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INVESTMENTS I – CHAPTER 7

An investor should buy a stock only if the prevailing market price exceeds the intrinsic value of the stock.
False
An investment should offer an expected return commensurate with the risk involved.
True
Advocates of the efficient market hypothesis would argue that it is virtually impossible for any investor to consistently outperform the market.
True
Investors who believe that most securities are efficiently priced should not not be concerned with fundamental analysis.
False
Fundamental analysis can only be profitable if some securities are at least temporarily mispriced.
True
Markets can only be efficient if many competent analysts are performing fundamental analysis.
True
One of the basic premises of security analysis, and in particular fundamental analysis, is that

A) a stock’s price is based on its past cash flows rather than on anticipated future cash flows.
B) market sectors do not move in concert with business cycles.
C) all securities have an intrinsic value that their market value will approach over time.
D) a security’s risk has relatively little effect on the security’s return.

C
The intrinsic value of a security is based on the
I. amount of risk.
II. current market value of the security.
III. discount rate applicable to the security.
IV. estimated future cash flows from the security.

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

D
The three steps in determining a stock’s intrinsic value are
I. estimating the stock’s future cash flows.
II. estimating the risk associated with future cash flows.
III. careful analysis of patterns in the stock’s recent price history.
IV. estimating an appropriate discount rate to apply to future cash flows

A) III and IV only
B) I, II and IV only
C) I, III and IV only

B
The security analysis process should help investors to
I. purchase investments that are priced at or above their intrinsic value.
II. sell investments that are priced at or above their intrinsic value.
III. purchase investments that are priced at or below their intrinsic value.
IV. identify investments appropriate for their goals.

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

D
Top-down security analysis

A) starts with the fundamental analysis of a firm.
B) includes economic, industry, and fundamental analysis.
C) concentrates on the competency of the senior management of a firm.
D) centers on the past performance of a firm.

B
Top-down security analysis begins with

A) an analysis of a company’s top management.
B) determining an investment’s risk and an appropriate discount rate.
C) an analysis of broad economic factors affecting the financial markets.
D) identifying specific industries that are likely to grow faster than the overall economy.

C
Fundamental analysis involves the in-depth study of the

A) role of nondiversifiable risk in an investor’s portfolio.
B) financial condition and operating results of a given firm.
C) pattern of security prices as revealed in chart formations.
D) role of diversifiable risk in an investor’s portfolio.

B
Investment analysts who believe that a thorough investigation of a company’s financial condition, product development, management and other intrinsic factors can discover stocks that are priced above or below their intrinsic value are advocates of

A) fundamental analysis.
B) behavioral analysis.
C) the efficient market hypothesis.
D) technical analysis.

A
Firms tend to be more profitable and have higher stock values when the economy is strong.
True
The purpose of economic analysis is to gain an insight into the underlying health or vitality of the economy and to formulate expectations about future security prices.
True
The business cycle reflects economic changes only in the industrial sectors of the economy.
False
The best time to buy stock is at the peak of an economic cycle.
False
Developing a general economic outlook assists in the identification of industries and firms that might be good investment opportunities.
True
Federal budget deficits tend to further depress an already depressed economy.
False
Changes in stock prices tend to lag changes in level of economic activity by several months.
False
Economic analysis is relatively useless for investment purposes since the stock market is used to forecast the economy.
False
Which measure of the business cycle represents the market value of all goods and services produced in a country over a twelve-month period?

A) industrial production index
B) money supply
C) gross domestic product
D) productivity average

C
Which one of the following is likely to have a negative effect on stock prices?

A) falling interest rates
B) a decrease in the money supply (M2)
C) low inflation
D) a decrease in the unemployment rate

B
The Federal Reserve through monetary policy can help expand the economy by

A) lowering income taxes on individuals.
B) reducing tariffs such that foreign exports can increase.
C) supporting a moderate growth of the money supply.
D) increasing government spending on the national infrastructure.

