Comprehensive Preview - Summer 2011 savannahstate.edu/misc/dowl /misc/dowlingw/3155/Practic ingw/3155/Practice%20Exams/com e%20Exams/comprehensive_preview prehensive_preview_-_summer_201 _-_summer_2011.htm 1.htm
1.
In general, the role of the financial manager is to plan for the acquisition and use of funds so as to maximize the value of the firm.
ANSWER:
T
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2.
Normal profits are those that result in rates of return that are just sufficient to attract new capital in financial markets.
ANSWER:
T
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3.
If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate.
ANSWER:
T
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4.
In a competitive marketplace "good ethics" is a wonderful idea but an impractical standard. There are simply too few benefits to be gained from maintaining high business ethics.
ANSWER:
F
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5.
Managers of firms using accounting manipulations to inflate current earnings are likely to generate long-term benefits to the shareholders of the firm.
ANSWER:
F
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6.
A proprietorship is an unincorporated business owned by one individual and the owner benefits from the limited liability for business which limits his losses to what he has invested in the company company..
ANSWER:
F
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7.
The income statement measures the flow of funds into (i.e. revenue) and out of (i.e. expenses) the firm over a certain time period. It is always based on accounting data.
ANSWER:
T
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8.
Depreciation, as shown on the income statement, is regarded as a use of cash because it is an expense.
ANSWER:
F
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9.
Non-cash assets are expected to produce cash over time but the amount of cash they eventually produce could be higher or lower than the values at which the assets are carried on the books.
ANSWER:
T
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10.
The degree to which the managers managers of a firm attempt attempt to magnify magnify the returns to owners' owners' capital capital through through the use of financial leverage is captured in debt management ratios.
ANSWER:
T
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11.
Profitability ratios show the combined effects of liquidity liquidity,, asset management, and debt management on operations.
ANSWER:
T
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12.
Genzyme Corporation has seen its days sales outstanding (DSO) decline from 38 days last year to 22 days this implying that more of the firm's suppliers are being paid on time.
ANSWER:
F
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13.
The fixed charge coverage ratio recognizes that firms often lease equipment under contract and thus, some firms must meet more than just their scheduled interest payments out of earnings. Therefore, the fixed charge coverage is more inclusive than the TIE ratio.
ANSWER:
T
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14.
If an individual investor buys and sells existing stocks through a broker, these are primary market transactions.
ANSWER:
F
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15.
The securities exchange commission is the U.S. government agency that regulates the issuance and trading of stocks and bonds.
ANSWER:
T
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16.
Cash flow time lines are used primarily for decisions involving paying off debt or investing in financial securities. They cannot be used when making decisions about investments in physical assets.
ANSWER:
F
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17.
One of the potential benefits of investing early for retirement is that an investor can receive greater benefits from the compounding of interest.
ANSWER:
T
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18.
Of all the techniques used in finance, the least important is the concept of the time value of money.
ANSWER:
F
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19.
During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) often are prevalent.
ANSWER:
T
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20.
The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.
ANSWER:
T
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21.
The real rate of interest is composed of a risk-free rate of interest plus a premium that reflects the riskiness of the security.
ANSWER:
F
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22.
LIBOR is an acronym for London Interbank Offer Rate, which is an average of interest rates offered by London banks to U.S. corporations.
ANSWER:
F
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23.
Restrictive covenants are designed so as to protect both the bondholder and the issuer even though they may constrain the actions of the firm's managers. Such covenants are contained in the bond's indenture.
ANSWER:
T
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24.
Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise. Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers.
ANSWER:
F
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25.
A 20-year original maturity bond with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates.)
ANSWER:
F
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26.
You have just noticed in the financial pages of the local newspaper that you can buy a bond ($1,000 par) for $800. If the coupon rate is 10 percent, with annual interest payments, and there are 10 years to maturity, should you make the purchase if your required return on investments of this type is 12 percent?
ANSWER:
T Cash flow time line: Tabular solution: Vd
= $100 (PVIFA 12%, 10) + $1,000 (PVIF 12%, 10) = $100 (5.6502) + $1,000 (0.3220) = $877.02.
Thus, the value is significantly higher than the market price and the bond should be purchased. Financial calculator solution: Inputs: N = 10; I = 12; PMT = 100; FV = 1,000. Output: PV = -$887.00. POINTS:
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27.
The book value per share is computed by taking the sum of common stock, additional paid in capital, and retained earnings and dividing the number by the number of shares outstanding.
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T
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28.
When a firm issues new equity, market pressure applies first to the new shares issued and then to existing shares. Subsequent to the new issue, the value of the new shares will rise to the equilibrium price of the old shares.
ANSWER:
F
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29.
When management controls more than 50% of the shares of the firm, they must be concerned with the potential of a proxy fights than can lead to takeovers of the firm and the replacement of management.
ANSWER:
F
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30.
According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock.
ANSWER:
F
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31.
A firm cannot change its beta through any managerial decision because betas are completely market determined.
ANSWER:
F
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32.
In the real world, the type of security that generates a return that is nearest to a risk-free rate of return is a Treasury bill.
ANSWER:
T
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33.
Assume Stock A has a standard deviation of 0.21 while Stock B has a standard deviation of 0.10. If both Stock A and Stock B must be held in isolation, and if investors are risk averse, we can conclude that Stock A will have a greater required return. However, if the assets could be held in portfolios, it is conceivable that the required return could be higher on the low standard deviation stock.
ANSWER:
T
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34.
The tighter the probability distribution, the less variability there is and the less likely it is that the actual outcome will be close to the expected value; consequently the more likely it is that the actual return will be much different from the expected return.
ANSWER:
F
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35.
If a project's NPV exceeds the project's IRR, then the project should be accepted.
ANSWER:
F
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36.
A capital budgeting project is acceptable if the rate of return required for such a project is greater than the project's internal rate of return.
ANSWER:
F
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37.
When considering two mutually exclusive projects, the financial manager should always select that project whose internal rate of return is the highest provided the projects have the same initial cost .
ANSWER:
F
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38.
The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, for the duration of a project's life, other things held constant.
ANSWER:
F
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39.
When calculating the cash flows for a project, you should include interest payments.
ANSWER:
F
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40.
Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.
ANSWER:
F
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41.
A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.
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T
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42.
Empirical studies of risk strongly support the contention that investors who are well diversified focus exclusively on market risk when they establish required returns.
ANSWER:
F
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43.
Superior analytical techniques, such as NPV, used in combination with adjustments to the average required rate of return, can overcome the problem of poor cash flow estimation in decision making.
ANSWER:
F
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44.
It is extremely difficult to estimate the revenues and costs associated with large complex projects that take several years to develop. This is why subjective judgment is recommended for such projects instead of cash flow analysis.
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F
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45.
It is possible with a replacement project that the incremental depreciation cash flows will be negative even if the actual depreciation on the new asset is positive.
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T
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46.
Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost.
ANSWER:
F
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47.
The cost of capital used in capital budgeting must be determined using the specific financing used to fund that particular project.
ANSWER:
F
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48.
If a firm cannot invest retained earnings and earn at least the cost of equity, it should pay these funds to shareholders and let them invest directly in other assets that do provide this return.
ANSWER:
T
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49.
The cost of debt, r d, is always less than r s , so r d(1 - T) will certainly be less than r s . Therefore, since a firm cannot be 100% debt financed, the weighted average cost of capital will always be greater than r d(1 - T).
ANSWER:
T
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50.
Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources. However, when the firm plans on using only debt or only equity to fund a particular project, it should use the after-tax cost of the specific source of capital to evaluate that project.
ANSWER:
F
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Multiple Choice Identify the choice that best completes the statement or answers the question.
51.
Which of the following is a reason why companies move into international operations? a.
To take advantage of lower production costs in regions of inexpensive labor.
b.
