Q4 - Fall 2007 savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/q4_review.htm
1.
Which of the following bonds is supported by collateral? a.
unsecured bo bonds
b.
income bonds
c.
equi eq uipm pmen entt trus trustt cert certif ific icat ates es
d.
debentures
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
2.
Default is a.
failur fai lure e to mee meett any any of of the the term terms s of the ind indent enture ure
b.
faililur fa ure e to to mak make e div divid iden end d pay payme ment nts s
c.
only on ly fa faililur ure e to to make make int inter eres estt paym paymen ents ts
d.
failur fai lure e to mai mainta ntain in more more ass assets ets tha than n liabi liabilit lities ies
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
1/35
3.
Which of the following reduces the investor's risk associated with investing in bonds? 1.
a sinking fu fund
2.
a va vari riab able le in inte tere rest st ra rate te
3.
a ca call fe feature
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
4.
Which of the following bonds are exempt from federal income taxation? a.
zero coupon bonds
b.
debenture bo bonds
c.
convertible bonds
d.
municipal bo bonds
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
2/35
5.
The yield to maturity on a bond is a.
the int intere erest st pai paid d divid divided ed by by the the price price of the bon bond d
b.
the bon bond's d's cou coupon pon div divide ided d by the pri princi ncipal pal amo amount unt
c.
the th e pric price e appr apprec ecia iati tion on ear earne ned d by the the bon bond d
d.
interest inter est plus plus price price appreci appreciatio ation n (or loss) achie achieved ved by holdi holding ng the bond to to maturit maturity y
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
3/35
6.
If a bond is selling for a discount, that implies 1.
interest rates have fallen
2.
interest rates have risen
3.
the yield to maturity exceeds the current yield
4.
the yield to maturity is less than the current yield
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
4/35
7.
Which of the following is not true if interest rates rise? a.
Existing bonds may be called.
b.
Prices of existing bonds fall.
c.
The yield to maturity rises more than the current yield.
d.
The market price of a zero coupon bond falls.
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
8.
If interest rates rise, a firm may retire a bond issue by 1.
calling it
2.
repurchasing it
3.
issuing new bonds and redeeming the old bonds
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
only 2
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
5/35
9.
The current yield on a bond is a.
interest paid divided by the bond's price
b.
the bond's coupon
c.
the interest rate stated on the bond
d.
the yield over the lifetime of the bond
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
10.
If interest rates in general rise, a.
the prices of existing bonds rise
b.
the prices of existing bonds fall
c.
the prices of matured bonds rise
d.
the prices of matured bonds fall
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
6/35
11.
If investors anticipate that interest rates will fall, they a.
should buy bonds
b.
should sell bonds
c.
should buy shares in money market mutual funds
d.
should take no action
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
12.
The current price of a bond is not affected by a.
current interest rates
b.
the risk classification of the bond
c.
the maturity date
d.
last year's interest rates
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
7/35
13.
The dividend paid by a preferred stock is usually a.
tax deductible
b.
variable
c.
paid in stock
d.
fixed
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
14.
Advantages of the corporate form of business include a.
limited liability for stockholders
b.
avoidance of state taxation
c.
limited life
d.
deductibility of dividends
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
8/35
15.
Break-even analysis requires knowing the relationship a.
between sales and earnings
b.
between sales and total costs
c.
between total revenues and fixed costs
d.
between sales and assets
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
16.
Break-even analysis may be used to show a.
the relationship between debt financing and earnings
b.
the level of sales necessary to avoid losses
c.
the level of output required to maximize profits
d.
the relationship between sales and equity
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
9/35
17.
Break-even analysis is not concerned with a.
the relationship between financial leverage and risk
b.
the relationship between sales and profits
c.
the relationship between total costs and revenues
d.
the relationship between fixed costs and output
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
18.
To determine the break-even level of output, management must know 1.
fixed costs of operation
2.
per unit variable costs of output
3.
total sales
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
all three
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
10/35
19.
A union contract suggests that labor costs may be a.
variable
b.
fixed
c.
a non-cash expense
d.
undetermined
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
20.