C
Rising interest rates tend to
A) contract the level of economic activity.
B) increase the level of business investment.
C) indicate governmental expansion of the economy.
D) signal the trough of a recessionary market.
A
The government has an expansionary economic policy when it
A) increases taxes.
B) increases government spending.
C) promotes rising interest rates.
D) limits exports of goods and services.
B
Rising corporate profits and are likely to have the greatest effect on which of the following industrial sectors?
A) business equipment
B) defense
C) food and agriculture
D) consumer durables
A
Which of the following businesses will be positively impacted by a weak dollar?
A) retailing
B) imports
C) exports
D) personal services
C
Which of the following business es will be negatively impacted by a strong dollar?
A) retailing
B) imports
C) exports
D) automotive
C
Which of the following tend to signal that stock prices are likely to rise in the future?
I. Employment increases after several months of recession.
II. Interest rates are low compared to the recent past.
III. Major market indexes have just reached record highs.
IV. Housing starts increase after several months of decline.

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

C
Which of the following tend to increase security market prices?
I. an increase in industrial production
II. an increase in corporate profits
III. an increase in the federal deficit when the economy is strong
IV. an increase in interest rates

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

A
Which one of the following statements is correct?
A) Stock prices are independent of the economic cycle.
B) Stock prices change simultaneously with the economy.
C) Stock prices are often used to predict changes in the economy.
D) Changes in stock prices generally lag changes in the economy.
C
To predict the demand for an industrial sector, it is essential to understand the economic forces that affect the industry.
True
Economic factors such as a weak dollar will have a negative impact on all industrial sectors.
False
Industries in the rapid expansion stage will be especially sensitive to a slowing economy.
False
In addition to company reports, Value Line also publishes industry analyses.
True
The economy will expand more slowly if consumers decided to save more and reduce their debt levels.
True
When the economic outlook for an industrial sector is strong, the outlook for many of the stocks of firms within that sector will also be strong.
True
Investors who conduct industry analyses typically favor companies with strong market positions over companies with less secure market positions because firms with strong market positions tend to
I. be price leaders.
II. benefit more from economies of scale.
III. have better R&D programs.
IV. have lower production costs.
A) II and IV only.
B) I, II and IV only.
C) I, II and III only
D) I, II, III and IV
D
The consumer electronics would be most significantly affected by
A) developments in technology.
B) interest rates and inflation.
C) labor relations.
D) government regulations
A
Which of the following factors are considered when analyzing an industry?
I. the nature and conditions of governmental regulations
II. the involvement and relations, if any, with labor unions
III. the development of new technologies relevant to the industry
IV. the extent of competition within the industry
A) I, II and IV only
B) II, III and IV only
C) I, II and III only
D) I, II, III and IV
D
Which stage of an industry’s growth cycle is most influenced by economic events?
A) initial development
B) stability or decline
C) mature growth
D) rapid expansion
C
Which stage of an industry’s growth cycle is interesting only for potentially high dividend payouts?
A) initial development
B) stability or decline
C) mature growth
D) rapid expansion
B
The rapid expansion phase of an industry is characterized by
A) extreme sensitivity to interest rates and other economic factors.
B) high returns and relatively low risks.
C) willingness of investors to buy almost any stock associated with the industry.
D) many decades of sustained above average growth.
C
The stage in an industry’s growth cycle in which product acceptance is spreading, investors can foresee the industry’s future, and overall economic variables have little to do with the industry’s overall performance, is known as the
A) initial development stage.
B) rapid expansion stage.
C) mature growth stage.
D) stability or decline stage.
B
Which stage of an industry’s growth cycle offers the greatest opportunity for an investor who is seeking capital gains?
A) initial development
B) mature growth
C) stability or decline
D) rapid expansion
D
Fundamental analysis is based on the presumption that the value of a stock is influenced by the financial performance of the issuing company.
True
Fundamental analysis encompasses return, but not risk, in the valuation process.
False
The statement of cash flows is used to assess a company’s long-term solvency.
False
The income statement indicates how successfully a company has utilized its assets.
True
Positive cash flow from investing activities is typical of firms experiencing healthy growth.
False
A company may appear to be profitable on its income statement, but fail to generate strong cash flows.
True
The balance sheet summarizes the company’s operations over the last fiscal year.
False
EBITDA stands for earnings before inflation, taxes, depreciation, and adjustments.
False
For a company to remain in business for the long term, cash flow from investing activities and financing activities must generally be positive numbers.
False
Which of the following are considered in the company analysis phase of a fundamental analysis of a firm?
I. the composition and growth in sales
II. the capital structure of the firm
III. the outlook of the national economy
IV. the composition and liquidity of the company’s assets
A) I and II only
B) I, II and IV only
C) II and IV only
D) I, II, III and IV
B
Which of the following accounting practices are potentially misleading or even fraudulent?
I. writing off goodwill as an extraordinary loss
II. using accrual rather than cash basis reporting
III. off-balance sheet liabilities
IV. recognizing revenues prematurely
A) I and II only
B) I, II and IV only
C) III and IV only
D) I, III and IV only
D
Which one of the following statements concerning accounting reports is correct?
A) The income statement reflects the position of a firm as of a single point in time.
B) The total equity of a firm is equal to the total assets plus the total liabilities.
C) The statement of cash flows identifies both the sources and the uses of cash.
D) The income statement reflects the amount of cash available for investment and financing activities.
C
Cash flow from operations
A) represents the amount of cash generated by the company.
B) is the least important section of the Statement of Cash Flows.
C) is the amount of cash acquired from the borrowing activities of the firm.
D) represents the cash flows from the purchase and sale of long-term assets.
A
Which of the following would be typical of a Statement of Cash Flows for a healthy firm in a sustainable business?
A) Cash flow from operations is negative, cash flows from investment activities and financing activities are positive.
B) Cash flow from operations , investment activities and financing activities must all be positive.
C) Cash flow from operations is positive, cash flows from investment activities and financing activities are negative.
D) If the Statement shows a net increase in cash, the source is unimportant.
C
Which of the following measures excludes non-cash charges against income.
A) operating expenses
B) EBIT
C) net income before taxes
D) EBITDA
D
Which of the following would be found on a company’s income statement?
I. cost of goods sold
II. interest expense
III. cash flow from operations
IV. earnings before taxes
A) I an IV only
B) I, II and III only
C) I, II and IV only
D) I, II, III and IV
C
Which of the following would be found on a company’s balance sheet?
I. Accounts receivable
II. Interest expense
III. Property plant and equipment
IV. Total stockholders’ equity
A) I an IV only
B) I, II and III only
C) I, II and IV only
D) I, III and IV only
D
Which of the following accounting practices are potentially misleading or even fraudulent?
I. writing off goodwill as an extraordinary loss
II. using accrual rather than cash basis reporting
III. off-balance sheet liabilities
IV. recognizing revenues prematurely
A) I and II only
B) I, II and IV only
C) III and IV only
D) I, III and IV only
D
On September 30, the Simpson Company reported the following information on its financial statements.

