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1) What

is the difference between fundamental risk and price risk?

ANS. Fundamental risk is the risk which is associated with the business activities or we can say
its internal to the business. Price risk is the loss occurring from adverse movement in the market
price of an asset. Hence fundamental risk is the changes in the future payoffs of an investment
due to changes in the business, whereas price risk considers the difference between the value of
the future payoffs and the price of the investment. To protect from the fundamental risk you need
to do diversification whereas to eliminate price risk you need to perform a fundamental analysis
of financial statements.
2) What is the difference between an alpha technology and a beta technology?
ANS. An alpha technology looks at extra returns that are generated over and above expected
return for the risk taken whereas beta technology gives an estimate of the required return as the
sum of the risk free rate and a risk premium. This premium consists of a risk premium on a risk
factor, multiplied by the sensitivity to this risk factor. Alpha technologies are used to identify
price risk and help to diminish the same, whereas beta technologies are used to diversify
fundamental risk.
3) Critique the following statement: Hold stocks for the long run, for in the long run, the
return to stocks is always higher than bond returns.
ANS. Yes, it is true as per statistics historical S&P 500 average annual return to stocks has been
12.3 percent, compared to 6 percent for corporate bonds and 3.5 percent for treasury bills. But
these are just the statistics these are not the guaranteed return one will be getting for the future
period also.
4) What is the difference between a passive investor and an active investors?
ANS. Passive investment management makes no attempt to distinguish attractive from
unattractive securities, or forecast securities prices, or time markets and market sectors. Active
management might best be described as an attempt to apply human intelligence to find "good
deals" in the financial markets. A passive investor assumes that markets are efficient and priced
correctly whereas active investor uses alpha technologies to identify price risk and assumes that
stocks are not always priced correctly. Hence passive investor uses the beta technologies and use
this to create a diversified portfolio that diminishes total fundamental risk whereas an active
investor separates price from value and tries to find the intrinsic value that needs to be the market
price.

5) Changes in shareholders equity are determined by total earnings minus net payout to
shareholders, but the change in shareholders equity is not equal to net income (in the
income statement) minus net payout to shareholders. Why?
ANS. Because you have to add other comprehensive income to net income in order to become
comprehensive income. Comprehensive income is the sum of net income and other items that
must bypass the income statement because they have not been realized, including items like an
unrealized holding gain or loss from available for sale securities and foreign currency translation
gains or losses. Hence
Change in equity = Comprehensive income net pay-out to shareholders
6) Dividends are the only way to pay cash out to shareholders. True or False?
ANS. No, you can also repurchase shares.
Buying Back Stock is another way to pay your investors. If you take the surplus cash on hand
and buy back company stock, it increases the price of the remaining stock (or it should) as each
share is, in theory, worth a larger slice of the company.
Retained Earnings is yet another way to pay back shareholders
7) Explain the difference between net income and net income available to common.
ANS. A companys Net income is calculated by taking revenues and adjusting for the cost of
doing business, depreciation, interest, taxes and other expenses. It is the profit attributable to
shareholders
Where as
Net income available to common shareholders = Net Income preferred dividends paid to the
preference shareholders
This is used for EPS calculations.
EPS = (Net Income preferred dividends paid to the preference shareholders) / Outstanding
Shares
8) Which definition of income is used in earnings-per-share calculations?
ANS. The portion of a company's profit allocated to each outstanding share of common stock.
Earnings per share serves as an indicator of a company's profitability
Hence we can say Net income available to common shareholders is used for calculating the
earnings-per-share
EPS = (Net Income preferred dividends paid to the preference shareholders) / Outstanding
Shares EPS = (Net Income preferred dividends) / Outstanding Shares
9) What explains differences between firms price-to-sales ratios?

ANS. Price to sales ratio = (Price/Earning) * (Earning/Sales)


where (E/S) is defined as each dollar of sales that end up in earnings.
Differences in Price/Sales explain differences in the profitability of sales.

10) It is common to compare firms on their price-to-ebit ratios. What are the merits of
using this measure? What are the problems with it? Hint: ebit leaves something out.
ANS. price-to-ebit ratios should be calculated as unlevered ratios because leverage does not produce
sales or earnings before interest and taxes. This is because we are not taking into account the interest
we are paying for the leverage which may be different for different firms based on the amount of
leverage they have. Hence, it is useful to control for differences in leverage between the target firm and
comparison firms.
Problem it leaves out interest and taxes

11) It is also common to compare firms on their price-to-ebitda ratios. What are the merits
of using this measure? What are the dangers? Hint: ebitda leaves something out.
ANS. (p/ebitda) adjusts for both leverage as we are taking not taking into account the interest and
depreciation, amortization measures can differ for different firms. It can be a better way to compare the
underlying businesses of companies with different amounts of debt as they may pay high amount as the
interest. Hence it is a real approximation of cash flow and takes into account the real income from the
operations.
Problem: It leaves out interests, taxes, depreciation and amortization.

12) Why do trailing P/E ratios vary with dividend payout?


ANS. As we know dividends reduce the share prices as the value of the dividend is taken out of the firm.
Hence the Price in the numerator of the trailing P/E is affected by dividends and the Earnings in the
denominator are not affected by dividends.
So if a company has paid a larger portion in dividend then it will affect its share price and in turn P/E
ratio.