A firm may obtain financial leverage by 1.
issuing debt
2.
leasing
3.
issuing preferred stock
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
11/35
21.
The lower the debt ratio, a.
the higher is the use of financial leverage
b.
the lower is the use of financial leverage
c.
the lower are the firm's total assets
d.
the higher are the firm's total assets
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
12/35
22.
Higher fixed costs are associated with 1.
higher operating leverage
2.
lower operating leverage
3.
increased risk
4.
lower risk
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
23.
The lower the debt ratio, a.
the higher is the use of financial leverage
b.
the lower is the use of financial leverage
c.
the lower are the firm's total assets
d.
the higher are the firm's total assets
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
13/35
24.
The greater the usage of financial leverage, the larger is the variability of a.
revenues
b.
gross profits
c.
operating earnings
d.
net earnings
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
25.
If a firm's fixed costs rise relative to variable costs, ____ and ____. a.
operating leverage, risk increase
b.
operating leverage, financial leverage increase
c.
financial leverage, risk increase
d.
operating leverage increases, financial risk decreases
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
14/35
26.
Successful use of financial leverage may 1.
increase the firm's earnings per share
2.
decrease the firm's earnings per share
3.
increase investors' return on their funds
4.
decrease investors' return on their funds
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
15/35
27.
The increased use of financial leverage may 1.
affect the firm's credit rating
2.
decrease risk
3.
alter the firm's earnings
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
16/35
28.
The cost of equity 1.
is less than the cost of debt
2.
is greater than the cost of debt
3.
depends on the riskiness of the firm
4.
depends on the firm's current ratio
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
29.
Retained earnings a.
have no cost
b.
are the firm's cheapest source of funds
c.
have a cost that equals the cost of capital
d.
are cheaper than the cost of new common stock
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
17/35
30.
If the capital asset pricing model is used, the cost of equity depends on 1.
the firm's earnings growth rate
2.
the firm's beta
3.
the return on the market
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
31.
The optimal capital structure involves a.
maximizing the cost of all funds
b.
minimizing the cost of all funds
c.
using no financial leverage
d.
minimizing the weighted average of the cost of funds
ANSWER:
D
POINTS:
0/1
FEEDBACK:
REF:
18/35
32.
If equity is negative, a.
debt exceeds total assets
b.
total assets exceed debt
c.
equity exceeds assets
d.
equity exceeds debt
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
33.
Preferred stock increases common stockholders' return a.
more than an equal dollar amount of debt
b.
less than an equal dollar amount of debt
c.
more than an equal dollar amount of retained earnings
d.
less than an equal dollar amount of retained earnings
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
19/35
34.
The cost of debt is affected by 1.
retained earnings
2.
firm's tax rate
3.
interest rate
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
35.
The marginal cost of capital a.
is the firm's cost of debt and equity finance
b.
is constant given an optimal capital structure
c.
declines as flotation costs alter equity financing
d.
refers to the cost of additional financing
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
20/35
Problem
36.
You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond matures after ten years. What is the yield to maturity?
RESPONSE:
ANSWER:
The yield to maturity equates the present value of the interest payments and principal repayment. In this problem, that rate is 10%: ($40)(12.462) + ($1,000)(0.377) = $875.48. (PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)
POINTS:
-- / 1
REF:
37.
An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?
RESPONSE: ANSWER:
Price of the bond with 15 years (30 time periods) to maturity: (PV = ?; I = 5; N = 30; PMT = 35.50, and FV = 1000, PV = -777.10.) Since the investor purchased the bond for $1,000, the loss is $1,000 - $776 = $224.
POINTS:
-- / 1
REF:
21/35
38.
The price of a product is $1 a unit. A firm can produce this good with variable costs of $0.50 per unit and total fixed costs of $100. a.
What is the break-even level of output?
b.
What is the break-even level of output if fixed costs increase to $180 and variable costs decline to $0.40 per unit?
RESPONSE: ANSWER:
a.
break-even level of output: $100/($1 - $0.50) = 200 units
b.
break-even level of output: $180/($1 - $0.40) = 300 units
POINTS:
-- / 1
REF:
39.