What is the amount of the stockholder’s equity in the Simpson Company?
A) $243,000
B) $277,000
C) $927,000
D) $3,217,000

A
Ratio analysis is the study of the relationships between various financial statement accounts.
True
Financial ratios can reveal a lot about a company’s liquidity, activity, and profitability.
True
A low current ratio may reveal liquidity problems in a profitable company.
True
Return on assets is a very important analytical tool because it measures how effectively management is using a firm’s assets to generate profits.
True
A firm with a very low debt-equity ratio has a low risk of defaulting on its loans.
True
A firm with a very low debt-equity ratio might be able to increase return on equity by taking on additional debt.
True
The Allied Computer Co. has sales of $300 million, a net profit margin of 9%, and 10 million shares of common stock outstanding. It has no preferred stock outstanding. If Allied stock trades at $50 per share, it has a price/earnings ratio of 20.9.
False
Return on equity (ROE) is computed by dividing net income by the market value of equity.
False
The fact that assets are recorded on the balance sheet at historical rather current values prevents the return on assets ratio (ROA) from being distorted by inflation.
False
In seeking potential stock investments, most analysts look for companies that have PEG ratios that are equal to or less than one.
True
Banks can use the times interest earned ratio as a measure of a borrower’s ability to repay their loan.
True
If a firm has an equity multiplier of 3, this means that the firm has $3 in equity for every $1 in long-term debt.
False
Return on equity can be expressed mathematically as “(net profit margin)(total asset turnover)(equity multiplier).”
True
A high P/E ratio may be an indication that a stock is overpriced.
True
Price-to-book-value indicates how aggressively a stock is being priced.
True
High dividend payout ratios are more of a concern to analysts than low payout ratios.
True
Which of the following are measures of liquidity?
I. net working capital
II. accounts receivable turnover
III. current ratio
IV. times interest earned
A) I and III only
B) I, II and III only
C) I, II and IV only
D) I, III and IV only
A
) Financial ratios
I. allow comparisons across firms without concern over firm size.
II. can compare a firm’s operating and financial status to industry norms.
III. reflect the future outlook for a firm as well as past performance.
IV. look at the liquidity, activity, leverage, profitability and market measures of a firm.
A) II and IV only
B) I and II only
C) I, II and IV only
D) I, II, III and IV
C
On December 31, the Gold Standard Company reported the following information on its financial statements.

