Comprehensive Review savannahstate.edu/misc/dowlingw/3155/Practice%20E /misc/dowlingw/3155/Practice%20Exams/comprehensive_makeup_review xams/comprehensive_makeup_review.htm .htm
1.
The term structure of interest rates relates a.
risk and yields
b.
yiel yi elds ds an and d bon bond d rat ratiing ngs s
c.
term and yields
d.
stoc st ock k an and d bo bond nd yi yiel elds ds
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
2.
Money serves as a.
a sub subs sti titu tutte for for equ quiity
b.
a pr prec ecau auti tion on ag agai ains nstt in infl flat atio ion n
c.
a me medium of of ex exchange
d.
a ri risk sk-f -fre ree e lia liab bil iliity
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
1/79
3.
M-2 includes 1.
demand de deposits
2.
savings accounts
3.
smal sm alll ce cert rtif ific icat ates es of de depo posi sitt
a.
1 and 2
b.
2 and 3
c.
1 and 3
d.
all three
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
4.
The regulation of securities markets a.
discourage disco urages s invest investing ing by requi requiring ring the regi registrat stration ion of inves investors tors
b.
is en enfo forc rced ed by th the e Fed Feder eral al Re Rese serv rve e
c.
protec pro tects ts inv invest estors ors fro from m the their ir own mis mistak takes es
d.
provid pro vides es invest investors ors with with inform informati ation on to make make informe informed d decisio decisions ns
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
2/79
5.
If an investor sells short, the individual 1.
sell se lls s bor borro rowe wed d sec secur urit itie ies s
2.
sells sel ls sec securi uritie ties s from from his or her por portfo tfolio lio
3.
anti an tici cipa pate tes s a pric price e incr increa ease se
4.
anti an tici cipa pate tes s a pric price e decr decrea ease se
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
3/79
6.
The efficient market hypothesis suggests 1.
Ameri Am erican can sec securi uritie ties s marke markets ts are are not not comp competi etitiv tive e
2.
Ameri Am erican can sec securi uritie ties s marke markets ts are are very very com compet petiti itive ve
3.
invest inv estors ors can exp expect ect to out outper perfor form m the the mar market ket
4.
invest inv estors ors can cannot not exp expect ect to outp outperf erform orm the mar market ket
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
7.
A specialis specialistt a.
stre st ress sses es on one e ty type pe of in inve vest stme ment nt
b.
only buys stock
c.
anal an alyz yzes es cor corpo pora rate te sec secur urit itie ies s
d.
make ma kes s a ma mark rket et in se secu curi riti ties es
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
4/79
8.
Over-the-counter stock quotes are obtained through a.
Nasdaq
b.
SEC
c.
SIPC
d.
FDIC
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
9.
The assets of a typical commercial bank include a.
commercial loans
b.
demand deposits
c.
common stock
d.
equity
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
5/79
10.
Federally insured investments include a.
savings accounts in national commercial banks
b.
certificates of deposit in excess of $100,000
c.
life insurance policies
d.
commercial bank assets
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
11.
An investment bank is not a financial intermediary because a.
it does not transfer money from investors to firms
b.
it does not create claims on itself
c.
it does facilitate the transfer of funds
d.
it creates claims on itself
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
6/79
12.
Withdrawing cash from a checking account does not decrease a.
the money supply
b.
demand deposits
c.
total reserves
d.
excess reserves
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
13.
By lowering the discount rate, the Federal Reserve a.
discourages commercial banks from lending
b.
encourages commercial banks to borrow reserves
c.
discourages depositors from withdrawing funds
d.
contracts the money supply
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
7/79
14.
The Federal Reserve may contract the money supply by 1.
selling securities
2.
buying securities
3.
raising reserve requirements
4.
lowering reserve requirements
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
15.
The Board of Governors a.
manages the nation's stock of gold
b.
has the substantive control over the money supply
c.
controls the U. S. Treasury
d.
is appointed by the U. S. Treasurer
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
8/79
16.
The tools of monetary policy include a.
open market operations
b.
the purchase of corporate stock
c.
the federal government deficit
d.
taxation
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
17.
Which is smallest if the interest rate is 10%? a.
present value of $100 annuity for five years
b.
future value of $100 annuity for five years
c.
present value of $100 after five years
d.
$100 received right now
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
9/79
18.
An annuity due is a set of a.
equal, annual payments made at the end of the year
b.
equal, annual payments
c.
equal, annual payments made at the beginning of the year
d.
rising annual payments
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
19.
Systematic risk 1.
is the tendency for a stock's return and the return on the market to move together
2.
is reduced by constructing a diversified portfolio
3.
depends on the firm's business and financial risk
4.
is measured by beta coefficients
a.
1 and 2
b.
2 and 3
c.
1 and 4
d.
2 and 4
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
10/79
20.
A beta coefficient for a risky stock is a.
less than 1.0
b.
equal to 1.0
c.
greater than 1.0
d.
negative
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
21.
A beta coefficient of 1.2 implies 1.
the stock is more risky than the market
2.
the stock's return is 1.2 times the return on the market
3.
the stock is less risky than the market
4.
the market's return is 1.2 times the return on the stock
a.
1 and 2
b.
1 and 4
c.
2 and 3
d.
3 and 4
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
11/79
22.
