CFP Exam Prep - Investment Planning (18%) Questions & Answers 100% Correct
The first step in this problem is to compute the required rate of return using the CAPM
formula:
R = Rf + B(Rm - Rf)
Stock A =14.8% = 6 + 1.1 x (14 - 6)
Stock B = 13.04% = 6 + .88 x (14 - 6)
Now that we have the required rate of return on the securities based on their volatility, I
would utilize the Gordon Growth Model (or dividend model) to determine the price that
the security should be at to be "fairly valued."
V = D * (1 + g) / (R - g)
Stock A =17.45 = [2 x (1+.03)] / (0.148-.03)
Stock B = 17.25 = [1.5 x (1+.04)] / (0.1304-.04)
So the "fair value" for our investor is $17.45 for stock A and it is trading at $18.
Therefore the stock is overvalued (trading higher than its value).
Stock B is valued at $17.25 for our investor and is trading at $12. Therefore the stock is
undervalued (trading lower than its value).
Walt Drizzly stock is currently trading at $45 and pays a dividend of $3.50. Analysts
project a dividend growth rate of 5%. Your client, Toby Benjamin, requires a rate of 12%
to meet his stated goal. Toby wants to know if he should purchase stock in Walt Drizzly.
A. Yes, the stock is undervalued.
B. No, the stock is overvalued.
C. No, the required rate of return is higher than the projected growth rate.
D. Yes, the required rate is higher than the expected rate. - ANSWER-Solution: The
correct answer is A.
The intrinsic value is: V = (D1 / r - g), therefore V = (3.50 × 1.05) / (.12 - .05), V = $52.50
compared to the selling price of $45. Therefore the stock is undervalued.
,D is incorrect, use the rate of return formula on the top right of the formula sheet.r =
(D1 / P) + Gr = ((3.50 x 1.05) / 45) + .05r = (3.) + .05r = .08167 + .05f = .1317 or
13.17% Required rate of return was 12% is not higher than the expected rate of return.
Jim and Anne Taylor are baby boomers who would like to add an equity investment to
their portfolio. They require a 12% rate of return and are considering the purchase of
one of the following two common stocks:
Stock 1: Dividends currently are $1.50 annually and are expected to increase 8%
annually; market price = $35Stock 2: Dividends currently are $2.25 annually and are
expected to increase 7% annually; market price = $50
Using the dividend growth model, determine which stock would be more appropriate for
the Taylors' to purchase at this time:
A. Stock 2, because the stock is undervalued.
B. Stock 2, because the return on investment is greater than the Taylor required rate of
return.
C. Stock 1, because its dividend growth rate is greater than Stock 2's growth rate.
D. Stock 1, because the expected return on investment is greater than the Taylor
required rate of return. - ANSWER-Use the intrinsic value formula to determine whether
the stock is over valued or under valued. Then use the expected rate of return formula
to determine whether the stock meets the investor's required rate of return.
r = D0(1 + g) + g (P) Stock 1 = $1.50 (1.08) + .08 = 12.63% $35 Stock 2 = $2.25 (1.07)
+ .07 = 11.82% $50
Using the constant growth dividend valuation model, calculate the intrinsic value of a
stock that pays a dividend this year of $2.00 and is expected to grow at 6%. The beta
for this stock is 1.5, the risk free rate of return is 3% and the market return is 12%.
A. $48.27
B. $35.33
C. $28.75
D. $20.19 - ANSWER-
,Which of the following elements of risk in mortgage-backed securities can be difficult to
determine?
I. Actual maturity is not known with certainty.
II. Mortgage rates vary between the different investment pools.
III. Actual cash flows are not known with certainty.
IV. Government guarantees make the determination of an appropriate discount rate for
calculating their present value difficult.
A. I and III only.
B. I and IV only.
C. II and III only.
D. II and IV only. - ANSWER-Solution: The correct answer is A.
Lack of a definite maturity date (you won't know if mortgages are paid off early ahead of
time) and uncertain cash flows (due to possible early payoffs) are the elements of risk in
mortgage-backed securities.
Eddie Bauer bought a tax-exempt Original Issue Discount (OID) bond in November of
1998. Which of the following statements is/are true?
I. The bond basis increases at a set rate each year.
II. The difference between maturity value and the original issue discount price is known
as the OID.