According to this information, the company’s current ratio is approximately
A) 1.39.
B) 1.68.
C) 1.73.
D) 1.90.

A
To determine whether a company is using leverage effectively, an analyst should consider
A) the current ratio and net working capital.
B) inventory, accounts receivable and total asset turnover ratios.
C) the debt to equity and times interest earned ratios.
D) ROA and the net profit margin.
C
A company has sales of $640,000, net profit after taxes of $23,000, and a total asset turnover of 2.5. What is the return on assets?
A) 3.6%
B) 4.5%
C) 8.1%
D) 9.0%
D
A company has sales of $640,000, net profit after taxes of $23,000, a total asset turnover of 2.5 and an equity multiplier of 1.67. What is the return on equity?
A) 15%
B) 9.0%
C) 8.1%
D) 4.5%
D
Substituting EBITDA for EBIT when computing the times interest earned ratio will make the company appear
A) more leveraged.
B) less leveraged.
C) more profitable.
D) less efficient
B
For their last fiscal year, the Short Company reported the following information.

What is the accounts receivables turnover rate?
A) 0.8
B) 2.8
C) 4.5
D) 7.3

D
The inventory turnover rate for a firm is 14.5 as compared to the relevant industry rate of 13.2. In this case, the firm is
A) selling its inventory slower than the industry.
B) underperforming the industry.
C) averaging less days of sales in inventory than the industry.
D) generating less sales per dollar of inventory.
C
A total asset turnover of 3 means that every
A) $1 in sales is supported by $3 of assets.
B) $3 in assets produces $1 in net earnings.
C) $1 in total assets is replaced on average every 3 years.
D) $1 in assets produces $3 in sales.
D
On March 31, Adolpha, Inc. reported the following information on its financial statements.

What is the available net working capital for Adolpha, Inc.?
A) -$126,922
B) -$66,133
C) $60,789
D) $936,510

A
A company has a net loss for the year of $(10,000,000) and a deficit (negative equity) of $(1,000,000). ROE will be
A) 1000% indicating an exceptional opportunity.
B) 1000% and meaningless.
C) -1000% indicating that the company is in dire straits.
D) 10.
B
The measure that indicates how efficiently assets are being used to support sales is called the
A) total asset turnover.
B) current ratio.
C) book value.
D) net profit margin.
A
A lending institution would prefer that a firm have a ________ debt-equity ratio and a ________ times interest earned ratio.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
C
Marco’s just reported an EPS of $1.68 on revenues of $440 million. The company has 12 million shares outstanding. Total assets are $280 million, current liabilities equal $48 million, and long-term debt is $112 million. Net fixed assets are worth $230 million. Given this information, which one of the following statements is correct?
A) Marco’s debt-equity ratio is 0.75.
B) Marco’s current ratio is 1.75.
C) Marco’s total asset turnover is 3.67.
D) Marco’s net working capital is $2 million.
C
Worcester Corporation has a P/E ratio of 15. Natick Corporation is in the same industry as Worcester, but has a P/E ratio of 20. Possible interpretations of this discrepancy include
A) Worcester Corporation is overpriced.
B) Natick Corporation has higher earnings per share.
C) Investors expect Natick to grow faster than Worcester.
D) Natick’s stock price is higher than Worcester’s.
C
Nadine Enterprises has total assets of $240,000, a debt-equity ratio of 0.60, and a return on assets of 9%. What is the return on equity?
A) 5.4%
B) 5.6%
C) 14.4%
D) 15.0%
C
Quick Cement has a return on assets of 8%. If it has $1.5 million in total assets and a total asset turnover of 2, it follows that the firm must have a net profit margin of
A) 4%.
B) 6%.
C) 8%.
D) 12%.
A
Investors are most interested in which one of the following ratios?
A) return on assets
B) current ratio
C) net profit margin
D) return on equity
D
Which one of the following is a leverage measure?
A) times interest earned
B) net working capital
C) return on equity
D) net profit margin
A
If a company’s ROA is high, then an investor can assume that the company
A) is in danger of defaulting on its loans.
B) pays a high dividend.
C) is profitable.
D) has more equity than debt in its capital structure.
C
If a firm has an ROA of 10% and an ROE of 10%, then the
A) operating results of the firm are improving.
B) firm has no financial leverage.
C) firm must have enough cash on hand to pay some extra dividends.
D) firm is losing money.
B
Kim has gathered the following information on a company.