Which of the following will reduce the required return on an investment? a.
an increase in beta and a reduction in the Treasury bill rate
b.
an increase in the Treasury bill rate and a decrease in beta
c.
a decrease in the Treasury bill rate and a decrease in beta
d.
an increase in the Treasury bill rate and an increase in beta
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
23.
For a security to help diversify a portfolio, the asset a.
must generate a greater return than the average return on the portfolio
b.
should not be sensitive to changes in security prices
c.
should have a return that is negatively correlated with the return on other securities in the portfolio
d.
must be a debt instrument if the portfolio consists primarily of stocks
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
12/79
24.
A beta coefficient is a measure of the volatility of a.
a firm's position in its industry
b.
a stock's return relative to the market return
c.
aggregate market stock prices
d.
a firm's earnings
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
25.
The risk-adjusted required rate of return excludes a.
the stock's standard deviation
b.
the stock's beta
c.
the risk-free rate
d.
the anticipated return on the market
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
13/79
26.
Current liabilities do not include a.
short-term bank loans
b.
accrued interest
c.
accounts payable
d.
additional paid-in capital (capital surplus)
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
27.
According to accountants, assets should be recorded at a.
the selling price
b.
the market value
c.
the lower of market value or cost
d.
the cost of the asset
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
14/79
28.
Determination of earnings (profits) requires knowing a.
paid-in capital (capital surplus)
b.
cash
c.
retained earnings
d.
depreciation
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
29.
No matter which method of depreciation is used, a.
the firm's earnings are unaffected
b.
the cash flow from an investment is reduced
c.
the maximum amount that may be depreciated is the cost of the investment
d.
only short-term assets may be depreciated
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
15/79
30.
The DuPont system of financial analysis combines a.
profitability and turnover
b.
liquidity and turnover
c.
profitability and liquidity
d.
turnover and coverage
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
31.
The more rapidly receivables turn over a.
the more rapidly the firm is receiving cash
b.
the larger are the firm's sales
c.
the smaller is the firm's inventory
d.
the larger are the firm's accounts payable
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
16/79
32.
Profitability ratios measure a.
liquidity
b.
leverage
c.
performance
d.
turnover
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
33.
Which of the following is equity? 1.
investments
2.
additional paid-in capital
3.
retained earnings
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
17/79
34.
A stock dividend causes the firm's a.
assets to increase
b.
equity to increase
c.
liabilities to remain unchanged
d.
assets to decrease
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
35.
The retention of earnings instead of paying dividends a.
may result in greater growth and higher prices
b.
is advantageous for all stockholders
c.
is favored by stockholders in lower income tax brackets
d.
leads to lower future dividends
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
18/79
36.
A stock dividend a.
reduces the firm's cash
b.
increases the firm's total equity
c.
decreases the firm's retained earnings
d.
increases the firm's assets
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
37.
Stock repurchases a.
increase per share earnings
b.
decrease per share earnings
c.
increase liabilities
d.
decrease liabilities
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
19/79
38.
According to the dividend-growth model, the value of a stock does not depend on a.
future dividends
b.
past dividends
c.
future growth
d.
investors' required rate of return
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
20/79
39.
The value of a stock may increase if 1.
risk is increased
2.
risk is decreased
3.
investors' required rate of return increases
4.
investors' required rate of return decreases
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
21/79
40.
A P/E ratio considers a.
profits relative to earnings
b.
price of the stock relative to earnings
c.
price of a preferred stock relative to earnings
d.
profits relative to equity
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
41.
An increase in investors' required return should cause the value of a common stock to a.
rise
b.
fall
c.
remain unchanged
d.
remain stable or rise slightly
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
22/79
42.
Interest is exempt from federal income taxation on a.
equipment trust certificates
b.
zero coupon bonds
c.
federal bonds such as savings bonds
d.
state of Florida bonds
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
43.
If a company enters bankruptcy court, bondholders should realize a.
subordinated debt is paid off at face value
b.
convertible debt is superior because it may be converted into common stock
c.
bondholders may lose their investments
d.
stockholders have the superior position
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
23/79
44.
Which of the following reduces the investor's risk associated with investing in bonds? 1.
a sinking fund
2.
a variable interest rate
3.
a call 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:
24/79
45.
Bonds may be retired prior to maturity by 1.
repurchases
2.
a sinking fund
3.
a call feature
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
all three
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
25/79
46.
The price of a bond depends on 1.
the bond's coupon
2.
the maturity date
3.
current interest rates
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
26/79
47.
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:
27/79
48.
If a bond is selling for a premium, that implies 1.
interest rates have risen
2.
interest rates have fallen
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:
D
POINTS:
0/1
FEEDBACK: REF:
49.
If interest rates decline after a bond is issued, a.
the bond's coupon is decreased
b.
the bond's price falls
c.
the yield to maturity will exceed the current yield
d.
the current yield will exceed the yield to maturity
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
28/79
50.
If interest rates rise after a bond is issued, 1.
the bond may be called
2.
the firm may repurchase the bond
3.
the current yield exceeds the yield to maturity
4.
the current yield is less than the yield to maturity
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
29/79
51.
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:
52.
Common features of preferred stock include a.
variable, cumulative dividends
b.
variable, non-cumulative dividends
c.
fixed, non-cumulative dividends
d.
fixed, cumulative dividends
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
30/79
53.
Which of the following is not equity? a.
paid-in capital
b.
retained earnings
c.
preferred stock
d.
debentures
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
54.
The price of a convertible bond is often 1.
greater than its value as stock
2.
less than its value as stock
3.
greater than its value as debt
4.
less than its value as debt
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
31/79
55.