III. The bond's earnings are treated as exempt interest income.
IV. The bond was issued at a discount to its par value.
A. II and III only.
B. I and IV only.
C. I, II and IV only.
D. I, II, III and IV. - ANSWER-Solution: The correct answer is D.
All of the above statements are descriptions of the Original Issue Discount bond. Read
this question carefully, a tax-exempt Original Issue Discount (OID) bond was
purchased.
, Jack Rich has an investment portfolio equally divided among the following funds:
Energy sector fund, Bond Unit Investment Trust (25-year average maturity), and a
Money Market fund. He is a buy-and-hold investor. Which of the following risks is his
portfolio exposed to?
I. Business risk.
II. Interest rate risk.
III. Political risk
IV. Purchasing power risk.
A. I and III only.
B. II and IV only.
C. I, II and III only.
D. III and IV only. - ANSWER-Solution: The correct answer is D.
Interest rate risk does not affect a bond investor if he or she holds the securities to
maturity. This is how unit investment trusts are structured. The energy sector will be
directly impacted by regulatory influences of a political nature.
You are faced with several fixed income investment options. Which of these bonds has
the greatest reinvestment rate risk?
A. A U.S. Treasury bond with an 11.625% coupon, due in five years with a price of
$1,225.39 and a yield to maturity of 6.3%.
B. A U. S. Treasury strip bond (zero-coupon) due in five years with a price of $735.12
and a yield to maturity of 6.25%.
C. A corporate B-rated bond with a 9.75% coupon, due in five years with a price of
$1,038.18 and a yield to maturity of 8.79%.
D. A corporate zero coupon bond due in 5 years with a price of $750 and a yield to
maturity of 5.9%. - ANSWER-Solution: The correct answer is A.
This is due to the high coupon and lack of similar rates currently.
A good visual to use in the bond chart in Lesson 6 under Yield Summary. If the YTM is
currently 6.3% on an 11.625% coupon bond, the bond is trading at a premium, meaning
investors are willing to pay more to purchase that bond than new ones issued at par
with the current coupon rate (much lower than 11.625%).
The first step in this problem is to compute the required rate of return using the CAPM
formula:
R = Rf + B(Rm - Rf)
Stock A =14.8% = 6 + 1.1 x (14 - 6)
Stock B = 13.04% = 6 + .88 x (14 - 6)
Now that we have the required rate of return on the securities based on their volatility, I
would utilize the Gordon Growth Model (or dividend model) to determine the price that
the security should be at to be "fairly valued."
V = D * (1 + g) / (R - g)
Stock A =17.45 = [2 x (1+.03)] / (0.148-.03)
Stock B = 17.25 = [1.5 x (1+.04)] / (0.1304-.04)
So the "fair value" for our investor is $17.45 for stock A and it is trading at $18.
Therefore the stock is overvalued (trading higher than its value).
Stock B is valued at $17.25 for our investor and is trading at $12. Therefore the stock is
undervalued (trading lower than its value).
Walt Drizzly stock is currently trading at $45 and pays a dividend of $3.50. Analysts
project a dividend growth rate of 5%. Your client, Toby Benjamin, requires a rate of 12%
to meet his stated goal. Toby wants to know if he should purchase stock in Walt Drizzly.
A. Yes, the stock is undervalued.
B. No, the stock is overvalued.
C. No, the required rate of return is higher than the projected growth rate.
D. Yes, the required rate is higher than the expected rate. - ANSWER-Solution: The
correct answer is A.
The intrinsic value is: V = (D1 / r - g), therefore V = (3.50 × 1.05) / (.12 - .05), V = $52.50
compared to the selling price of $45. Therefore the stock is undervalued.
,D is incorrect, use the rate of return formula on the top right of the formula sheet.r =
(D1 / P) + Gr = ((3.50 x 1.05) / 45) + .05r = (3.) + .05r = .08167 + .05f = .1317 or
13.17% Required rate of return was 12% is not higher than the expected rate of return.