What is the amount of the earnings per share?
A) $0.14
B) $0.25
C) $0.28
D) $0.30

B
A high P/E ratio may be justified if
A) the market to book ratio is also high.
B) if ROA is higher than ROE
C) the PEG ratio is also high
D) the PEG ratio is low.
D
JJ Industries has a P/E ratio of 18 and an EPS of $0.93. This means that JJ’s stock is currently selling for
A) $16.74 per share.
B) $17.07 per share.
C) $18.00 per share.
D) $19.35 per share.
A
For most companies, the dividend payout ratio falls within the range of
A) 10 to 20%.
B) 20 to 40%.
C) 40 to 60%.
D) 60 to 80%.
C
Which of the following may be signs of future problems for a company?
I. Inventories growing faster than sales.
II. Rapidly increasing debt to equity ratio.
III. Cash flow from operations is higher than net income.
IV. Current liabilities increasing faster than current assets.
A) I and III only
B) II and IV only
C) I, II and IV only
D) I, II and III only
C
The PEG ratio
A) preferred by investors is equal to 2.0 or higher.
B) compares the price/earnings ratio to the rate of growth of the company’s earnings.
C) is a measure of a firm’s liquidity.
D) measures the ability of a firm’s assets to generate growth for the firm.
B
45) Which of the following directly impact return on equity?
I. net profit margin
II. leverage
III. return on assets
IV. cash flow from investment activities
A) I and III only
B) II and IV only
C) I, II and IV only
D) I, II and III only
D
A companies ratios are more meaningful when compared to other companies in the same industry.
True
The debt to equity ratio should be approximately the same across all industrial sectors.
FALSE
Financial ratios give little indication whether a company is well managed or not.
FALSE
Investors who want to analyze a company’s ratios usually need to compute them from the financial statements.
FALSE
Historical comparisons will reveal whether a company’s performance is improving or deteriorating.
TRUE
Generally, the market price of a stock is
A) below its book value.
B) above its book value.
C) equal to its par value.
D) equal to its book value.
B
To determine whether a pharmaceutical company’s profitability ratios indicate strength or weakness, we should
I. compare them to others in the same industry.
II. compare them to companies in unrelated industries such as energy or banking.
III. compare them to previous years.
IV. compare them to absolute standards established by the CFA Institute.
A) I and II only
B) I and III only
C) III and IV only
D) IV only
B
Which of the following is a readily available source of industry comparisons.
I. Standard & Poor’s
II. MSN Money, Yahoo Finance and other financial portals
III. Mergent (Moody’s)
IV. The Wall Street Journal
A) I and II only
B) I, II and III only
C) III and IV only
D) II, III and IV only
B
A comparison of a firm’s current financial ratios to those of prior years allows one to
A) accurately predict the future performance of a firm.
B) see how a firm’s performance compares to that of a competitor.
C) see trends that are developing.
D) determine if the firm is performing better than the overall industry.
C
Amgen’s debt to equity ratio is .54 while Walmart’s is .68. By comparing these ratios we can conclude
A) that Walmart is in danger of bankruptcy.
B) that Amgen uses too little debt financing.
C) that Walmart uses too little equity financing.
D) very little because the firm’s are in different industries.
D

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