As the price of common stock rises, a.
the value of convertible bonds and convertible preferred stock declines
b.
the value of convertible bonds falls but convertible stock rises
c.
the value of convertible bonds rises but convertible preferred stock falls
d.
the value of convertible bonds and convertible preferred stock rises
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
56.
Convertible bonds have 1.
an indenture
2.
perpetual life
3.
a specified conversion price
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
32/79
57.
The value of a convertible bond as stock depends in part upon a.
interest rates
b.
the maturity date
c.
the exercise price
d.
the call penalty
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
58.
Studies of rates of return on large stocks suggest a.
the average return is about 7.4 percent annually
b.
over a period of years, the rate is approximately 10 percent
c.
equity investors rarely sustain losses
d.
dividends account for over half the return
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
33/79
59.
Mutual funds a.
pay federal income taxes
b.
distribute earnings to receive favorable tax treatment
c.
pay only state and local taxes
d.
pay taxes only on capital gains
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
60.
The net asset value of a mutual fund's share increases with a.
an increase in loading fees
b.
an increase in interest rates
c.
an increase in security prices
d.
an increase in the fund's assets
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
34/79
61.
The shares of mutual funds are bought a.
in the secondary markets
b.
from closed-end investment companies
c.
from commercial banks
d.
from the mutual fund
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
62.
Owners in which of the following forms of business have unlimited liability? a.
LLCs
b.
corporations
c.
sole proprietorships
d.
limited partnerships
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
35/79
63.
Which of the following is usually a variable expense? a.
salaries
b.
rent
c.
wages
d.
insurance premiums
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
64.
Variable costs a.
are greater than fixed costs
b.
are greater than total costs
c.
are paid after fixed costs
d.
change with the level of output
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
36/79
65.
Business risk refers to 1.
use of accelerated depreciation
2.
the risk inherent in the nature of the business
3.
the sources of the firm's finances
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
only 2
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
66.
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:
37/79
67.
Increased operating leverage is associated with additional risk because 1.
Lower variable costs increase the variability of total costs
2.
Lower variable costs increase the variability of earnings before interest and taxes
3.
Higher fixed costs increase the variability of earnings before interest and taxes
4.
Higher fixed costs require higher sales to cover total costs.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
3 and 4
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
68.
Increased variability of operating income is associated with a.
increased interest expense
b.
increased variable cost
c.
increased taxes
d.
increased fixed costs
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
38/79
69.
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:
70.
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:
39/79
71.
The marginal cost of capital rises 1.
because the cost of retained earnings exceeds the cost of new shares
2.
because the cost of new shares exceeds the cost of retained earnings
3.
if the firm issues secured debt instead of debentures
4.
if the firm issues debentures instead of secured debt
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
40/79
72.
The cost of capital includes 1.
cost of debt
2.
cost of preferred stock
3.
cost of retained earnings
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
41/79
73.
In the capital assets pricing model, the cost of equity is investors' required return and includes 1.
the expected return on the market
2.
the firm's beta
3.
the firm's tax rate
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
74.
NPV may be preferred to IRR because a.
IRR makes the more conservative assumption concerning reinvestment
b.
NPV makes the more conservative assumption concerning reinvestment
c.
IRR excludes salvage value
d.
NPV includes salvage value
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
42/79
75.
Risk analysis may be introduced by a.
estimating an investment's beta
b.
using the firm's cost of capital
c.
reducing an investment's expected life
d.
using accelerated depreciation
ANSWER: POINTS:
A 0/1
FEEDBACK: REF:
Problem
76.
What is a nation's cash inflow (outflow) on its current account and its capital account given the following information? Was there a net currency inflow or outflow?
imports
$145
exports
211
direct investments abroad
72
foreign investments in the country
143
foreign purchases of domestic securities
86
purchases of foreign securities
29
net income from foreign investments
37
government spending abroad
22
RESPONSE:
43/79
ANSWER:
Debit
Credit
Current account exports
$211
imports
$145
government spending abroad
22
net income from investment abroad
37
Balance on current account
$81
Capital account direct investment abroad
72
foreign investment in U.S. purchases of foreign securities foreign purchases of U.S. securities Balance on capital account
143 29 86 $128
In this problem there is a net credit balance on both the current and capital accounts, which means there is a currency inflow. This inflow may be used to increase foreign reserves or repay any loans from the IMF. POINTS:
-- / 1
REF:
44/79
77.
If you open an individual retirement account (IRA) at a commercial bank and deposit $1,000 in the account per year, how much will be in the account after 20 years if the funds earn 7% annually?
RESPONSE:
ANSWER:
$1,000(40.995) = $40,995 40.995 is the interest factor for the future value of an annuity at 7% for twenty years. (PV = 0; N = 20; I = 7; PMT = -1000, and FV = ?. FV = 40995.)
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78.
You borrow $100,000 to buy a house; if the annual interest rate is 6% and the term of the loan is 20 years, what is the annual payment required to retire the mortgage loan?
RESPONSE: ANSWER:
X = $100,000/11.470 = $8,718.40 8.514 is the interest factor for the present value of an annuity at 6% for twenty years. (PV = 100000; N = 20; I = 6; PMT = ?, and FV = 0. PMT = -8718.46.)
POINTS:
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79.
An investor expects a stock to double in 7 years. What is the expected annual rate of growth in the price of the stock?
