bonds that carry a stated interest rate because the payment of
interest on income bonds is not guaranteed. An income bond would not have the least
risk among the answer choices.
Explanation for Choice C:
Debenture bonds are unsecured bonds, meaning they are not backed by any specific
asset as collateral. A debenture bond would not have the least risk among the answer
choices.
Explanation for Choice D:
A subordinated debenture is unsecured and has a lower (inferior) claim than other
bonds have on the assets of the company in the event of a bankruptcy. Subordinated
debentures have a claim on the debtor's assets that may be satisfied only after senior
debt has been paid in full. A subordinated debenture would not have the least risk
among the answer choices.
2. Question ID: CIA 589 IV.49 (Topic: Risk and Return)
Which of the following classes of securities are listed in order from lowest
risk/opportunity for return to highest risk/opportunity for return?
A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds;
preferred stock.correct
, Hock P2 2020
Section B - Corporate Finance.
Answers
B. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;
corporate income bonds.
C. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;
subordinated debentures.
D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
Question was not answered
Correct Answer Explanation:
The general principle is that risk and return are directly correlated. U.S. Treasury
securities are backed by the full faith and credit of the federal government and are
therefore the least risky form of investment. However, their return is correspondingly
lower. Corporate first mortgage bonds are less risky than income bonds or stock
because they are secured by specific property. In the event of default, the bondholders
can have the property sold to satisfy their claims. Holders of first mortgages have rights
paramount to those of any other parties, such as holders of second mortgages. Income
bonds pay interest only in the event the corporation earns income. Thus, holders of
income bonds have less risk than shareholders because meeting the condition makes
payment of interest mandatory. Preferred shareholders receive dividends only if they
are declared, and the directors usually have complete discretion in this matter. Also,
shareholders have claims junior to those of debt holders if the enterprise is liquidated.
Explanation for Choice B:
The proper listing among the securities listed is corporate first mortgage bonds,
corporate second mortgage bonds, corporate income bonds and common stock.
Common stock is the riskiest type of instrument.
Explanation for Choice C:
The proper listing among the securities listed is corporate mortgage bonds,
subordinated debentures, corporate income bonds, and convertible preferred stock.
Subordinated debentures are less risky than income bonds and convertible preferred
stock becauase even though subordinated debentures are unsecured debt instruments,
their holders have enforceable claims against the issuer even if no income is earned or
dividends declared.
Explanation for Choice D:
The proper listing among the securities listed is corporate mortgage bonds, corporate
debentures, preferred stock, and common stock. Preferred shareholders receive
preference over common shareholders in an asset distribution in a liquidation and they
generally must receive their dividend before common stockholders receive any
dividend.
3. Question ID: CIA 1192 IV.57 (Topic: Risk and Return)
, Hock P2 2020
Section B - Corporate Finance.
Answers
An investor is currently holding income bonds, debentures, subordinated debentures,
and first-mortgage bonds. Which of these securities traditionally is considered to have
the least risk?
A. Subordinated debentures.
B. Income bonds.
C. First-mortgage bonds.correct
D. Debentures.
Question was not answered
Correct Answer Explanation:
A mortgage bond is secured with specific fixed assets, usually real property. Thus,
under the rights enumerated in the bond indenture, creditors will be able to receive
payments from liquidation of the property in case of default. In a bankruptcy proceeding,
these amounts are paid before any transfers are made to other creditors, including
those preferences. Hence, mortgage bonds are less risky than the others listed.
Explanation for Choice A:
A subordinated debenture is unsecured and has a lower (inferior) claim than other
bonds have on the assets of the company in the event of a bankruptcy. Subordinated
debentures have a claim on the debtor's assets that may be satisfied only after senior
debt has been paid in full. A subordinated debenture would not have the least risk
among the answer choices.
Explanation for Choice B:
An income bond pays interest only if the issuer achieves a certain level of income. Such
bonds are riskier than bonds that carry a stated interest rate because the payment of
interest on income bonds is not guaranteed. An income bond would not have the least
risk among the answer choices.
Explanation for Choice D:
Debenture bonds are unsecured bonds, meaning they are not backed by any specific
asset as collateral. A debenture bond would not have the least risk among the answer
choices.
4. Question ID: CIA 1187 IV.66 (Topic: Risk and Return)
A measure that describes the risk of an investment project relative to other investments
in general is the
A. Expected return.
B. Standard deviation.
C. Coefficient of variation.
, Hock P2 2020
Section B - Corporate Finance.
Answers
D. Beta coefficient.correct
Question was not answered
Correct Answer Explanation:
The required rate of return on equity capital in the capital asset pricing model is the risk-
free rate (determined by government securities), plus the product of the market risk
premium times the beta coefficient (beta measures the firm's risk). The market risk
premium is the amount above the risk-free rate that will induce investment in the
market. The beta coefficient of an individual stock is the correlation between the
volatility (price variation) of the stock market and that of the price of the individual stock.
For example, if an individual stock goes up 15% and the market only 10%, the stock's
beta is 1.5. For this reason, beta is a measure that describes the risk (volatility) of an
investment project relative to other investments in general (the market).
Explanation for Choice A:
The expected return of an investment is the weighted average of all of the possible
investment returns, with the probabilities of each return occurring serving as the
weights. It is not a measure that describes the risk of an investment relative to other
investments in general.
Explanation for Choice B:
The standard deviation of the probable expected future returns of an investment is
the absolute measure of the investment's risk. It is not a measure that describes the
risk of an investment relative to other investments in general.
Explanation for Choice C:
The coefficient of variation compares risk with expected return (standard deviation
expected return).
5. Question ID: HOCK CMA P2 SDV1 (Topic: Risk and Return)
New Company's sales and profits are growing rapidly, and so is its dividend. Its dividend
is growing at an annual rate of 25%. This growth in the dividend is expected to continue
for two years. After that, the rate of growth is expected to slow down to 10% per year.
The investors' required rate of return on the stock is 16%. The next annual dividend is
expected to be $1.00. The beta of New Company's stock is 1.5. The U.S. Treasury bill
rate is 4%.
What is the expected market rate of return?
A. 16.0%
B. 10.67%
C. 12.0%correct
D. 14.67%
Question was not answered
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