To develop new markets for their finished products.
c.
To better serve their primary customers.
d.
Because important raw materials are located abroad.
e.
All of the above.
ANSWER:
E
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52.
Which of the following statements is correct? a.
The corporate bylaws are the set of rules drawn up by the state to enable managers to run the firm in accordance with state laws.
b.
Procedures for electing corporate directors are contained in bylaws while the declaration of the activities that the firm will pursue and the number of directors are included in the corporate charter .
c.
Procedures which govern changes in the bylaws of the corporation are contained in the corporate charter .
d.
Although most companies design a charter , only the bylaws are legally required to be filed with the secretary of state in order for a corporation to be in official existence.
ANSWER:
B
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53.
Which of the following statements is correct? a.
In a partnership, liability for other partners' misdeeds includes but is limited to the amount a particular partner has invested in the business.
b.
Partnerships must be formed according to specific rules which include the filing of a formal written agreement with state authorities where the partnership does business.
c.
A fast growth company would be more likely to set up a partnership for its business organization than would a slow-growth company.
d.
Partnerships have difficulty attracting capital in part because of the other disadvantages of the partnership form of business, including impermanence of the organization.
e.
A major disadvantage of a partnership as a form of business organization is the high cost and practical difficulty of its formation.
ANSWER:
D
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54.
Which of the following statements is incorrect ? a.
Large European firms generally have many more individual owners than large U.S. firms.
b.
One reason domestic firms "go global" is to sell products in new markets.
c.
Often firms can avoid regulatory hurdles that apply to foreign manufacturers by establishing operations in the country where the hurdles apply.
d.
A difficulty associated with doing business in international markets is that not all countries have the same currency.
e.
Cultural differences among countries make it difficult for a multinational firm to use the same marketing strategy¾that is, packaging, advertising, and so forth ¾in every country in which it operates.
ANSWER:
A
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55.
In the United States, the most common form of business is the ____, and the form of business that generates most of the sales and profits is the ____. a.
corporation; corporation
b.
corporation; proprietorship
c.
proprietorship; partnership
d.
proprietorship; corporation
e.
corporation; partnership
ANSWER:
D
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56.
Which of the following financial statements includes information about a firm's assets, equity, and liabilities? a.
Income statement
b.
Cash flow statement
c.
Balance sheet
d.
Statement of retained earnings
e.
All of the above
ANSWER:
C
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57.
Which of the following ratios measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs? a.
fixed charge coverage ratio
b.
debt ratio
c.
times-interest-earned ratio
d.
return on equity
e.
profit margin
ANSWER:
C
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58.
Which of the following statements is most correct? a.
An increase in a firm's debt ratio, with no changes in its sales and operating costs, could be expected to lower its profit margin on sales.
b.
An increase in DSO, other things held constant, would generally lead to an increase in the total asset turnover ratio.
c.
An increase on the DSO, other things held constant, would generally lead to an increase in the ROE.
d.
In a competitive economy, where all firms earn similar returns on equity, one would expect to find lower profit margins for airlines, which require a lot of fixed assets relative to sales, than for fresh fish markets.
e.
It is more important to adjust the Debt/Asset ratio than the inventory turnover ratio to account for seasonal fluctuations.
ANSWER:
A Statement a is true because, if a firm takes on more debt, its interest expense will rise, and this will lower its profit margin. Of course, there will be less equity than there would have been, hence the ROE might rise even though the profit margin fell.
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59.
Which of the following statements is correct? a.
The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of changes in long-term financing.
b.
Although the annual report is geared toward the average stockholder, it represents financial analysts' most complete source of financial information about the firm.
c.
The key importance of annual report information is that it is used by investors when they form their expectations about the firm's future earnings and dividends and the riskiness of those cash flows.
d.
The annual report provides no relevant information for use by financial analysts or by the investing public.
e.
None of the above statements is correct.
ANSWER:
C
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60.
Which of the following statements about ratio analysis is incorrect ? a.
Classifying a large, well-diversified firm into a single industry often is difficult because many of the firm's divisions are involved with different products from different industries.
b.
As a rule of thumb, it is safe to conclude that any firm with a current ratio greater than 1.0 should be able to meet its current obligations¾that is, pay bills that come due in the current period. [Current ratio = (Current assets) / (Current liabilities)]
c.
Sometimes firms attempt to use "window dressing" techniques to make their financial statements look better than they actually are in the current period.
d.
Computing the values of the ratios is fairly simple; the toughest and most important part of ratio analysis is interpretation of the values derived from the computations.
e.
General conclusions about a firm should not be made by examining one or a few ratios ¾ratio analysis should be comprehensive.
ANSWER:
B
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61.
Collins Company had the following partial balance sheet and complete income statement information for last year:
19/76
Balance Sheet:
Cash
$
A/R
1,000
Inventories
20
2,000
Total current assets
$ 3,020
Net fixed assets
2,980
Total assets
$ 6,000
Income Statement :
Sales
$10,000
Cost of goods sold EBIT
9,200 $
Interest (10%)
800 400
EBT
$
Taxes (40%)
400 160
Net Income
$
240
The industry average DSO is 30 (360-day basis). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and which has a 10% interest rate), what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet? a.
33.33%
b.
45.28%
c.
52.75%
d.
60.00%
e.
65.71%
ANSWER:
E Industry average DSO = 30 days. Reduce receivables by Debt = $400/0.10 = $4,000.
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62.
A firm has total interest charges of $10,000 per year, sales of $1 million, a tax rate of 40 percent, and a net profit margin of 6 percent. What is the firm's times-interest-earned ratio? a.
16 times
b.
10 times
c.
7 times
d.
11 times
e.
20 times
ANSWER:
D NI = $1,000,000(0.06) = $60,000. EBT = $60,000/0.6 = $100,000. EBIT = $100,000 + $10,000 = $110,000. TIE = EBIT/I = $110,000/$10,000 = 11 times.
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63.
A corporate stock that was issued last year would now trade in the ____ market. a.
primary
b.
secondary
c.
money
d.
debt
e.
government securities
ANSWER:
B
POINTS:
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64.
Which of the following is not a considered financial intermediary? a.
commercial bank
b.
savings and loan association
c.
pension fund
d.
investment bank
e.
All of the above are financial intermediaries.
ANSWER:
D
POINTS:
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65.
Large, well-known public companies can reduce the time required to register and issue securities by using a(n) a.
Shelf registration.
b.
Subchapter S registration.
c.
Underwriting syndicate.
d.
Secondary market registration.
e.
"Red herring" registration.
ANSWER:
A
POINTS:
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66.
Which of the following is usually cited as a disadvantage of issuing new common stock as a method of financing? a.
Common stock does not have a maturity date, thus it is an open-end commitment of the firm's earnings.
b.
Since sale of common stock increases the number of owners and the amount of capital at risk, the firm's bond rating is usually negatively affected and its cost of debt rises.
c.
If the firm currently has more equity than its optimal capital structure dictates and it issues more equity, then the average cost of capital will most likely rise.
d.
Common stock is not an attractive option if the firm seeks to increase its reserve borrowing capacity.
ANSWER:
C
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67.
Which form of informational market efficiency states that the market price of an asset contains all of the pertinent information regarding the value of that security? a.
Strong-form
b.
Semistrong-form
c.
Weak-form
d.
Economic-form
ANSWER:
A
POINTS:
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68.
Which of the following statements is correct? a.
For all positive values of r and n, FVIF r, n ³ 1.0 and PVIFA r, n ³ n.
b.
You may use the PVIF tables to find the present value of an uneven series of payments. However, the PVIFA tables can never be of use, even if some of the payments constitute an annuity (for example, $100 each year for Years 3, 4, and 5), because the entire series does not constitute an annuity.
c.
If a bank uses quarterly compounding for saving accounts, the simple rate will be greater than the effective annual rate.
d.