RESPONSE: ANSWER:
$1(1 + g) 7 = $2 (1 + g) 7 = $2/$1 = 2 g is approximately 10%. (PV = -1; N = 7; I = ?; PMT = 0, and FV = 2. I = 10.41.)
POINTS:
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80.
An apartment will generate $12,000 a year for 5 years, after which you expect to sell the property for $100,000. What is the maximum you should pay for the property if your cost of money is 10%?
RESPONSE: ANSWER:
This is another valuation problem set as a real estate investment. The maximum price you should pay is the present value of the estimated cash flow and sale price: $12,000(3.791) + $100,000(0.621) = $107,592. The annual cash flows are insufficient to justify buying the property. (PV = ?; N = 5; I = 10; PMT = 12000, and FV = 100,000. PV = -107582.)
POINTS:
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81.
The Big-Sox currently have 30,000 spectators per game and anticipate annual growth in attendance of 9%. If the Big Stadium holds 65,000 people, how long will it take for the team reach capacity?
RESPONSE: ANSWER:
30,000(1 + .09) t = 65,000 (1 + .09) t = 65,000/30,000 = 2.167 t is 9 years. Look up 2.167 in the future value of $1 table at 9% and determine that n is approximately 9 years. (PV = -30000; N = ?; I = 9; PMT = 0, and FV = 65000. N = 8.97.)
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82.
You bought a Picasso for $50,000 and sold it after 5 years for $88,000. What was the annual return on the investment?
RESPONSE: ANSWER:
(1 + x) 5 = $88,000/$50,000 = 1.760 x = 12% Look up 1.760 in the interest table for the future value of $1 for 5 years, and determine the annual growth rate. (PV = -50000; N = 5; I = ?; PMT = 0, and FV = 88000. I = 11.97.)
POINTS:
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83.
AZ's dividend rose from $1 to $1.61 in five years. What has the dividend's annual rate of growth?
RESPONSE: ANSWER:
This is an example of future value. Solve for the interest factor: $100(FVIF) = $161 The interest factor is $161/$100 = 1.61 Find 1.61 in the interest table for the future value of a dollar using five years. The growth rate is 10 percent. (PV = -100; N = 5; PMT = 0; FV = 161; I = ?; I = 9.99.)
POINTS:
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84.
If a company paid a dividend of $1 in 2006 and the dividend grows annually by 7 percent, what will be the dividend in 2011?
RESPONSE: ANSWER:
This is another example of future value: $100(1 + .07) 5 = X The interest factor for the future value of a dollar at 7 percent for 5 years is 1.403. Hence $100(1.403) = $1.40 (PV = -100; N = 5; I = 7; PMT = 0; FV = ?; FV = 140.26.)
POINTS:
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85.
If a new college graduate wants a car costing $15,000, how much must be saved annually if the funds earn 5 percent?
RESPONSE: ANSWER:
This is an example of the future value of an annuity. The question is, what amount (X) times the interest factor for the future sum of an ordinary annuity of $1.00 for 4 years at 5 percent (interest factor = 4.310) equals $10,000? X(4.310) = $15,000 X = $15,000/4.310 = $3,480 The graduate will have to save $3,480 annually to have accumulated the $15,000. (PV = 0; N = 4; I = 5; FV = 15000; PMT = ?; PMT = 3480.18.)
POINTS:
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86.
If an annuity costs $200,000 and yields 7 percent annually for 5 years, how much cash can an individual withdraw each year such that the principal is consumed at the end of the time period?
RESPONSE: ANSWER:
This illustrates the present value of an annuity of $1.00. The interest factor at 7 percent for 5 years is 4.10. (FVAIF)(X) = $200,000 4.1X = $200,000 X = $200,000/4.1 = $48,780 The person may withdraw over $48,778 annually for five years. (PV = -200000; N = 5; FV = 0; I = 7; PMT = ? PMT = 48778.14.)
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87.
A firm earns 10 percent annually on its investments. One possible investment offers $50,000 a year for 10 years and costs $300,000. Should the firm make this investment?
RESPONSE: ANSWER:
This problem is an example of the present value of an annuity. The interest factor for the present value of the annuity of $1.00 at 10 percent for 10 years is 6.145. X = $50,000 ´ 6.145 X = $307,250 The firm should make this investment because the present value of the cash inflow generated by the investment ($307,250) exceeds the cost (cash outflow) of the investment ($300,000). (PMT = 50000; N = 10; FV = 0; I = 10; PV = ? PV = 307228.36.)
POINTS:
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88.
You inherit a trust account that promises to pay $13,000 a year for 10 years and then distribute $100,000. If current yields are 10 percent, what is the value of the trust?
RESPONSE: ANSWER:
This problem is another illustration of present value, consisting of an annuity component and a single, lump sum payment. $13,000(6.145) + 100,000(.386) = $118,485 The trust is currently worth $118,485. (PMT = -13000; N = 10; FV = -100000; I = 10; PV = ? PV = 118433.70.)
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89.
If a creditor owes $24,000 and annually pays $3,000, how quickly will the loan be retired if the interest rate is 8 percent annually?
RESPONSE: ANSWER:
This is an example of the present value of an annuity in which the number of years is the unknown. Solve for the interest factor: $3,000(PVAIF) = $24,000 PVIF = 24,000/3,000 = 8. The number of years to retire the loan is slightly more than thirteen, using the interest table for the present value of an annuity. (PMT = -3000; FV = 0; I = 8; PV = 24000; N = ?; N = 13.27.)