Given the following information, answer the following questions. TR = $3Q TC = $1,500 + $2Q a.
What is the break-even level of output?
22/35
b.
If the firm sells 1,300 units, what are its earnings or losses?
c.
If sales rise to 2,000 units, what are the firm's earnings or losses?
d.
If the total cost equation were TC = $2,000 + $1.80Q, what happens to the break-even level of output units?
RESPONSE: ANSWER:
a.
Break-even level of output: $1,500/($3 - $2) = 1,500 units
b.
Earnings
= $3Q - $1,500 - $2Q = $3(1,300) - 1,500 - 2(1,300) = ($200)
c.
Earnings
= $3Q - $1,500 - $2Q = 3(2,000) - 1,500 - 2(2,000) = $500
d.
Break-even level of output: $2,000/($3 - $1.80) = 1,667 units
POINTS:
-- / 1
REF:
23/35
40.
You want to start a firm whose output you believe you can sell for $25 per unit. The operation will require fixed costs of $10,000, and the variable costs are expected to be $18 a unit. What will be the break-even level of output?
RESPONSE: ANSWER:
Break-even level of output: $100,000/($25 - 18) = 14,286 units
POINTS:
-- / 1
REF:
24/35
41.
Given the following information, what happens to operating income and net income if output is increased by 10 percent? Verify your answer. Total assets
$100,000
Debt (12% interest rate)
$80,000
Equity
$20,000
Variable costs of production
$14 per unit
Fixed cost of production
$27,000
Units sold
12,300
Sale price per unit
$19.75
RESPONSE: ANSWER:
The operating income: Revenues: $19.75(12,300) = $242,925 Expenses: $14.00(12,300) + $27,000 = $199,200 Operating income: $242,925 - 199,200 = $43,725 Net income: $43,725 - (.12)(80,000) = $34,125 Operating income rose from $43,725 to $50,797.50 for a 16.2 percent increase. Net income rose from $34,125 to $41,197.50 for a 20.7 percent increase.
POINTS:
-- / 1
REF:
42.
(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and expects
Sales
$200
Expenses
$185
Tax rate
a.
33% of earnings
What are earnings if the owners invest the $100?
25/35
b.
If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?
c.
What is the return on the owners' investment in each case? Why do the returns differ?
d.
If expenses rise to $194, what will be the returns in each case?
e.
In which case did the returns decline more?
f.
What generalization can you draw form the above?
RESPONSE: ANSWER:
a.
and b.
Sales
a
b
no financial
with financial
leverage
leverage
$200
$200
185
185
Expenses EBIT
15
15
Interest
-
4
EBT
15
11
Taxes
c.
5
Net earnings
$
10
Return on equity
$10/$100 = 10%
3.63 $
7.37
$7.37/$60 = 12.28%
26/35
The return for b is higher because of the successful use of financial leverage. (Point out that operating income is 15% of assets versus the 10% interest rate and the reduction in taxes that results from the interest expense.)
d.
Sales
no financial
with financial
leverage
leverage
$200
$200
194
194
Expenses
POINTS:
EBIT
6
6
Interest
-
4
EBT
6
2
Taxes
2
0.66
Net earnings
$
Return on equity
$4/$100 = 4%
4
$
1.34
$1.34/$60 = 2.23%
e.
The return on equity fell more for the firm that was financially leveraged.
f.
The generalization is that the use of financial leverage to increase the return on equity works both ways. If revenues fall and/or expenses rise, the use of financial leverage will magnify the swing in the firm's return on equity.
-- / 1
REF:
43. a.
Given the following schedules,
cost of
cost of
27/35
debt/assets s
debt
equity
0%
7%
14%
10
7
14
20
7
14
30
8
14
40
8
16
50
10
18
60
12
20
What is firm's cost of capital at the various combinations of debt and equity?
b.
What is the firm's optimal capital structure? Construct a balance sheet showing that combination of debt and equity financing.
Balance Sheet for Firm ´ as of XX/XX/XX Assets
$100
Debt Equity $100
c.
If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their required rate of return if the firm uses its optimal combination of debt and equity financing?
d.