The present value of a future sum decreases as either the simple interest rate or the number of discount periods per year increases.
e.
All of the above statements are false.
ANSWER:
D
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69.
Suppose that the present value of receiving a guaranteed $450 in two years is $385.80. The opportunity rate of return on similar risk investments is 8 percent. According to this information, all else equal, which of the following statements is correct? a.
It always would be preferable to wait two years to receive the $450 because this value is greater than the present value.
b.
Risk averse investors always would prefer to take the $385.80 today because it is a guaranteed amount whereas there is uncertainty as to whether the future amount will be paid.
c.
No investor should be willing to pay more than $385.80 for such an investment.
d.
It is apparent the present value was computed incorrectly because the present value of a future amount always should be greater than the future value.
e.
None of the above is a correct answer.
ANSWER:
C
POINTS:
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FEEDBACK: REF:
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70.
Gomez Electronics needs to arrange financing for its expansion program. Bank A offers to lend Gomez the required funds on a loan where interest must be paid monthly, and the quoted rate is 8 percent. Bank B will charge 9 percent, with interest due at the end of the year. What is the difference in the effective annual rates charged by the two banks? a.
0.25%
b.
0.50%
c.
0.70%
d.
1.00%
e.
1.25%
ANSWER:
C Bank A: 8%, monthly Bank B: 9%, interest due at end of year EARB = 9%. 9.00% - 8.30% = 0.70%.
POINTS:
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25/76
71.
Assume you are to receive a 20-year annuity with annual payments of $50. The first payment will be received at the end of Year 1, and the last payment will be received at the end of Year 20. You will invest each payment in an account that pays 10 percent. What will be the value in your account at the end of Year 30? a.
$6,354.81
b.
$7,427.83
c.
$7,922.33
d.
$8,591.00
e.
$6,752.46
ANSWER:
B Cash flow time line: Tabular solution: FVYear 20
= $50 (FVIFA 10$, 20) = $50 (57.275) = $2,863.75.
FVYear 30
= $2,863 (FVIFA 10$, 10) = $2,863.75 (2.5937) = $7,427.71.
Financial calculator solution: Calculate FV at Year 20, then take that lump sum forward 10 years to Year 30 at 10%.
Inputs: N = 20; I = 10; PMT = -50. OutputYear 20: FV = $2,863.75. At Year 30
Inputs: N = 10; I = 10; PV = -2,863.75. OutputYear 30: FV = $7,427.83. POINTS:
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72.
You expect to receive $1,000 at the end of each of the next 3 years. You will deposit these payments into an account which pays 10 percent compounded semiannually. What is the future value of these payments, that is, the value at the end of the third year? a.
$3,000
b.
$3,310
c.
$3,318
d.
$3,401
e.
$3,438
ANSWER:
C Cash flow time line: Tabular solution: FV
= $1,000(FVIF 5%,4) + $1,000(FVIF 5%,2) + $1,000 = $1,000(1.2155) + $1,000(1.1025) + $1,000 = $1,215.50 + $1,102.50 + $1,000 = $3,318.00.
Financial calculator solution: Convert r SIMPLE to EAR using interest rate conversion
Inputs: P/YR = 2; NOM% =10. Output: EFF% = EAR = 10.25%. Solve for FV on annual basis using EAR
Inputs: N = 3; I = 10.25; PMT = -1,000. Output: FV = $3,318.006 » $3,318.00. POINTS:
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27/76
73.
You want to buy a Nissan 350Z on your 27th birthday. You have priced these cars and found that they currently sell for $30,000. You believe that the price will increase by 5 percent per year until you are ready to buy. You can presently invest to earn 14 percent. If you just turned 20 years old, how much must you invest at the end of each of the next 7 years to be able to purchase the Nissan in 7 years? a.
$4,945.57
b.
$3,933.93
c.
$7,714.72
d.
$3,450.82
e.
$6,030.43
ANSWER:
B Cash flow time lines: Tabular solution: Price of car on 27th birthday
FV = $30,000 (FVIF 5%, 7) = $30,000 (1.4071) = $42,213. Annual investment required
FV of annuity = FVA n = PMT (FVIFA i, n) $42,213 = PMT (FVIFA 14%, 7) PMT = $42,213/10.7305 = $3,933.93. Financial calculator solution: Price of car on 27th birthday
Inputs: N = 7; I = 5; PV = -30,000. Output: FV = $42,213.01 » $42,213. Annual investment required Inputs: N = 7; I = 14; FV = 42,213. Output: PMT = -$3,933.93. POINTS:
0/1
FEEDBACK: REF:
28/76
Financial Calculator Section
The following question(s) may require the use of a financial calculator.
74.
The Desai Company just borrowed $1,000,000 for 3 years at a quoted rate of 8 percent, quarterly compounding. The loan is to be amortized in end-of-quarter payments over its 3-year life. How much interest (in dollars) will your company have to pay during the second quarter? a.
$15,675.19
b.
$18,508.81
c.
$21,205.33
d.
$24,678.89
e.
$28,111.66
ANSWER:
B ·
Compute the quarterly payment:
·
Beg Bal
PMT
INT
Principal
End Bal
$1,000,000.00
$94,559.60
$20,000.00
$74,559.60
$925,440.40
925,440.40
94,559.60
18,508.81
76,050.79
849,389.61
Interest in the second quarter (payment) is $18,508.81.
POINTS:
0/1
FEEDBACK: REF:
29/76
75.
You plan to invest $2,500 in a money market account which will pay an annual stated (simple) interest rate of 8.75 percent, but which compounds interest on a weekly basis. If you leave this money on deposit for one year (52 weeks), what will be your ending balance when you close the account? a.
$2,583.28
b.
$2,611.72
c.
$2,681.00
d.
$2,703.46
e.
$2,728.50
ANSWER:
E Numerical solution: Financial calculator solution: Convert simple rate to EAR
Inputs: P/YR = 52; NOM% = 8.75. Output: EFF% = EAR + 9.1362% » 9.14% Calculate FV
Inputs: N = 1; I = 9.14; PV = -2,500. Output: FV = $2,728.50 POINTS:
0/1
FEEDBACK: REF:
76.
Your father, who is 60, plans to retire in 2 years, and he expects to live independently for 3 years. He wants a retirement income which has, in the first year, the same purchasing power as $40,000 has today. However, his retirement income will be of a fixed amount, so his real income will decline over time. His retirement income will start the day he retires, 2 years from today, and he will receive a total of 3 retirement payments. Inflation is expected to be constant at 5 percent. Your father has $100,000 in savings now, and he can earn 8 percent on savings now and in the future. How much must he save each year, starting today, to meet his retirement goals? a.
$1,863
b.
$2,034
c.
$2,716
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d.
$5,350
e.
$6,102
ANSWER:
C Step 1:
The retirement payments, which begin at t = 2, must be:
$40,000 (1 + Infl) 2 = $40,000 (1.05) 2 = $44,100
Step 2:
There will be 3 retirement payments of $44,100, made at t = 2, t = 3, and t = 4. We find the PV of an annuity due at t = 2 as follows: Set calculator to "Begin". Then enter: N = 3; I = 8, PMT = 44,100; FV = 0. Solve for PV = $122,742. If he has this amount at t = 2, he can receive the 3 retirement payments.
Step 3:
The $100,000 now on hand will compound at 8% for 2 years:
$100,000 (1.08)2 = $116,640
Step 4:
Step 5:
So, he must save enough each year to accumulate an additional $122,742 $116,640 - $6,102: Need at t = 2
$122,742
Will have
(116,640)
Net additional needed
$
6,102
He must make 2 payments, at t = 0 and at t = 1, such that they will grow to a total of $6,102 at t = 2 This is the FV of an annuity due found as follows: Set calculator to "Begin". Then enter: N = 2; I = 8; PV = 0; FV = 6,102. Solve for PMT = $2,716
POINTS:
0/1
FEEDBACK:
31/76
REF:
77.