POINTS:
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90.
An annuity offers $1,000 for 10 years. If you can earn 12 percent annually on your funds, what is the maximum amount you should pay for this annuity?
RESPONSE: ANSWER:
This problem is similar to #21 but is applied to an individual's investment. The present value of the annuity is PVA = $1,000(5.650) = $5,650. 5.650 is the interest factor for the present value of an ordinary annuity at 12 percent for 10 years. The investor should pay no more than $5,650 for this investment. (PMT = 1000; N = 10; FV = 0; I = 12; PV = ? PV = -5650.22.)
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91.
How much additional interest will you earn on $1,000 at 10 percent percent for 10 years if interest is compounded semi-annually instead of annually?
RESPONSE: ANSWER:
This problem illustrates the impact of more frequent compounding. Annual compounding: compounding: $1,000(1 + .1) 10 = $1,000(2.594) = $2,594 (PV = -1000; N = 10; I = 10; PMT = 0; FV = ?; FV = 2593.74.) Semi-annual compounding: $1,000(1 + .1/2) 10x2 = 1,000(1.05) 20 = $1,000(2.653) = $2,653 (PV = -1000; N = 20; I = 5; PMT = 0; FV = ?; FV = 2653.30.) The difference in interest earned is $59.
POINTS:
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92.
You bought a stock with a beta of 1.4 1.4 and earned a return of 8.3%. Did you outperform outperform the market if, during the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a Treasury bill?
RESPONSE: ANSWER:
The material in this problem was not explicitly covered in the chapter chapter.. You may use the problem to set up the question, "What return should you have earned during a particular investment horizon?" The answer uses the capital asset model to evaluate performance. Thus, the return that should have been realized is Rf + (R m - Rf ) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%. 9.46%. The actual return (8.3% return) is less than the return that would be expected given the beta and the market performance. The stock under-performed the market on a risk-adjusted basis.
POINTS:
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93.
Construct a balance sheet from the following information.
Accrued interest payable
$
4,000
Accumulated depreciation
30,000
Trade accounts payable
10,000
Retained earnings
86,000
Accrued wages
11,000
Work in process
5,000
Finished goods
30,000
Plant and equipment
100,000
Cash Ca sh an and d ma mark rket etab able le se secu curi riti ties es
10,0 10 ,000 00
Land La
10,000
Accounts receivable
32,000
Allo Al lowa wanc nce e fo forr do doub ubtf tful ul ac acco coun unts ts
2,00 2, 000 0
Bank note (due in six months)
15,000
Long-term debt
15,000
Raw materials
7,000
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Investments
10,000
Taxes due
1,000
Additional paid-in capital (capital surplus)
20,000
$1 par value common stock 20,000 shares authorized 10,000 shares outstanding
RESPONSE: ANSWER:
Firm XYZ Balance Sheet for the Period Ending December 31, 20XX Assets Current assets Cash and marketable securities Accounts receivable
$10,000 $32,000
Less allowance for doubtful accounts
(2,000)
30,000
Inventory In Finished goods
30,000
Work in process
5,000
Raw materials
7,000
Total current assets
42,000 $82,000
Long-term assets Plant and equipment
$100,000
Less accumulated
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depreciation Land
(30,000)
70,000 10,000
Total long-term assets
$80,000
Investments
$ 10,000
Total assets
$172,000
Liabilities and Stockholders' Equity Current liabilities Accounts payable
$10,000
Accrued wages
11,000
Bank notes
15,000
Accrued interest payable
4,000
Accrued taxes
1,000
Total current liabilities
$41,000
Long-term debt
$15,000
Total liabilities
$56,000
Stockholders' equity Comm Co mmon on st stoc ock k ($1 ($1 pa parr val value ue;; 20, 20,00 000 0 shares au authorized; 10 10,000 sh shares outstanding)
$ 10,000
Paid-in capital
20,000
Retained earnings Total stockholders' equity
Tot otal al li liab abil ilit itie ies s an and d st stoc ockh khol olde ders rs'' eq equi uity ty
86,000 $116,000
$172 $1 72,0 ,000 00
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94.
Given the following information, construct the statement of cash flow. What happened to the firm's liquidity position during the year?
Net income
$16.7
Decrease in accounts receivable
6.1
Increase in accounts payable
13.6
Sale of bonds
55.1
Dividends
14.8
Retirement of bonds
10.8
Increase in inventory
15.2
Depreciation expense
56.0
Cost of goods sold
72.1
Reduction in income taxes payable
5.0
Sale of stock
0.4
Purchase of plant and equipment
91.0
Beginning cash
1.1
Repurchase of stock
5.6
RESPONSE: ANSWER:
Statement of Cash Flows for the Period Ending December 31, 20XX
Operating activities Net income
$16.7
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Depreciation
56.0
Decrease in accounts receivable
6.1
Increase in inventory
(15.2)
Increase in accounts payable
13.6
Decrease in income taxes payable
(5.0)
Net cash provided by operating activities
$72.2
Investment activities Increase in plant
(91.0)
Net cash used in investing activities
($91.0)
Financing activities Proceeds from sale of long-term debt
55.1
Payments on long-term debt
(10.8)
Dividends
(14.8)
Repurchase of stock
(5.6)
Sale of stock
0.4
Net cash provided by financing activities
$24.3
Cash at beginning of the year
$1.1
Cash at the end of the year
$6.6
The firm's cash position has increased, but that does not mean the firm is more liquid since inventory and accounts payable increased while accounts receivable declined. You should also note that the firm increased its investment in plant by using the cash generated through depreciation and the issuing of new long-term debt. The earnings and sale of stock did not cover dividends and stock repurchases. This indicates that the firm is more financially leveraged.