Jim and Anne Taylor are baby boomers who would like to add an equity investment to
their portfolio. They require a 12% rate of return and are considering the purchase of
one of the following two common stocks:
Stock 1: Dividends currently are $1.50 annually and are expected to increase 8%
annually; market price = $35Stock 2: Dividends currently are $2.25 annually and are
expected to increase 7% annually; market price = $50
Using the dividend growth model, determine which stock would be more appropriate for
the Taylors' to purchase at this time:
A. Stock 2, because the stock is undervalued.
B. Stock 2, because the return on investment is greater than the Taylor required rate of
return.
C. Stock 1, because its dividend growth rate is greater than Stock 2's growth rate.
D. Stock 1, because the expected return on investment is greater than the Taylor
required rate of return. - ANSWER-Use the intrinsic value formula to determine whether
the stock is over valued or under valued. Then use the expected rate of return formula
to determine whether the stock meets the investor's required rate of return.
r = D0(1 + g) + g (P) Stock 1 = $1.50 (1.08) + .08 = 12.63% $35 Stock 2 = $2.25 (1.07)
+ .07 = 11.82% $50
Using the constant growth dividend valuation model, calculate the intrinsic value of a
stock that pays a dividend this year of $2.00 and is expected to grow at 6%. The beta
for this stock is 1.5, the risk free rate of return is 3% and the market return is 12%.
A. $48.27
B. $35.33
C. $28.75
D. $20.19 - ANSWER-
,Which of the following elements of risk in mortgage-backed securities can be difficult to
determine?
I. Actual maturity is not known with certainty.
II. Mortgage rates vary between the different investment pools.
III. Actual cash flows are not known with certainty.
IV. Government guarantees make the determination of an appropriate discount rate for
calculating their present value difficult.
A. I and III only.
B. I and IV only.
C. II and III only.
D. II and IV only. - ANSWER-Solution: The correct answer is A.
Lack of a definite maturity date (you won't know if mortgages are paid off early ahead of
time) and uncertain cash flows (due to possible early payoffs) are the elements of risk in
mortgage-backed securities.
Eddie Bauer bought a tax-exempt Original Issue Discount (OID) bond in November of
1998. Which of the following statements is/are true?
I. The bond basis increases at a set rate each year.
II. The difference between maturity value and the original issue discount price is known
as the OID.
III. The bond's earnings are treated as exempt interest income.
IV. The bond was issued at a discount to its par value.
A. II and III only.
B. I and IV only.
C. I, II and IV only.
D. I, II, III and IV. - ANSWER-Solution: The correct answer is D.
All of the above statements are descriptions of the Original Issue Discount bond. Read
this question carefully, a tax-exempt Original Issue Discount (OID) bond was
purchased.
, Jack Rich has an investment portfolio equally divided among the following funds:
Energy sector fund, Bond Unit Investment Trust (25-year average maturity), and a
Money Market fund. He is a buy-and-hold investor. Which of the following risks is his
portfolio exposed to?
I. Business risk.
II. Interest rate risk.
III. Political risk
IV. Purchasing power risk.
A. I and III only.
B. II and IV only.
C. I, II and III only.
D. III and IV only. - ANSWER-Solution: The correct answer is D.
Interest rate risk does not affect a bond investor if he or she holds the securities to
maturity. This is how unit investment trusts are structured. The energy sector will be
directly impacted by regulatory influences of a political nature.
You are faced with several fixed income investment options. Which of these bonds has
the greatest reinvestment rate risk?
A. A U.S. Treasury bond with an 11.625% coupon, due in five years with a price of
$1,225.39 and a yield to maturity of 6.3%.
B. A U. S. Treasury strip bond (zero-coupon) due in five years with a price of $735.12
and a yield to maturity of 6.25%.
C. A corporate B-rated bond with a 9.75% coupon, due in five years with a price of
$1,038.18 and a yield to maturity of 8.79%.
D. A corporate zero coupon bond due in 5 years with a price of $750 and a yield to
maturity of 5.9%. - ANSWER-Solution: The correct answer is A.
This is due to the high coupon and lack of similar rates currently.
A good visual to use in the bond chart in Lesson 6 under Yield Summary. If the YTM is
currently 6.3% on an 11.625% coupon bond, the bond is trading at a premium, meaning
investors are willing to pay more to purchase that bond than new ones issued at par
with the current coupon rate (much lower than 11.625%).