Your father, who is 60, plans to retire in 2 years, and he expects to live independently for 3 years. Suppose your father wants to have a real income of $40,000 in today's dollars in each year after he retires. His retirement income will start the day he retires, 2 years from today, and he will receive a total of 3 retirement payments. Inflation is expected to be constant at 5 percent. Your father has $100,000 in savings now, and he can earn 8 percent on savings now and in the future. How much must he save each year, starting today, to meet his retirement goals? a.
$1,863
32/76
b.
$2,034
c.
$2,716
d.
$5,350
e.
$6,102
33/76
ANSWER:
D Step 1:
The retirement payments, which begin at t = 2, must be:
t = 2: $40,000 (1.05) 2 = $44,100 t = 3: $44,100 (1.05) = $46,305 t = 4: $46,305 (1.05) = $48,620
Step 2:
Now we need enough at t = 2 to make the 3 retirement payments as calculated in Step 1. We cannot use the annuity method, but we can enter, in the cash flow register, the following: CF0 = $44,100 CF1 = 446,305 CF2 = $48,620 Then enter I = 8, and press NPV to find NPV = PV = $128,659
Step 3:
The $100,000 now on hand will compound at 8% for 2 years:
$100,000 (1.08)2 = $116,640.
Step 4:
78.
The net funds needed are:
Need at t = 2
$128,659
Will have
(116,640)
Your client just turned 75 years old and plans on retiring in 10 years on her 85th birthday. She is saving money today Net needed $ 12,019 for her retirement and is establishing a retirement account with your office. She would like to withdraw money from her retirement account on her birthday each year until she dies. She would ideally like to withdraw $50,000 on her 85th birthday, and increase her withdrawals 10 percent a year through her 89th birthday (i.e., she would like to withdraw $73,205 on her 89th birthday). She plans to die on her 90th birthday, at which time she would like to leave $200,000 to her descendants. Your currently has $100,000. You $12,019. estimate that the calculator money in to the"Begin" retirement Step Find theclient payments needed to accumulate Set the and account will earn 8 percent a year over the next 15 years. Your client plans to contribute an equal amount of money 5: then enter: each year until her retirement. Her first contribution will come in one year; her tenth and final contribution will come in ten years (on her 85th birthday). How much should she contribute each year in order to meet her objectives? N = 2; I = 8; PV = 0; FV = 12,019. Solve for PMT = $5,350. a.
$12,401.59
b.
$12,998.63
POINTS:
c.
0/1
$13,243.18
FEEDBACK:
d.
$13,759.44
REF:
e.
$14,021.53
34/76
ANSWER:
A Annuity payments Value of cash outflows: Age 85
CF0 = ($50,000) CF1 = ( 55,000) = ( -50,000) (1.1) CF2 = ( 60,000) = ( -50,000) (1.1) 2 CF3 = ( 66,550) = ( -50,000) (1.1) 3 CF4 = ( 73,205) = ( -50,000) (1.1) 4 CF5 = (200,000)
Solve for NPV at 8% = ($395, 548.96). Value for $100,000 at age 85; $100,000 (1.08) 10 = $215,892.50 Shortfall at age 85 = $215,892.50 - $395,548.96 = ($179,656.46). Calculate annual payments to equal this shortfall: N = 10; I/YR = 8; PV = 0; FV = 179,656.46. Solve for PMT = $12,401.59
POINTS:
0/1
FEEDBACK: REF:
79.
Semiannual payment bonds with the same risk (Aaa) and maturity (20 years) as your company's bonds have a simple (not EAR) yield of 9 percent. Your company's treasurer is thinking of issuing at par some $1,000 par value, 20-year, quarterly payment bonds. She has asked you to determine what quarterly interest payment, in dollars, the company would have to set in order to provide the same effective annual rate (EAR) as those on the 20-year, semiannual payment bonds. What would the quarterly interest payment be, in dollars? a.
$45.00
b.
$25.00
c.
$22.25
d.
$27.50
e.
$23.00
35/76
ANSWER:
C Cash flow time lines: Semi-annual Quarterly
Numerical solution: Step 1:
Solve for the EAR of 9% simple compounded semiannually .
.
Step 2:
Solve for r SIMPLE of 9.2025% EAR but with quarterly compounding.
. r SIMPLE/4 = (1.092025) 0.25 - 1 = 0.02225. r SIMPLE = 0.02225 ´ 4 = 0.08901.
Step 3:
Calculate the quarterly payment using the periodic rate.
Multiple 0.02225 ´ $1,000 = $22.25 = quarterly payment
Financial calculator solution: Step 1:
Calculate the EAR of 9% simple yield bond compounded semi-annually. Use interest rate conversion feature .
Inputs: P/YR = 2; NOM% = 9. Output: EFF% = 9.2025%
Step 2:
Calculate the simple rate, r SIMPLE , of a 9.2025% EAR but with quarterly compounding .
Inputs: P/YR = 4; EFF% = 9.2025. Output: NOM% = 8.90%
Step 3:
Calculate the quarterly periodic rate from r SIMPLE of 8.9% and calculate the quarterly payment.
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r Per = r SIMPLE/4 = 8.90%/4 = 2.225% Inputs: N = 80; I = 2.225; PV = -1,000; FV = 1,000. Output: PMT = $22.25.
POINTS:
0/1
FEEDBACK: REF:
80.
Garcia Inc. has a current dividend of $3.00 per share (D 0 = $3.00). Analysts expect that the dividend will grow at a rate of 25 percent a year for the next three years, and thereafter it will grow at a constant rate of 10 percent a year. The company's cost of equity capital is estimated to be 15 percent. What is the current stock price of Garcia Inc.? a.
$75.00
b.
$88.55
c.
$95.42
d.
$103.25
e.
$110.00
37/76
ANSWER:
C Step 1
Find the dividend stream to D 3: = $3.00 = ($3.00)(1.25) = $3.7500 = ($3.75)(1.25) = $4.6875 = ($4.6875)(1.25) = $5.8594
Step 2
Find :
Step 3
Find the NPV of the cash flows, the stock's value: =0 = 3.7500 = 4.6875 = 134.7654 I = 15 Solve for NPV = $95.42.
POINTS:
0/1
FEEDBACK: REF:
81.
Assume that you would like to purchase 100 shares of preferred stock that pays an annual dividend of $6 per share. However, you have limited resources now, so you cannot afford the purchase price. In fact, the best that you can do now is to invest your money in a bank account earning a simple interest rate of 6 percent, but where interest is compounded daily (assume a 365-day year). Because the preferred stock is riskier, it has a required annual rate of return of 12 percent (assume that this rate will remain constant over the next 5 years). For you to be able to purchase this stock at the end of 5 years, how much must you deposit in your bank account today, at t = 0? a.
$2,985.00
b.
$4,291.23
c.
$3,138.52
d.
$3,704.18
e.
$4,831.25
38/76
ANSWER:
D Numerical solution: Amount needed to buy 100 shares: $50(100)
= $5,000
$5,000
= PV(1 + 0.06/365) 5(365)
$5,000
= PV(1.3498)
PV
= $3,704.18.
Financial calculator solution: Convert the simple interest rate to an EAR
Inputs: P/YR = 365; NOM% = 6. Output: EFF% = EAR = 6.183%. Calculate PV of deposit required today
Inputs: N = 5; I = 6.183; FV = 5,000. Output: PV = -$3,704.205 » -$3,704.21. Note: The numerical solution is used as the correct answer because of its greater precision. If the financial calculator derived EAR is expressed to five decimal places it yields a PV = -3,704.18.
POINTS:
0/1
FEEDBACK: REF:
82.