If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if the cost of new shares is one percentage point higher at the firm's optimal capital structure?
e.
If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital structure if the firm needs $2,000,000?
RESPONSE:
28/35
ANSWER:
a.
Determination of cost of capital:
k
= weight ´ cost of debt + weight ´ cost of equity = .0(.07) + 1(.14) = 14.00% = .1(.07) + .9(.14) = 13.30 = .2(.07) + .8(.14) = 12.60 = .3(.08) + .7(.14) = 12.20 = .4(.08) + .6(.16) = 12.80 = .5(.10) + .5(.18) = 14.00 = .6(.12) + .4(.20) = 15.20
b.
The optimal capital structure is 30% debt and 70% equity. The balance sheet is
Balance Sheet for Firm ´ as of XX/XX/XX Assets
$100
Liabilities Equity
c.
$ 30 70 $100
If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the stockholders will not receive their required return of 14%. With 30% debt financing, $2.40 must go to creditors ($30 ´ .08 = $2.40), which leaves $7.60 for stockholders ($10 - 2.40). Since the stockholders have invested $70, they earn a return of 10.86% ($7.60/$70).
For the stockholders to earn their required return, the firm must earn at 12.2%. Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80) so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 = 14%).
d.
If the cost of new equity rises to 15 percent, the cost of capital at the optimal capital structure becomes:
29/35
.3(.08) + .7(.15) = 12.90.
e.
If the firm has retained earnings of $1,500,000, the breakpoint in the marginal cost of capital schedule is $1,500,000/.7 = $2,142,857.
The cost of capital from $0 - $2,142,857 is 12.2%. The cost of capital above $2,142,857 is 12.9%.
The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is $142,857 at 12.2 percent and $1,857,143 at 12.7 percent.
POINTS:
-- / 1
REF:
44.
Fill in the table using the following information. Assets required for operation: $2,000 Case A
- firm uses only equity financing
Case B
- firm uses 30% debt with a 10% interest rate and 70% equity
Case C
- firm uses 50% debt with a 12% interest rate and 50% equity
Debt outstanding
A
B
C
$
$
$
300
300
300
Stockholders' equity Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40% of earnings)
30/35
Net earnings Return on stockholders'
%
%
%
investment
What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why did the rate of interest increase in case C?
RESPONSE: ANSWER:
A 0
B
C
$ 600
$1,000
Debt outstanding
$
Stockholders' equity
2,000
1,400
1,000
Earnings before
300
300
300
Interest expense
0
60
120
Earnings before taxes
300
240
180
Taxes (40% of earnings)
120
96
72
Net earnings
$ 180
$ 144
$ 108
Return on stockholders'
9%
10.3%
10.8%
interest and taxes
investment
The rate of return to stockholders rises because the after tax cost of debt in B is .1(1 .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest rate increases because the firm becomes riskier when it uses more financial leverage. POINTS:
-- / 1
REF:
31/35
45.
The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital structure. a.
What is the firm's cost of capital if it uses only retained earnings?
b.
What is the firm's cost of capital if it uses new equity?
c.
How much total financing may the firm have before the marginal cost of capital rises?
RESPONSE:
32/35
ANSWER:
a.
The cost of capital using retained earnings: (.35)(.08) + (.65)(.14) = 11.9%
b.
The cost of capital using new equity: (.35)(.08) + (.65)(.149) = 12.485%
Notice that the marginal cost of capital rises after the firm exhausts its retained earnings and must start using more expensive new equity.
c.
The break-point in the marginal cost of capital schedule: $23,678/.65 = $36,428
The retained earnings can support up to $36,428 in total financing and still maintain the optimal combination of debt and equity financing. However, after $36,428 of total financing, the retained earnings are exhausted, and the firm must start using more expensive new equity.
POINTS:
-- / 1
REF:
46.
Given the following information: interest rate
8%
tax rate
30%
dividend
$ 1
price of the common stock
$50
33/35
growth rate of dividends
7%
debt ratio
40%
a.
Determine the firm's cost of capital.
b.
If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of capital?
c.
If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock falls to $30, what is the cost of capital? Why is this cost different?
RESPONSE:
34/35
