Answers: Chapter 10 - Business and Financial Concepts You Should Know



10.1: The principle of supply and demand is most closely related to the following:

  1. The more people want to buy a particular product, the higher the price of that product

  2. The more people want to buy a particular product, the lower the price of that product

  3. The less people want to buy a particular product, the higher the price of that product

The correct answer is #1
As demand for a product increases, the price of that product will rise. Keep in mind that these types of questions assume "ceteris paribus", meaning that all other factors - in this case, supply - are kept the same.

 

10.2: Two of the ways you can make money with stocks include:

  1. Dividends

  2. Capital Appreciation

  3. Retained Earnings 

  4. Item#1 and Item#2

  5. Item#1 and Item#3

The correct answer is #4
Dividends are the portion of a company’s earnings that is paid to the investor every three months, and capital appreciation is the increase in stock price (if you own shares of stock that are increasing in value, you can sell the shares for a higher price than you bought them for).

 

10.3: Is the following statement True or False?

It's important to group companies into industries because sometimes it's useful to compare how stocks within a specific industry are performing, especially since different industries have their own particular characteristics. The statement is true.

 

10.4: Is the following statement True or False?

If you bought a 10-year bond with a 3% fixed interest rate last year and you want to sell it this year when the interest rate on similar bonds have increased to 5%, you will generally get less money than the amount you payed for it last year. The statement is true.

The interest rate that your bond returns is fixed at 3%. A year after buying it, similar bonds have an interest rate of 5%. If you try to sell a 3% fixed interest rate bond when potential buyers can go and find similar bonds offering a 5% interest rate, then your bond is less valuable. You will receive less money than the amount you payed for it a year ago.

 

10.5: The word diversification with regards to stocks generally implies that you should:

  1. Put all your investments in different stocks within the same industry 

  2. Put your investments in different stocks in different industries

  3. Put your investments in blue-chip stocks

The correct answer is #2
Investors diversify their portfolios because when a stock goes down or rises in value, other stocks in the same industry tend to do the same. Therefore, diversification implies that you should buy the stocks of companies in different industries so as to reduce the chance that the entire portfolio will lose too much value if one industry has a problem.

 

10.6: Which of the stocks in the Dow Jones listed below would most likely be considered the riskiest stock when risk is measured only by Beta?

  1. Goldman Sachs Group (GS)

  2. Home Depot (HD)

  3. The Coca-Cola Company (KO)

The correct answer is #1
If you look up the beta of each stock, you would most likely find that Goldman Sachs has the highest beta  of the three stocks.

 

10.7: The business cycle can best be described as:

  1. The cycle of inflation and deflation

  2. The various stages in the economic life of a company

  3. The increase in Gross Domestic Product

The correct answer is #2
The business cycle - maturation, contraction (or recession), revival, and expansion - is affected by inflation and deflation but is more accurately described as the various stages of economic life of a company

 

10.8: Which of the following can best describe growth stocks:

  1. Stocks of large companies that have paid steady dividends over many years

  2. Stocks of companies that are growing dramatically

  3. Stocks of utility companies that have paid steady dividends over many years

The correct answer is #2
A growth company usually spends a lot of money on research and puts all its profits back into the company instead of paying dividends, so answers #1 and #3 are incorrect.

 

10.9: Which one of the following stocks would most likely be considered an interest-rate sensitive stock:

  1. LinkedIn stock

  2. Apple stock

  3. Bank of America stock

The correct answer is #3
Interest-rate sensitive stocks are affected primarily by changes in interest rates. Banks and other financial companies can be considered interest-rate sensitive companies. These companies feel the effects of any move by the Federal Reserve to hold off inflation or to kick-start the economy.

 

10.10: Which one of the following stocks would most likely not be considered a cyclical stock:

  1. Dow Chemical stock 

  2. United Airline stock

  3. Wal-Mart stock

  4. Ford stock

The correct answer is #3
Cyclical companies can be found in the following types of industries: paper, chemicals, steel, machinery and machine tools, airlines, railroads and railroad equipment, and automobiles. Dow Chemical, United Airlines and Ford are in the chemical, airline and automobiles industries, respectively. Wal-Mart, a retailer, does not fall under any of the categories above.

Cyclical companies usually invest in heavy equipment to make their products. While Was-Mart does offer some "store brand" products, it is also selling products made by other companies. Furthermore, whatever products Wal-Mart does manufacture are much cheaper to make than chemicals, airplanes or cars. Wal-Mart does not have to invest nearly as much in equipment to make it's products as a cyclical company would. 

 

10.11: True or False. Income stocks  usually are stocks of companies that pay no dividends while growth stocks are stocks of companies that grow quickly and pay heavy dividends. The answer is False.

Income stocks usually are stocks of companies that pay large dividends. A growth company usually spends a lot of money on research and puts all its profits back into the company instead of paying dividend.

 

10.12: True or False. Value investors sometimes look for stocks that have fallen on hard times, and therefore are therefore  relatively cheap compared with their prices. The answer is True.

 

10.13: If you bought a stock that pays no dividend for $110 exactly one year ago today, and then sell it today for $120, your return on investment would be which of the following?

  1. 10.0%

  2. 9.1%

  3. 8.3%

The correct answer is #2
ROI = ((End Value - Beginning Value) / (Beginning Value)) x 100
Where End Value is the price received for selling the investment.
Where Beginning Value is the price you paid when you purchased the investment. (We assume there are no fees charged by anyone who helped you buy or sell the investment).

((120 - 110)/110) x 100 = (10/110) x 100 = 9.09%, roughly 9.1%

 

10.14: Assume you put $1000 in a bank account that pays 10% simple interest annually. At the end of 3 full years, how much interest would you have earned?

Simple interest only uses the principal balance ($1000 in this case) to calculate your interest payment. You will have earned $300 in interest at the end of 3 full years.

End of year 1: You earn $100, which is 10% of $1000. Your balance is now $1,100.

End of year 2: You earn $100, which is 10% of $1000. Your balance is now $1,200.

End of year 3: You earn $100, which is 10% of $1000. Your balance is now $1,300.

You have earned a total of $100 + $100 + $100 in interest, or $300.

 

10.15: Assume you put $1000 in a bank account that pays 10% compound interest annually. At the end of 3 full years, how much interest would you have earned?

You will have earned $331 in interest at the end of 3 full years.

End of year 1: You earn $100, which is 10% of $1000. Your balance is now $1,100.

End of year 2: You earn $110, which is 10% of $1100. Your balance is now $1,210.

End of year 3: You earn $121, which is 10% of $1210. Your balance is now $1,331.

You have earned a total of $100 + $110 + $121 in interest, or $331.

 

10.16a: Choose One. How much do you have to invest today so that in 1 year, you receive $1000 if the interest rate you will be paid for the investment is 12%?

  1. $888

  2. $900

  3. $893

The correct answer is #3

Remember that Present Value = Future Value / (1 + Rate on Investment)

The future value is $1000, and the Rate on Investment is 12% (or 0.12).

$1000/(1 + 0.12) = $1000/1.12 = $892.84, roughly $893

 

10.16b: Which one of the choices below is correct

  1. The answer to 10.16a represents future value
  2. The answer to 10.16a represents present value

The correct answer is #2
Present value refers to today’s value of a sum of money to be received in the future. Question 10.16a is asking for the present value of $1000 to be received in one year if a 12% discount rate is applied.