A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast Start's beta is 1.75. The current earnings per share (EPS0) is $2.50. The company has a 40 percent payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent this year, 20 percent next year, and 15 percent the following year. After three years the dividend is expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its current payout ratio. The analyst believes that the stock is fairly priced. What is the current price of the stock?
39/76
a.
$16.51
b.
$17.33
c.
$18.53
d.
$19.25
e.
$19.89
ANSWER:
C a.
Use the SML equation to solve for r s . r s = 0.0625 + (0.05)(1.75) = 0.15 = 15%.
b.
Calculate dividend per share, D0:
(EPS0)(Payout ratio) = D 0 ($2.50)(0.4) = $1.00.
c.
Calculate the dividend and price stream (once the stock becomes a constant growth stock):
D0 = $1.00; D 1 = $1.00 ´ 1.25 = $1.25; D 2 = $1.25 ´ 1.20 = $1.50; D 3 = $1.50 ´ 1.15 = $1.725; D4 = $1.725 ´ 1.07 = $1.8458; .
d.
Use the cash flow register to calculate PV: = 0; = 1.25; = 1.50; = 1.725 + 23.072 = 24.797; I = 15%. Solve for NPV = $18.53.
POINTS:
0/1
FEEDBACK: REF:
40/76
41/76
83.
Your company is choosing between following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your required rate of return is 10 percent. How much value will your firm sacrifice if it selects the project with the higher IRR? Project L
Project S
Time
CF
CF
0
-2,000
-1,000
1
668.76
500
2
668.76
500
3
668.76
500
4
668.76
5
668.76
a.
$243.43
b.
$291.70
c.
$332.50
d.
$481.15
e.
$535.13
ANSWER:
B NPVS = $243.43; IRR S = 23.38% NPVL = $535.13; IRR L = 20.00% Value sacrificed: $535.13 - $243.43 = $291.70
POINTS:
0/1
FEEDBACK: REF:
84.
Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent required rate of return. Inflation is zero. What is the project's NPV? a.
$7,673.71
b.
$12,851.75
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c.
$17,436.84
d.
$24,989.67
e.
$32,784.25
ANSWER:
A Purchase
(50,000)
Sales
50,000
50,000
50,000
-VC
(20,000)
(20,000)
(20,000)
-Deprec.
(40,000)
(5,000)
(5,000)
EBT
(10,000)
25,000
25,000
(10,000)
(10,000)
-Taxes
4,000
Net income
(6,000)
15,000
15,000
+Depreciation
40,000
5,000
5,000
34,000
20,000
20,000
NWC
(12,000)
12,000
RV(AT)
______
______
______
6,000
NCF
(62,000)
34,000
20,000
38,000
NPV15% = $7,673.71. POINTS:
0/1
FEEDBACK: REF:
43/76
85.
After a long drought, the manager of Long Branch Farm is considering the installation of an irrigation system which will cost $100,000. It is estimated that the irrigation system will increase revenues by $20,500 annually, although operating expenses other than depreciation will also increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5 years) to a zero salvage value. If the tax rate on ordinary income is 40 percent, what is the project's IRR? a.
12.6%
b.
-1.3%
c.
13.0%
d.
10.2%
e.
-4.8%
ANSWER:
B [MACRS table required ] Depreciation cash flows: MACRS
Depreciable
Annual
Year
Percent
Basis
Depreciation
1
0.20
$100,000
$ 20,000
2
0.32
100,000
32,000
3
0.19
100,000
19,000
4
0.12
100,000
12,000
5
0.11
100,000
11,000
6
0.06
100,000
6,000 $100,000
Project analysis worksheet: I
Initial investment outlay 1) Machine cost 2) Decrease in NWC 3) Total net inv.
($100,000) -($100,000)
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II
Incremental operating cash flows
Year:
0
1
2
3
4
5
6
$15,500
$15,500
$15,500
$15,500
$15,500
$15,500
5) After-tax inc. in revenues
9,300
9,300
9,300
9,300
9,300
9,300
6) Depr. (from table)
20,000
32,000
19,000
12,000
11,000
6,000
4) Inc. in before tax & depr. earnings
7) Tax savings deprec. (line 6 ´ 0.4)
8,000
12,800
7,600
4,800
4,400
2,400
$17,300
$22,100
$16,900
$14,100
$13,700
$11,700
8) Net operating CFs (line 5 + 7)
III
IV
Terminal CF 9) Estimated salvage value
0
10) Tax on salvage value
0
11) Return of NWC
0
12) Net CF
0
Net CFs 13) Total Net CFs
($100,000)
$17,300
$22,100
$16,900
$14,100
$13,700
$11,700
Financial calculator solution: Inputs: = -100,000; = 17,300; = 22,100; = 16,900; = 14,100; = 13,700; = 11,700; I = 12. Output: IRR = -1.32%
POINTS:
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FEEDBACK: REF:
45/76
86.
The normal yield curve is upward sloping implying that a.
the return on short-term securities are higher than the return on long-term securities of similar risk.
b.
the return on long-term securities are equal to the return on short-term securities of similar risk.
c.
the return on short-term securities are lower than the return on long-term securities of similar risk.
d.
the return on bonds with a higher default risk is higher than the returns on bonds with lower default risk.
e.
the return on bonds with a lower default risk is higher than the returns on bonds with higher default risk.
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
87.
As a corporate investor paying a marginal tax rate of 34 percent, if 70 percent of dividends are excludable, what would be your after-tax dividend yield on preferred stock with a 16 percent before-tax dividend yield? a.
6.36%
b.
7.36%
c.
12.19%
d.
13.01%
e.
14.37%
ANSWER:
E 16%[1 - 0.34(0.30)] = 14.368% » 14.37%.
POINTS:
0/1
FEEDBACK: REF:
46/76
88.
Assume that the real risk-free rate, r *, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP 2? a.
2.1%
b.
1.8%
c.
5.0%
d.
3.0%
e.
2.5%
ANSWER:
A First, note that we will use the equation r t = 4% + IP t + MRP t. We have the data needed to find the IPs: IP5 = (9% + 6% + 4% + 4% + 4%)/5 = 27%/5 = 5.4%. IP2 = (9% + 6%)/2 = 7.5%. Now we can substitute into the equation: r 5 = 4% + 5.4% + MRP = 12%. r 2 = 4% + 7.5% + MRP = 12%. Now we can solve for the MRPs, and find the difference: MRP5 = 12% - 9.4% = 2.6%. MRP2 = 12% - 11.5% = 0.5%. Difference = (2.6% - 0.5%) = 2.1%.
POINTS:
0/1
FEEDBACK: REF:
47/76
89.
Which of the following are generally considered advantages of term loans over publicly issued bonds? a.
Lower flotation costs.
b.
Speed, or how long it takes to bring the issue to market.
c.
Flexibility, or the ability to adjust the bond's terms after it has been issued.
d.
All of the above.
e.
Only answers b and c above.
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
90.
Bonds that can be exchanged for shares of equity at the owner's discretion are called what? a.
Debenture.
b.
Indenture.
c.
Callable bond
d.
Convertible bond.
e.
Putable bond.
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
48/76
91.
Which of the following ratings by Moody's represent bonds that are at least investment grade? a.
Caa
b.
Baa
c.
B
d.
Ba
e.
None of the above.
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
92.
S. Claus & Company is planning a zero coupon bond issue. The bond has a par value of $1,000, matures in 2 years, and will be sold at a price of $826.45. The firm's marginal tax rate is 40 percent. What is the annual after-tax cost of debt to the company on this issue? a.
4.0%
b.
6.0%
c.
8.0%
d.
10.0%
e.