POINTS:
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95.
The inventory turnover for an industry is 6 (every two months) but Slow Corp. turns over its inventory 4 times a years (every three months). If annual sales are $1,000,000 and the interest cost to carry inventory is 12 percent, what is the potential savings in interest expense if the firm achieves the industry for the turnover of its inventory?
RESPONSE: ANSWER:
The current level of inventory is Inventory turnover: Sales/Average inventory 1,000,000/X = 4 X = $250,000.
The level of inventory implied by the industry average is Inventory turnover: Sales/Average inventory 1,000,000/X = 6 X = $166,667.
The potential reduction in inventory: $250,000 - 166,667 = $83,333.
The potential savings in interest expense (if the firm can achieve the industry average for the turnover of its inventory): $83,888 ´ 0.12 = $10,000.
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96.
What is the debt/net worth ratio and the debt to total assets ratio for a firm with total debt of $600,000 and equity of $400,000?
RESPONSE: ANSWER:
Debt/Net worth: $600,000/$400,000 = 1.5 Debt ratio (Debt/Total assets): $600,000/($600,000 + $400,000) = 0.6 = 60%
POINTS:
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97.
Currently the price of a stock is $58 a share. The firm's balance sheet is as follows: Assets
Liabilities and Equity
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
Common stock ($10 par;
10,000,000
receivable Inventory
120,000,000
Plant and
325,000,000
equipment
1,000,000 shares outstanding) Paid-in capital Retained earnings
$705,000,000
90,000,000 185,000,000 $705,000,000
Construct a new balance sheet showing the impact of a two-for-one stock split. What will be the new price of the stock?
RESPONSE:
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ANSWER:
The new balance sheet after the two-for-one stock split: Assets
Liabilities and Equity
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
Common stock ($5 par;
10,000,000
receivable Inventory
120,000,000
2,000,000 shares outstanding)
Plant and
325,000,000
Add. paid-in capital
equipment
Retained earnings $705,000,000
90,000,000 185,000,000 $705,000,000
The only changes are the entries under common stock since there are now 2,000,000 shares of $5 par stock outstanding. The new price of the stock is $58/2 = $29.
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98.
Construct a new balance sheet showing the impact of a 5 percent stock dividend. What will be the new price of the stock?
RESPONSE: ANSWER:
The new balance sheet after the 5 percent stock dividend: Assets
Liabilities and Equity
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
Common stock ($10 par;
10,500,000
receivable Inventory
120,000,000
1,050,000 shares outstanding)
Plant and
325,000,000
Add. paid-in capital
equipment
Retained earnings $705,000,000
92,400,000 182,100,000 $705,000,000
The firm issues (.05)(1,000,000) = 50,000 shares with a $10 par value. The common stock entry is increased by $500,000 to $10,500,000. The market value of the stock is $58 ´ 50,000 = $2,900,000. Retained earnings are reduced by $2,900,000 to $182,100,000. Since retained earnings are reduced by $2,900,000 and common stock is increased only by $500,000, $2,400,000 is unaccounted for. In order to balance the balance sheet, additional paid-in capital is increased by $2,400,000. The new price of the stock is $58 /1.05 = $55.24. This price adjustment is necessary to adjust for the dilution of the old stock that results from the stock dividend. Be certain to point out that in both the stock split and the stock dividend (1) assets are not changed, (2) liabilities are not changed, and (3) total equity is not changed. All that occurs is (1) a reduction in the price of the stock resulting from the increase in the number of shares, and (2) some changes in the individual entries in the equity section of the balance sheet. POINTS:
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99.
Two stocks each pay a $1 dividend that is growing annually at 8 percent. Stock A's beta = 1.3; stock B's beta = 0.8. a.
Which stock is more volatile?
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b.
If Treasury bills yield 9 percent and you expect the market to rise by 13 percent, what is your riskadjusted required return for each stock?
c.
Using the dividend-growth model, what is the maximum price you would be willing to pay for each stock?
d.
Why are their valuations different?
RESPONSE:
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ANSWER:
a.
Stock A is more volatile because it has the higher beta coefficient.
b.
Required rate of return = r f + (r m - r f )beta
For stock A: Required rate = .09 + (.13 - .09)1.3 = 14.2%
For stock B: Required rate = .09 + (.13 - .09)0.8 = 12.2%
c.
Valuation of stock A:
Valuation of stock B:
d.
POINTS:
Even though the dividends and growth rates are equal, stock A is riskier (higher beta) which reduces its valuation.
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100.
What is the value of a preferred stock that pays an annual dividend of $3 a share and competitive yields are 5%, 10%, and 15%?
RESPONSE: ANSWER:
Value of the perpetual preferred stock: At 5%: Pp = $3/.05 = $60 At 10%: P p = $3/.10 = $30 At 15%: P p = $3/.15 = $20
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101.
Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent and answer the following questions. XY 5 1/4 percent (interest paid annually) for 20 years AB 14 percent (interest paid annually) for 20 years a.
Which bond has a current yield that exceeds the yield to maturity?
b.
