Frohlich
Fall 2002
October 31, 2002
Investments Finance 4504
Midterm
Total points 109 (9 extra credit)
Name _________________________
In signing your test you assert that you have not used any human assistance in any manner or
mode.
------------------------Short Answers: (2 points per question—total of 34 points) Be brief but complete
on Short Answer Questions. Please type answers.
1. Would it be useful to the analyst to compare industry data to basic economic data such as the GDP or
consumer spending?
2. Briefly explain the fees charged by funds.
3. Distinguish between direct and indirect investing.
4. Why are upward sloping yield curves more consistent with the usual risk-return tradeoff than
downward sloping yield curves?
5. What are the main differences between a closed-end and an open-end investment company?
6 Compare the cash flows an investor expects from coupon bonds, zero-coupon bonds, and preferred
stock.
7. Why do stock investors pay attention to the bond market?
8. Would one expect to find higher P/E ratios in an aggressive growth fund or in a growth and income
fund?
9. Jack invests primarily in U.S. Treasury bills. Since T-bills are short-term, they must be replaced as
they mature, causing a lot of turnover. Mack invests primarily in three growth-oriented stock mutual
funds, adding to them monthly. ( Consider load vs no-load funds and automatic deposit into fund) Both
have been following their investment strategies over the past 10 years. Would Jack or Mack be more
interested in inflation adjusted returns on their investments? Which would be more interested in
transactions costs?
10. Would you recommend a 65-year old retiree to invest all of his/her retirement assets in an income
fund?
11. When constructing a portfolio, standard deviations are typically calculated from historical data. Why
may that be a problem?
12. How is the total book value of equity affected by stock splits? Stock dividends? Are the book
values of common stock, capital in excess of par, or retained earnings affected by either?
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13. Will risk-averse investors ever include commodity futures or options in their portfolios? Explain.
14. You have decided to invest in an aggressive growth fund for long-run future needs. You have a
publication listing a number of such funds with their most recent 12-month total returns. Is this a good
predictor of future performance?
15. Are T-bills totally risk-free? Explain.
16. How is the individual investor's income tax position affected by owning investment companies
compared to owning securities directly?
17. Which classification of funds are expected to have the lowest management fees?
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Essay Questions/Problems (75 points) SHOW ALL WORK
1. ( 5 points) Some market scholars talk about tiers of stocks in the markets. A
top tier on the NYSE would be the largest, most widely held stocks.
Second and third tiers would consist of stocks that are less widely
held and followed by fewer analysts. Is it possible that the market
might be more efficient for the top tier and progressively less
efficient for the lower tiers? Discuss the EMH, the three levels,and
how it relates to the the efficiency of the tiers of stocks in the market.
2. ( 4 points) If an astute (or lucky) market analyst were to find a "money
machine" system that consistently beat the market, would the system
eventually become self-defeating?
3. (5 points) Under the Efficient Market Hypothesis, securities in the market are
assumed to be fairly priced. Does this mean that security analysis
is a waste of time?
4. A. (4 points) Using the last working day of October 2002 WSJ (ATTACH COPY
OF SECTION USED), draw a yield curve using Treasuries. Using a WSJ from
the last working day of October 2001 ((ATTACH COPY OF SECTION of
WSJ USED OR A COPY OF THE WEB PAGE) draw another yield curve on
the same graph. Using a WSJ from the last working day of October 2000
((ATTACH COPY OF SECTION of WSJ USED OR A COPY OF THE
WEB PAGE) draw another yield curve on the same graph. Using a WSJ or the
Web from the last working day of October 1999 (ATTACH COPY OF
SECTION of WSJ USED OR A COPY OF THE WEB PAGE) draw another
yield curve on the same graph. Create individual tables for all 4 yield curves
indicating the points you are using on your graph.
Be sure to label your graph. [Note you will have four yield curves on the same graph.
You will have four tables with appropriate yields.]
B. (3 points) What has happened to the level of the yield curve from (1) 1999 to 2000, (2)
2000 to 2001 and (3) 2001 to 2002?
Explain using Liquidity Preference Theory—why the level has from (1) 1999 to
2000, (2) 2000 to 2001 and (3) 2001 to 2002. Refer to the change in Money Supply,
GDP, CPI [provide documentation as to changes in these]
C. (4 points) (1) Explain the current curve using the unbiased expectation theory.
(2) Explain the October 2000 curve using the segmentation theory.