12.0%
49/76
ANSWER:
B Tabular solution: First, find the value of r d as the interest rate which will cause $826.45 to grow to $1,000 in 2 years. $1,000 = $826.45(FVIF i,2) FVIFi,2 = 1.2100 I = 0.10 = r d = 10%. r dT = r d(1 - T) = 0.10(0.6) = 0.06 = 6%. Analysis of cash flows method using calculated r d = 10% and financial calculator: Year:
0
1
2
Accrued value
$826.45
$909.10
$1,000.00
Interest ((Vt ´ 1.10) - V t)
82.65
90.90
Tax saving (Interest ´ 0.40)
33.06
36.36
Cash flows
+826.45
+33.06
+36.36 -1,000.00 -$ 963.64
Financial calculator solution: (Using CFs from worksheet analysis) Inputs: = 826.45; = 33.06; = -963.64. Output: IRR% = 6.0%. r dT = 6.0%.
POINTS:
0/1
FEEDBACK: REF:
50/76
93.
Bonds issued by BB&C Communications that have a coupon rate of interest equal to 10.65 percent currently have a yield to maturity (YTM) equal to 15.25 percent. Based on this information, BB&C's bonds must currently be selling at ____ in the financial markets. a.
par value
b.
a discount
c.
a premium
d.
Not enough information is given to answer this question.
e.
None of the above is a correct answer.
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
94.
If the yield to maturity (the market rate of return) of a bond is less than its coupon rate, the bond should be a.
selling at a discount; i.e., the bond's market price should be less than its face (maturity) value.
b.
selling at a premium; i.e., the bond's market price should be greater than its face value.
c.
selling at par; i.e., the bond's market price should be the same as its face value.
d.
purchased because it is a good deal.
ANSWER:
B
POINTS:
0/1
FEEDBACK: REF:
51/76
95.
A 12-year bond that has a 12 percent coupon rate is currently selling for $1,000, which equals the bond's face value. If interest is paid semiannually, the bond's yield to maturity is a.
equal to 12 percent.
b.
greater than 12 percent.
c.
less than 12 percent.
d.
More information is needed to answer this question.
e.
None of the above is correct.
ANSWER:
A
POINTS:
0/1
FEEDBACK: REF:
96.
If you buy a bond that is selling for less than its face, or maturity, value what will happen to the price (value) of the bond as the maturity date nears if market interest rates do not change during the life of the bond? a.
Because interest rates remain constant, nothing happens to the market value of the bond.
b.
The price of the bond should decrease even further below the bond's face value because the rates in the market are too high.
c.
The price of the bond will increase as the bond gets closer to its maturity because the bond's value has to equal its face value at maturity.
d.
This question cannot be answered without additional information.
e.
None of the above is a correct answer.
ANSWER:
C
POINTS:
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FEEDBACK: REF:
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97.
You are contemplating the purchase of a 20-year bond that pays $50 in interest each six months. You plan to hold this bond for only 10 years, at which time you will sell it in the marketplace. You require a 12 percent annual return, but you believe the market will require only an 8 percent return when you sell the bond 10 years hence. Assuming you are a rational investor, how much should you be willing to pay for the bond today? a.
$1,126.85
b.
$1,081.43
c.
$737.50
d.
$927.68
e.
$856.91
ANSWER:
D Cash flow time line: Financial calculator solution: Calculate value of bond at Year 10
Inputs: N = 20; I = 4; PMT = 50; FB = 1,000. Output: PV = -1,135.90. Calculate value of bond at Year 0 using V 10 as FV
Inputs: N = 20; I = 6; PMT = 50; FV = 1,135.90. Output: PV = -$927.675 = $927.98; V d = $927.68. POINTS:
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FEEDBACK: REF:
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98.
A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred stock, what is your simple (not effective) annual rate of return? a.
10%
b.
8%
c.
6%
d.
12%
e.
14%
ANSWER:
A Yearly dividend = $0.50(4) = $2.00. r ps = D ps/Vps = $2.00/$20.00 = 0.10 = 10%.
POINTS:
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FEEDBACK: REF:
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99.
Over the past few years, Swanson Company has retained, on the average, 70 percent of its earnings in the business. The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected to be 10 percent. If the risk-free rate, r RF, is 8 percent, the expected return on the market, r M, is 12 percent, Swanson's beta is 2.0, and the most recent dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Swanson's stock today? a.
$27.50; 5.0x
b.
$33.00; 6.0x
c.
$25.00; 5.0x
d.
$22.50; 4.5x
e.
$45.00; 4.5x
ANSWER:
A Step 1
Calculate the required rate of return
r s = 8% + 2.0(12% - 8%) = 16%
Step 2
Calculate the current market price
Step 3
Calculate the earnings and P/E ratio
= $1.50(1.10) = $1.65 = 0.30E1. E1 = $1.65/0.30 = $5.50.
POINTS:
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FEEDBACK: REF:
55/76
100.
Which of the following statements is correct? a.
Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.
b.
Portfolio diversification reduces the variability of returns on an individual stock.
c.
When company specific risk has been diversified, the inherent risk that remains is market risk which is constant for all securities in the market.
d.
A stock with a beta of -1.0 has zero systematic (or market) risk.
e.
The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line cannot be controlled by the financial manager.
ANSWER:
E
POINTS:
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FEEDBACK: REF:
56/76
101.
Which of the following statements is correct? a.
If the returns on a stock could vary widely, and its standard deviation is large, then the stock will necessarily have a large beta coefficient.
b.
A stock that is more highly positively correlated with "The Market" than most stocks would not necessarily have a beta coefficient that is greater than 1.0.
c.
A stock's standard deviation of returns is a measure of the stock's "stand-alone" risk, while its coefficient of variation measures its risk if the stock is held in a portfolio.
d.
A portfolio that contained 100 low-beta stocks would be riskier than a portfolio containing 100 high-beta stocks.
e.
Negative betas cannot exist; if you calculate one, you made an error.
ANSWER:
B Beta is defined as the slope of the regression line between returns on a stock and returns on the market. A stock could be highly correlated with the market, indicating that it went up when the market went up and down when the market declined, but the beta could be low, say 0.7, indicating that the stock simply did not move as much as the market.
POINTS:
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FEEDBACK: REF:
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102.
According to the capital asset pricing model, which of the following stocks should have the highest required rate of return? Stock Name
Standard Deviation
Beta
Alpha Automobiles
19.0%
1.8
Beta Electronics
28.0
1.1
Omega Foods
8.0
0.7
a.
Beta Electronics because its standard deviation is highest.
b.
Alpha Automobiles because its beta coefficient is highest.
c.
Omega foods because the ration of standard deviation/beta is the lowest.
d.
Not enough information is given to answer this question.
ANSWER:
B
POINTS:
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FEEDBACK: REF:
103.
In a portfolio of three different stocks, which of the following could not be true? a.
The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
b.
The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
c.
The beta of the portfolio is less than the beta of each of the individual stocks.
d.
The beta of the portfolio is greater than the beta of one or two of the individual stock's betas.
e.
None of the above (i.e., they all could be true, but not necessarily at the same time).
ANSWER:
C
POINTS:
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FEEDBACK: REF:
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104.
Other things held constant, (1) if the expected inflation rate decreases, and (2) investors become more risk averse, the Security Market Line would shift a.
Down and have steeper slope.
b.
Up and have less steep slope.
c.
Up and keep same slope.
d.
Down and keep same slope.
e.
Down and have less steep slope.
ANSWER:
A
POINTS:
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FEEDBACK: REF:
105.
If a stock has a beta coefficient, b, equal to 1.20, the risk premium associated with the market is 9 percent, and the risk-free rate is 5 percent, application of the capital asset pricing model indicates the appropriate return should be ____. a.
9.8%
b.
14%
c.
5%
d.
15.8%
e.
None of the above is correct.
ANSWER:
D
POINTS:
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FEEDBACK: REF:
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106.
Sharon Stonewall currently has an investment portfolio that contains 10 stocks that have a total value equal to $160,000. The portfolio has a beta (b) equal to 1.0. Sharon wants to invest an additional $40,000 in a stock with b = 2.0. After Sharon adds the new stock to her portfolio, what will be the portfolio's beta? a.