Which bond may you expect to be called? Why?
c.
If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower rated, what would be its price relative to the XY, Inc bond? Explain.
RESPONSE:
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ANSWER:
Price of the XY, Inc. bond: (PV = ?; I = 10; N = 20; PMT = 52.50, and FV = 1000, PV = -596.) Price of the AB, Inc. bond: (PV = ?; I = 10; N = 20; PMT = 140, and FV = 1000, PV = -1341.) The current yields are
102.
a.
The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25% versus 10%) because the current yield does not consider the loss of the premium the investors will suffer over the lifetime of the bond.
b.
There is no reason to expect the firm to call the XY bond, because the firm could repurchase the bonds at a discount. The AB bond, however, may be called. Current interest rates are lower (10% versus the 14% coupon on that bond), so the firm could refund the debt. (The instructor should ask what impact the expectation of such refunding may have on the price of the bond.)
c. Since the CD and XY(interest bonds are with regard paid and An investor buys a $1,000, 20 year 7 percent paididentical semiannually) bondtoatinterest par. After five years term to maturity, the factor that differentiates them is the credit rating. The have passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond? CD bond has a lower credit rating, so its value relative to the XY bond should be less. Such a lower price will increase the yield to the investor and presumably would be necessary to induce the investor to purchase the riskier bond. RESPONSE: ANSWER:
Price of the bond with 15 years (30 time periods) to maturity:
POINTS:
(PV -- / 1= ?; 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.
REF: POINTS:
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103.
A convertible bond has the following features:
Coupon
6.5%
Maturity date
10
Exercise price
$20
Principal
$1,000
Call price
$1,065
years
Convertible preferred stock Annual dividend $2.25 Convertible into 2.5 shares of common stock Callable at $25 a share Currently the common stock is selling for $13; the yield on non-convertible bonds is 10%, and the yield on comparable preferred stocks is 14%. What is the value of the above securities in terms of the common stock? What would be the value of each security if it lacked the conversion feature?
RESPONSE: ANSWER:
Value of the convertible bond as stock: First, determine the number of shares into which the bond may be converted: $1,000/$20 = 50 shares. Next, multiply the number of shares by the price per share: 50 ´ $13 = $650. Value of the convertible bond as debt: $65(6.145) + $1,000(0.386) = $785.43 (6.145 and 0.386 are respectively the interest factors for the present value of an annuity and the present value of a dollar at 10 percent for ten years. If a financial calculator is used, enter PMT = 65, FV = 1000, I = 10, N = 10, and solve for PV. In this example, PV = -784.94.) Since the bond's value as debt exceeds its value as stock, the bond will sell for at least $785.43, its value as debt. (The bond will probably sell for more than $785.43, as it will command a premium over the bond's value as debt.) Value of the convertible preferred stock as common stock: 2.5 shares ´ $13 = $32.50 Value of the convertible preferred stock as non-convertible preferred stock: $2.25/.14 = $16.07 Since the conversion value of the stock exceeds its value as non-convertible preferred stock, the convertible preferred stock will sell for at least $32.50, its value as common stock.
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104.
You bought a stock for $28.29 that paid the following dividends Year
1
2
3
Dividend
$1.00
$1.50
$1.80
After the third year, you sold the stock for $35. What was the annual rate of return?
RESPONSE: ANSWER:
Select a rate and determine if it equates both sides of the equation. For example, select 12 percent: $1(.893) + 1.50(.797) + 1.80(.712) + 35(.712) = $28.29 The annual rate of return is 12 percent. The same answer may be derived using a financial calculator, but it requires the student to enter unequal cash inflows for each period.
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105.
If an investor purchases shares in a no load fund for $36, receives cash distributions of $1.27 and sells the shares after one year for $41.29, what is the percentage return on the investment?
RESPONSE: ANSWER:
The percentage return: ($1.27 + 5.29)/$36 = 18.2%
POINTS:
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106.
Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?
RESPONSE:
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ANSWER:
a.
for $1,000: ($1,000)0.15 = $150
b.
for $10,000: ($10,000)0.15 = $1,500
c.
for $100,000: ($50,000).15 + (25,000).25 + 25,000(.34) = $22,250
d.
for $1,000,000: ($50,000).15 + (25,000).25 + 25,000(.34) + (235,000).39 + (665,000).34 = $340,000
e.
for $10,000,000: ($50,000).15 + (25,000).25 + 25,000(.34) + (335,000).39 + (665,000).34 + (9,000,000)x.34 =
POINTS:
$3,400,000
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REF:
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107.
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
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108.
Given the following information, answer the following questions. TR = $3Q TC = $1,500 + $2Q a.
What is the break-even level of output?
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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:
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109.
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:
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REF:
110.
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
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Earnings before taxes Taxes (40% of earnings) 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:
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REF:
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111.
An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to the net present value and internal rate of return methods of capital budgeting, should the firm make this investment if its cost of capital is (a) 10% or (b) 14%?
RESPONSE:
Internal rate of return: $10,000 = (PVAIF x%, 10y)$1,770 $10,000 = $1,770X X = $10,000/$1,770 = 5.650 r = 12% (PV = -10000; N= 10; I = ?; PMT = 1770, and FV = 0. I = 12.)