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5. RETIREMENT CASE ( 40 points)
Investment Decisions Are More Than Security Selection or Allocation Mix
Guidelines on the Retirement Fund:
Employee can choose between the funds listed in the following table. They may choose any or
all fund(s).
Company matches the employee’s contribution to the plan (maximum 5% of Gross Salary) by
investing in the same allocation mix as designated by the employee (10% Fund A, 70% Fund B,
etc.).
In addition, ESOP places stock into the company stock, Federal Signal Stock.
added to the individual’s plan per year.
100 shares are
After Five years of employment the employee can transfer 50% of the cumulative total of the
Federal Signal Stock value to any other fund(s).
FUND
Vanguard Short-Term Bond
Index Fund Investor Shares
Vanguard Total Bond Market
Index Fund (Bond Fund)
Vanguard Wellington Fund
(Balanced Fund)
Vanguard 500 Index Fund
(Stock Fund)
Vanguard Primecap Fund
(Stock Fund)
Vanguard Explorer Fund (Stock
Fund)
Vanguard International Growth
Fund (Int’l Stock)
Federal Signal Stock (fss)
(ESOP)
YTD
1 YEAR
5 YEAR
10 YEAR
RETURN RETURN RETURN RETURN
4.51
3.67
4.33
N
/A
5.76
4.38
-9.71
-4.28
-28.2
-12.00
-26.15
-13.4
-26.81
-29.00
-20.65
-18.9
-23.3
-12.8
4.75
4.40
1.21
7.44
-2.21
8.07
-0.28
12.35
-1.58
7.00
-6.54
3.99
-4.4
6.8
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Currently your client’s retirement funds are invested as follows:
FUND
Vanguard Short-Term Bond Index Fund Investor Shares
Vanguard 500 Index Fund
Vanguard Wellington Fund
Federal Signal Stock (Stock symbol FSS) (ESOP)
73,397.64
15,874.00
33,000.00
14,985.44
Total
137,257.08
Your client may opt at retirement to withdraw a set dollar amount per month from the 401-k
while leaving the balance invested and earning a return on those remaining funds in the plan.
Your client currently takes home $2800 (after tax) per month. He has been contributing $214
per month to the 40l-K plan which was matched by his employer up to 5% of his gross salary.
He is currently contributing $375 per month to the 40l-K plan which is matched by his employer
up to 5% of his gross salary. The max contribution is $11,000 of gross income.
http://www.irs.gov/taxtopics/page/0,,id%3D16216,00.html
The client plans to retire in 5 years and would like to remain at his current level of after-tax
take-home pay ($2800). You will need to find the social security tax rate, the medicare tax rate,
and your client’s federal tax rate. Your client is married. You must determine whether medicare,
social security, and federal income tax are paid on gross salary, regardless of deductions for 401k plans.
See: http://www.bankrate.com/brm/itax/tax_adviser/20020813a.asp?prodtype=itax
http://www.bankrate.com/nsc/definitions.asp?channelid=10
Your client knows he will receive social security plus the retirement benefits. You must estimate
your client’s social security payments. He has a wife that has never worked and they will
both be 65 in 5 years and plan to retire then. How much will the couple receive in social
security (both the wife and husband will receive social security)? Both the wife and husband
will receive retirement benefits at the same time. See the following sites:
http://www.ssa.gov
Client’s Retirement amount:
http://www.ssa.gov/retire2/
Women-Spouse-Non-working Spouse Issues:
http://www.ssa.gov/policy/pubs/SSB/v62n3y1999/artUsingDatafor.pdf#xml=http://www.ssa.gov
/search97cgi/s97_cgi?action=View&VdkVgwKey=http%3A%2F%2Fwww%2Essa%2Egov%2F
policy%2Fpubs%2FSSB%2Fv62n3y1999%2FartUsingDatafor%2Epdf&doctype=xml&Collecti
on=SSA&QueryZip=spouse+benefits%3COR%3E+%28keywords+%3Ccontains%3Espouse+be
nefits%29&
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http://ssa-custhelp.ssa.gov/cgibin/ssa.cfg/php/enduser/std_alp.php?p_sid=cHRun6tg&p_lva=&p_li=&p_page=1&p_cat_lvl1=3
&p_cat_lvl2=%7Eany%7E&p_search_text=spouse&p_new_search=1&p_search_type=3
http://ssa-custhelp.ssa.gov/cgibin/ssa.cfg/php/enduser/std_adp.php?p_sid=cHRun6tg&p_lva=&p_faqid=504&p_created=9759
40445&p_sp=cF9zcmNoPTEmcF9ncmlkc29ydD0mcF9yb3dfY250PTMxJnBfc2VhcmNoX3Rle
HQ9c3BvdXNlJnBfc2VhcmNoX3R5cGU9MyZwX2NhdF9sdmwxPTMmcF9jYXRfbHZsMj1_
YW55fiZwX3BhZ2U9MQ**&p_li=
Analysis of Current Situation:
1. Compute the client’s gross income.
2002 federal personal income tax rates
(Ordinary taxable income. To see the rates for 2001, click here)
Married filing jointly or
qualifying widow/widower
Tax rate
Single filers
10%
Up to $6,000
15%
$6,001 - $27,950
$12,001 - $46,700
27%
$27,951 - $67,700
$46,701 - $112,850
30%
35%
38.6%
$67,701 $141,250
$141,251$307,050
Up to
$12,000
$112,851 - $171,950
$171,951 - $307,050
Married filing
separately
Head of household
Up to $6,000
Up to $10,000
$6,001 - $23,350 $10,001 - $37,450
$23,351 $56,425
$37,451 - $96,700
$56,426 -
$96,701 -
$85,975
$156,600
$85,976 -
$156,601 -
$153,525
$307,050
$307,051
$307,051
$153,526
$307,051
or more
or more
or more
or more
2. Estimate your client’s social security (you will need to calculate the client’s gross
salary). Part of their social security is taxable.
http://ssa-custhelp.ssa.gov/cgibin/ssa.cfg/php/enduser/std_alp.php?p_sid=RZRto6tg&p_lva=&p_li=&p_page=1&
p_cat_lvl1=%7Eany%7E&p_cat_lvl2=%7Eany%7E&p_search_text=tax+deferred
+benefits&p_new_search=1&p_search_type=3
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3. Compute the risk (the portfolio’s Beta) and the inflation-adjusted return of the
current retirement portfolio (see spreadsheet on your instructor’s Web page for the
calculating the portfolio’s return).
4. Determine the before-tax amount needed to be withdrawn monthly from the
retirement portfolio to meet your client’s desired monthly $2800 after-tax cash
flow.
You will need to convert the net monthly after-tax cash flow needed after
considering the non-taxable portion of the couple’s social security to a before
tax amount. Part of their social security is taxable.
http://www.ssa.gov/cgibin/cqcgi/@ssa.env?CQ_SESSION_KEY=XLHZJPFYJEPI&CQ_CUR_DO
CUMENT=1&CQ_RESULTS_DOC_TEXT=YES
Payment of medicare premiums still occur during retirement.
http://www.medicare.gov/Basics/Amounts2002.asp
Considering their taxable social security monthly payment, what must your
client receive from his 401-K plan monthly to reach his objective of a monthly
$2800 after tax amount.for the couples expected life-time of 25 years during
retirement?
5. Compute the anticipated retirement funds value upon retirement in 5 years under the
current investment plan’s inflation adjusted return.
The client will be contributing $375 per month to the 40l-K plan which is matched
by his employer up to 5% of his gross salary. In addition, the ESOP will have an
additional 100 shares contributed yearly over the remaining five years.
6. Determine how long the retirement funds would last if monthly before-tax
withdrawals were made in the amount that you calculated to supplement the social
security payments using the portfolio return you calculated.
7. Using the anticipated retirement fund’s inflation-adjusted return compute what
portfolio value would be necessary to have upon the couple’s retirement to achieve their
objective of monthly $2800 after tax payments .if the couples expects to live an
additional 25 years after retirement?
8.Compute the inflation-adjusted rate for a portfolio that would be necessary to achieve
the couples objective.
6. (10 points) Using Federal Signal Stock (FSS)
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Download the stock’s monthly prices from 1996 through 2001
Compute the monthly returns including dividends for this period
Download the monthly prices from 1996 through 2001 for the S&P 500
Compute the monthly returns for this period
Run a regression to find Federal Signal’s alpha and Beta
Compare your Beta with the Yahoo .com beta for FSS---try to explain any
differences
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