1.2
b.
1.5
c.
2.0
d.
Not enough information is given to compute the portfolio's beta ( b).
e.
None of the above is correct.
ANSWER:
A
POINTS:
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FEEDBACK: REF:
107.
Assume the risk-free rate of return (r RF ) is 5 percent, the market risk premium (RP M) is 8 percent, and an investment exists that has a beta (b) equal to 1.5. According to the Capital Asset Pricing Model (CAPM), which of the following statements is correct? a.
The risk premium associated with the investment would be 12 percent.
b.
The appropriate rate of return for the investment is 9.5 percent.
c.
All investments that have betas less than 1.0 must earn a total rate of return less than 8 percent.
d.
There is not enough information to answer this question.
e.
None of the above is a correct statement.
ANSWER:
A
POINTS:
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FEEDBACK: REF:
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108.
Based on the information given below, which of the investments would be considered best based on its risk and return relationship? Assume all investors are risk-averse and the investments will be held in isolation, not in a portfolio.
Investment
Expected return, Standard deviation, s
D
E
F
10.0%
18.0%
18.0%
7.0%
12.0%
20.0%
a.
D, because its total risk is lowest.
b.
E, because its coefficient of variation is lowest.
c.
F, because its standard deviation, s, is highest.
d.
E and F, because the have the same expected return, .
e.
None of the above.
ANSWER:
B
POINTS:
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FEEDBACK: REF:
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109.
You are managing a portfolio of 10 stocks which are held in equal amounts. The current beta of the portfolio is 1.64, and the beta of Stock A is 2.0. If Stock A is sold, what would the beta of the replacement stock have to be to produce a new portfolio beta of 1.55? a.
1.10
b.
1.00
c.
0.90
d.
0.75
e.
0.50
ANSWER:
A Before: bp
= 1.64 = 0.9 (bR) + 0.1 (2.0)
bR
= Average beta of the other 9 stocks in the portfolio = 1.44/0.9 = 1.60
After:
POINTS:
bNew
= 1.55 m= 0.9(bR) + 0.1(b) = 1.44 + 0.1(b)
b
= 1.01(0.11) = 1.10.
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FEEDBACK: REF:
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110.
Two firms evaluated the same capital budgeting project to determine whether to purchase it. The CFO of Anchor Weights Corporation (AWC) reported that she determined that the project's internal rate of return equals 9 percent, and she recommended that the project be purchased. The CFO of Sectional Spas Incorporated (SSI) simply reported that the project was unacceptable to his firm when he evaluated it using one of the capital budgeting techniques that considers the time value of money. Given this information, which of the following statements is correct? a.
The net present value of the project must be positive for both firms.
b.
If the SSI's CFO computes the IRR for the project, he will find that it is less than 9 percent for his company.
c.
AWC's CFO must have used the traditional payback period method to evaluate the project.
d.
If the project is acceptable (unacceptable) to one firm, it must be acceptable (unacceptable) to both firms. As a result, one of the CFOs made a mistake when evaluating the project.
e.
SSI's must have a required rate of return that is greater than 9 percent.
ANSWER:
E
POINTS:
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FEEDBACK: REF:
111.
All of the following factors can complicate the post-audit process except a.
each element of the cash flow forecast is subject to uncertainty.
b.
projects sometimes fail to meet expectations for reasons beyond the control of operating executives.
c.
it is often difficult to separate the operating results of one investment from those of a larger system.
d.
executives who were responsible for a given decision might have moved on by the time the time the results of the long term project are known.
e.
the most successful firms, on average, are the ones that put the least emphasis on the post-audit.
ANSWER:
E
POINTS:
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FEEDBACK: REF:
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112.
Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax cash flow will be increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the approximate payback period? a.
2 years
b.
4 years
c.
6 years
d.
8 years
e.
10 years
ANSWER:
C Cash flow time line: ( In thousands ) Payback =
POINTS:
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FEEDBACK: REF:
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113.
Which of the following statements is correct? a.
One can find the "cross-over rate," or the discount rate at which two normal projects have the same NPV, by finding the IRR of the differences in the projects' yearly cash flows.
b.
If you calculate a project's MIRR and find it to be the same as the regular IRR, you can be sure you made a mistake.
c.
If a project's IRR is less than its required rate of return, then the discounted payback period will be less than the regular payback period.
d.
If a project has a cash outflow at t = 0 followed by a single cash inflow at t = 10, then the MIRR will be less than the regular IRR.
e.
If a project has a cash outflow at t = 0 followed by a single cash inflow at t = 10, then the MIRR will be greater than the regular IRR.
ANSWER:
A The cross-over rate is the discount rate where two normal projects' NPV profiles intersect, thus, indicating the two projects have the same NPV at this point. This intersection point can be found as the IRR of the differences of the projects' annual cash flows. The other statements are false.
POINTS:
0/1
FEEDBACK: REF:
114.
The modified IRR (MIRR) is normally a.
Less than the regular IRR if IRR > r.
b.
Greater than the regular IRR if IRR > r.
c.
Equal to the regular IRR if IRR = r.
d.
Answers a and c are both correct.
e.
Answers b and c are both correct.
ANSWER:
D
POINTS:
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FEEDBACK: REF:
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115.
If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true? a.
If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.
b.
If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.
c.
If the beta of the asset is greater than the corporate beta prior to the addition of that asset, then the corporate beta after the purchase of the asset will be smaller than the original corporate beta.
d.
If the beta of an asset is larger than the corporate beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
e.
None of the above is a true statement.
ANSWER:
D
POINTS:
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FEEDBACK: REF:
66/76
116.
Which of the following statements is correct? a.
Sensitivity analysis is used frequently in capital budgeting analysis. Its big advantage is that because it shows correlations between changes in input variables and NPV, it accounts for within-firm risk.
b.
Other things held constant, the lower the correlation between a project's returns and returns on the market, the less risky the project.
c.
In judging the relative stand-along risks of a set of projects, the projects' standard deviations of NPV are a better measure than their coefficients of variation.
d.
One can run a regression of returns on a project versus returns on the firm's other assets, get a beta coefficient, and use this beta as a measure of the project's market risk.
e.
One can run a regression of returns on a project versus returns on the stock market, get a beta coefficient, and use this beta as a measure of the project's within-firm risk.
ANSWER:
B Statement a is false. While sensitivity analysis shows the sensitivity of NPV to changes in key variables, it doesn't give the range of likely values. A project's stand-alone risk depends on both factors. Statement c is false; the coefficient of variation is a better measure of relative standalone risk between a set of projects than standard deviation. Statements d and e are false. The statements have been reversed. A regression of a project's returns versus returns on the firm's other assets provides a beta which could be used to measure the project's within-firm risk. A regression of a project's returns versus the returns on the stock market provides a beta which could be used to measure the project's market risk.
POINTS:
0/1
FEEDBACK: REF:
67/76
117.
An evaluation of four independent capital budgeting projects by the director of capital budgeting for Ziker Golf Company yielded the following results: Internal rate of Project
of return, IRR
L
19.0%
Risk level Average
E
15.0
High
M
12.0
Low
Q
11.0
Average
The firm's weighted average cost of capital is 12 percent. Ziker Golf generally evaluates projects that are riskier than average by adjusting its required rate of return by 4 percent, whereas projects with less-than-average risk are evaluated by adjusting the required rate of return by 2 percent. Which project(s) should the firm purchase? a.
Project L
b.
Projects L and E
c.
Projects L and M
d.
Projects L, E, and M
e.
None of the above is a correct answer.
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
118.
Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3 years; initial decrease in accounts receivable = $1000, which must be restored at the end of the project's life; estimated salvage value = $1,000; net income before taxes and depreciation = $2,000 per year; method of depreciation = MACRS; tax rate = 40 percent; required rate of return = 18 percent. a.