ANSWER:
Net present value at 10%: NPV
= $1,770(PVAIF 10%, 10y) = $1,770(6.145) - $10,000 = $10,876.65 - $10,000 = $876.65
(PV = ?; N = 10; I = 10; PMT = 1770, and FV = 0. PV = -10876.) Net present value at 14%: NPV
= $1,770(PVAIF 14%, 10y) = $1,770(5.216) - $10,000 = ($767.68)
(PV = ?; N = 14; I = 10; PMT = 1770, and FV = 0. PV = -9233.) At k = 10% the firm should make the investment. (NPV is positive and IRR exceeds the firm's cost of capital.) At k = 14% the firm should not make the investment. (NPV is negative and IRR is less than the firm's cost of capital.) -- / 1
POINTS: REF:
112.
A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost of capital is 6 percent. Year
1
Cash Inflow A
B
$175
$1,100
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2
175
-
3
175
-
4
175
-
5
175
-
6
175
-
7
175
-
8
175
-
a.
What is the internal rate of return on each investment? Which investment should the firm make?
b.
What is the net present value of each investment? Which investment should the firm make?
c.
If the cash inflows can be reinvested at 8 percent, which investment should be made?
RESPONSE: ANSWER:
a.
Determination of the internal rates of return: A:
$175(PVAIF x%, 8y) = $1,000 Interest factor = $1,000/$175 = 5.174 r A = approximately 8% (PV = -1000; N = 8; I = ?; PMT = 175, and FV = 0. I = 8.15.)
B:
$1,100/(1 + r B ) = $1,000 Interest factor = $1,000/$1,100 = .909 r B = 10%
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Since the investments are mutually exclusive, the firm should select B because it has the higher internal rate of return.
b.
Determination of the net present values:
A:
Net present value A: $175(PVAIF 6%, 8y) - $1,000 = $175(6.210) - $1,000 = $87
B:
Net present value B: $1,100/(1 + .06) - $1,000 = $1,100(.943) - $1,000 = $37
Since the investments are mutually exclusive, the firm should select A because it has the higher net present value.(This contradicts part a, which selected investment B.)
c.
If the firm is able to reinvest the annual payments of $175, the terminal value of A is $175(10.637) = $1,861.48 (10.637 is the interest factor for the future value of an ordinary annuity at 8% for eight years.)
If the firm selects B, it receives $1,100 in year one, which is reinvested at 8% for seven years. The terminal value is $1,100(1.714) = $1,885.40. This is higher than the terminal value for A, so the firm should make investment B.
POINTS:
-- / 1
REF:
113.
Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and the investments' estimated cash inflows are cash inflow
A
B
year
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1
$2,320
---
2
---
---
3
---
$2,810
a.
What investment(s) should the firm make according to net present value?
b.
What investment(s) should the firm make according to internal rate of return?
c.
If the firm can reinvest funds earned in year 1 at 10%, which investment(s) should the firm make?
RESPONSE:
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ANSWER:
a.
Net present value of A: $2,320/(1 + .09) - 2,000 = $128
Net present value of B: $2,810/(1 + .09) 3 - 2,000 = $170
Since the investments are mutually exclusive, the firm cannot make both and will select B since it has the higher NPV.
b.
Internal rate of return of A: $2,000 = $2,320/(1 + r) PVIF = .862 r = 16%
Internal rate of return of B: $2,000 = $2810/(1 + r) 3 PVIF = .712 r = 12%
Since the investments are mutually exclusive, the firm cannot make both and will select A since it has the higher IRR.
c.
There is an obvious conflict in the rankings. The purpose of this question is to help reconcile the conflict. If the $2,320 grow annually at 10 percent, then the future value is
$2,320(1 + .1) 2 = $2,320(1.210) = $2,807.20.
Investment B is now clearly preferred to A because the terminal value of S is $2,807.20, which is less than $2810.
POINTS:
-- / 1
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REF:
114.
A risky $500,000 investment is expected to generate the following cash flows:
Year
1
2
3
$250,000
$266,667
$285,715.
The probability of receiving each cash inflow is 80, 75, and 70 percent, respectively. If the firm's cost of capital is 10 percent, should the investment be made?
RESPONSE: ANSWER:
The risk-adjusted cash inflows are (0.80) ($250,000) = $200,000 (0.75) ($266,667) = 200,000 (0.70) ($285,715) = 200,000
The present value of the cash inflows is $200,000(PVAIF, 10I, 3N) = $200,000(2.487) = $497,400 (FV = 0; PMT = 200000, I = 10; N = 3; PV = ?. PV = -497370.) Since the net present value is negative [$497,400 - 500,000 = ($2,600)], the investment should not be made. POINTS:
-- / 1
REF:
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115.
A risky $1,000 investment is expected to generate the following cash flows: Year
1
2
3
$600
$600
$600.
a.
If the firm's cost of capital is 10 percent, should the investment be made?
b.
An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually and repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management believes that the cash inflows from the risky investment are only equivalent to 70 percent of the certain investment. Does this information alter the decision in (a)?
RESPONSE: ANSWER:
a.
The net present values if the firm's cost of capital is 10 percent: $600(PVAIF 10I, 3N) - $1,000 = $600(2.487) - $1,000 = $492.20.
The net present value is positive. The investment should be made.
b.
If the cash flows are considered to be only 70 percent certain and the riskfree, certain discount rate is 5 percent, the net present value is (0.7)$600(PVAIF 5I, 3N) - $1,000 = $420(2.723) - $1,000 = $143.66.
The adjusted net present value remains positive, so the investment should be made.
POINTS:
-- / 1
REF:
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