$1,137
b.
-$151
c.
$137
d.
$804
e.
$544
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ANSWER:
E [MACRS table required ] Project analysis worksheet: I
Initial investment outlay 1) Cost
($4,000)
2) Decrease in NWC
1,000
3) Total net investment
II
Incremental operating flows:
($3,000)
Year:
0
1
2
3
4) EBT and depreciation
2,000
$2,000
$2,000
5) Earnings after taxes (line 4 ´ 0.6)
1,200
1,200
1,200
6) Depreciation (from table)
1,320
1,800
600
7) Tax savings from depreciation (5 ´ 0.4)
528
720
240
$1,728
$1,920
$1,440
8) Net operating flows (line 5 + 7)
III
Terminal cash flow: 9) Estimated salvage value
$1,000
10) Tax on salvage value ((1,000 - 280) ´ 0.4)
IV
(288)
11) Return of NWC
(1,000)
12) Net CF
($ 288)
Net cash flows: 13) Total net cash flows
($3,000)
$1,728
$1,920
$1,152
Financial calculator solution: Inputs: = -3000; = 1728; = 1920; = 1152; I = 18. Output: NPV = $544.46 » $544.
POINTS:
0/1
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FEEDBACK: REF:
70/76
119.
Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have? a.
2.2
b.
1.0
c.
1.8
d.
1.6
e.
2.0
ANSWER:
B Old assets = 1.0.
New assets = 0.5.
Total assets = 1.5.
Old required rate: 18% = 7% + (5%) b beta = 2.2. New required rate: 16% = 7% + (5%) b beta = 1.8. New b must not be greater than 1.8, therefore 0.3333(b) = 0.3333 b = 1.0. Therefore, beta of the new division cannot exceed 1.0. POINTS:
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FEEDBACK: REF:
120.
Mom's Cookies Inc. is considering the purchase of a new cookie oven. The original cost of the old oven was
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$30,000; it is now 5 years old, and it has a current market value of $13,333.33. The old oven is being depreciated over a 10-year life towards a zero estimated salvage value on a straight line basis, resulting in a current book value of $15,000 and an annual depreciation expense of $3,000. The old oven can be used for 6 more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $4,000 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the required rate of return is 10 percent. Assume a 40 percent tax rate. What is the net present value of the new oven? a.
-$2,418
b.
-$1,731
c.
$1,568
d.
$163
e.
$1,731
ANSWER:
C [MACRS table required ] Depreciation cash flows: MACRS
New Asset
Old Asset
Change In
Year
Percent
Depreciation
Depreciation
Depreciation
1
0.20
$ 5,000
$ 3,000
$ 2,000
2
0.32
8,000
3,000
5,000
3
0.19
4,750
3,000
1,750
4
0.12
3,000
3,000
0
5
0.11
2,750
3,000
(250)
6
0.06
1,500
______
1,500
$25,000
$15,000
$10,000
Project analysis worksheet: I
Initial investment outlay 1) New equipment cost
($25,000.00)
2) Market value old equip.
13,333.33
3) Tax savings sale of old equip.
666.67*
4) Increase in NWC 5) Total net investment
-($11,000.00)
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*(Market value - Book value)(Tax rate) ($13,333.33 - $15,000)
(0.4) = 666.67
II
Incr In crem emen enta tall oper operat atin ing g cash cash flo flows ws
Year: Ye
0
1
2
3
4
5
6
6) Before-tax savings new equip.
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
7) After-tax savings new equip.
2,400
2,400
2,400
2,400
2,400
2,400
8) Dep. new machine
5,000
8,000
4,750
3,000
2,750
1,500
9) Dep. old machine
3,000
3,000
3,000
3,000
3,000
0
10) Change in deprec.
2,000
5,000
1,750
0
(250)
1,500
(line 6 ´ 0.6)
(line 8 - 9) 11) Tax savings from deprec.
800 80
2 ,000 2,
700
0
600 (100)
(line 10 ´ 0.4) 12) Net operating CFs
$3,200
$4,400
$3,100
$2,400
$2,300
$3,000
(line 7 + 11)
III
IV
Terminal CF CF 13) Estimated salvage value
0
14) Net CF
0
Net CFs 15) Total Net CFs
($11,000)
$3,200
$4,400
$3,100
$2,400
$2,300
$3,000
Financial calculator solution: Inputs: = -11,000; -11,000; = 3,200; = 4,400; = 3,100; = 2,400; = 2,300; = 3,000; I = 10. Output: NPV = $2,635.30 $2,635.30 » $2,635.
POINTS:
0/1
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FEEDBACK: REF:
121.
If a firm firm can shift its capital capital structure so as to to change its weighted average cost of capital (WACC), which of the the following results would be preferred? a.
The firm firm should should try to to decrease decrease the WACC becaus because e such an an action action will increas increase e the value value of the the firm.
b.
The firm firm should should try to to increase increase the the WACC becau because se such an action action will increa increase se the value value of the firm. firm.
c.
The firm firm should should try to to decrease decrease the WACC becaus because e such an an action action will decreas decrease e the value value of the the firm. firm.
d.
The firm firm should should try to to increase increase the the WACC becau because se such an action action will decrea decrease se the value value of of the firm. firm.
e.
The firm firm should should not try to change change the the WACC becau because se changing changing the the WACC will will not chang change e the value value of the the firm.
ANSWER:
A
POINTS:
0/1
FEEDBACK: REF:
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122.
Which of the following statements is correct? a.
Capital component Capital components s are the types types of capital capital used by by firms to raise raise money money.. All All capital capital comes comes from one one of three components: long-term debt, preferred stock, and equity.
b.
Preferred Pref erred stock stock does does not involve involve any adjust adjustment ment for for flotation flotation cost cost since the the dividend dividend and price price are fixed. fixed.
c.
The cost cost of debt debt used in calculati calculating ng the WACC WACC is an an average average of the the after-tax after-tax cost cost of new debt and and of outstanding debt.
d.
The opportun opportunity ity cost princi principle ple implies implies that that if the firm canno cannott invest retain retained ed earnings earnings and and earn at least least r s , it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return.
e.
The cost cost of new new common common equity equity includes includes an an adjustmen adjustmentt for flotati flotation on costs costs which is is expressed expressed as a fixed percentage of the current stock price. The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate.
ANSWER:
D
POINTS:
0/1
FEEDBACK: REF:
Rollins Corporation
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-p bond-yield-plus-risk-premium remium method to find r s . The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
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123.
Refer to Rollins Corporation. What is Rollins' component cost of debt? a.
10.0%
b.
9.1%
c.
8.6%
d.
8.0%
e.
7.2%
ANSWER:
E Since the bond sells at par of $1,000, its YTM and coupon rate (12%) are equal. Thus, the before-tax cost of debt to Rollins is 12.0%. The after-tax cost of debt equals: r dT = 12.0%(1 - 0.40) = 7.2%. Financial calculator solution: Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000. Output: I = 6.0% = r d/2 r d = 6.0% ´ 2 = 12% r dT = 12.0%(0.6) = 7.2%.
POINTS:
0/1
FEEDBACK: REF:
76/76
124.
Refer to Rollins Corporation. What is the firm's cost of retained earnings using the DCF approach? a.
13.6%
b.
14.1%
c.
16.0%
d.
16.6%
e.
16.9%
ANSWER:
C
POINTS:
0/1
FEEDBACK: REF:
Jackson Company
The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price.
125.
Refer to Jackson Company . How much should an investor be willing to pay for this stock today? a.
$62.81
b.
$70.00
c.
$43.75
d.
$55.00
e.
$30.00
ANSWER:
D r s = 10% + 1.5(4%) = 16%.
POINTS:
0/1
FEEDBACK: REF:
77/76
