TEST BANK for Financial Management: Theory & Practice 16th Edition Eugene F. Brigham & Michael C. Eh

(Financial Management Theory & Practice, 16e Eugene Brigham, Michael Ehrhardt) (Test Bank all Chapters)

Chapter 01: An Overview of Financial Management and the Financial Environment 1. The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 2. The major advantage of a regular partnership or a corporation as a form of business organization is the fact that both offer their owners limited liability, whereas proprietorships do not. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 3. There are three primary disadvantages of a regular partnership: (1) unlimited liability, (2) limited life of the organization, and (3) difficulty of transferring ownership. These combine to make it difficult for partnerships to attract large amounts of capital and thus to grow to a very large size. a. True b. False ANSWER: True POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 4. Two disadvantages of a proprietorship are (1) the relative difficulty of raising new capital and (2) the owner's unlimited personal liability for the business' debts. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proprietorship KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 5. One key value of limited liability is that it lowers owners' risks and thereby enhances a firm's value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Limited liability Bloom’s: Knowledge 10/31/2018 8:20 AM 10/31/2018 8:20 AM

6. The disadvantages associated with a proprietorship are similar to those under a partnership. One exception relates to the more formal nature of the partnership agreement and the commitment of all partners' personal assets. As a result, partnerships do not have difficulty raising large amounts of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 7. The facts that a proprietorship, as a business, pays no corporate income tax, and that it is easily and inexpensively formed, are two key advantages to that form of business. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proprietorship KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment 8. Which of the following statements is CORRECT? a. One of the disadvantages of incorporating a business is that the owners then become subject to liabilities in the event the firm goes bankrupt. b. Sole proprietorships are subject to more regulations than corporations. c. In any type of partnership, every partner has the same rights, privileges, and liability exposure as every other partner. d. Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones. e. Corporations of all types are subject to the corporate income tax.

ANSWER: d RATIONALE: Sole proprietorships and partnerships pay personal income tax, but they avoid the corporate income tax. Small corporations that meet certain requirements can elect to be classified as S Corporations, and then the business is taxed as a partnership.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 9. Which of the following statements is CORRECT? a. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability. b. It is generally easier to transfer one's ownership interest in a partnership than in a corporation. c. One of the advantages of the corporate form of organization is that it avoids double taxation. d. One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote." e. Corporations of all types are subject to the corporate income tax.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Firm organization Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 10/31/2018 8:20 AM 10/31/2018 8:20 AM

10. Which of the following statements is CORRECT? a. It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required. b. Corporations face fewer regulations than sole proprietorships. c. One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level. d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership. e. If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

ANSWER: d RATIONALE: Corporations have limited liability; however, they face more regulations than the other forms of organization.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 11. Cheers Inc. operates as a partnership. Now the partners have decided to convert the business into a regular corporation. Which of the following statements is CORRECT? a. Assuming Cheers is profitable, less of its income will be subject to federal income taxes. b. Cheers will now be subject to fewer regulations. c. Cheers' shareholders (the ex-partners) will now be exposed to less liability. d. Cheers' investors will be exposed to less liability, but they will find it more difficult to transfer their ownership. e. Cheers will find it more difficult to raise additional capital.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 12. Which of the following statements is CORRECT? a. It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship. b. Corporate shareholders are exposed to unlimited liability. c. Corporations generally face fewer regulations than sole proprietorships. d. Corporate shareholders are exposed to unlimited liability, and this factor may be compounded by the tax disadvantages of incorporation. e. Shareholders in a regular corporation (not an S corporation) pay higher taxes than owners of an otherwise identical proprietorship.

ANSWER: a RATIONALE: If ownership in a proprietorship or partnership is transferred, the basic documents under which the firm operates must be rewritten, whereas for a corporation the seller simply sells shares to a buyer, and the corporation records the transfer on its books.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 13. Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally find it relatively difficult to raise large amounts of capital. b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.

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Chapter 01: An Overview of Financial Management and the Financial Environment c. Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization. d. Corporate investors are exposed to unlimited liability. e. Corporations generally face relatively few regulations.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 14. One drawback of switching from a partnership to the corporate form of organization is the following: a. It subjects the firm to additional regulations. b. It cannot affect the amount of the firm's operating income that goes to taxes. c. It makes it more difficult for the firm to raise additional capital. d. It makes the firm's investors subject to greater potential personal liabilities. e. It makes it more difficult for the firm's investors to transfer their ownership interests.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 15. Which of the following statements is CORRECT? a. The main method of transferring ownership interest in a corporation is by means of a hostile takeover.

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Chapter 01: An Overview of Financial Management and the Financial Environment b. Two key advantages of the corporate form over other forms of business organization are unlimited liability and limited life. c. A corporation is a legal entity that is generally created by a state; its life and existence is separate from the lives of its individual owners and managers. d. Limited liability of its stockholders is an advantage of the corporate form of organization, but corporations have more trouble raising money in financial markets because of the complexity of this form of organization. e. Although its stockholders are insulated by limited legal liability, the corporation's legal status does not protect the firm's managers in the same way; i.e., bondholders can sue its managers if the firm defaults on its debt, even if the default is the result of poor economic conditions.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 16. Which of the following statements is CORRECT? a. In a regular partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. b. Attracting large amounts of capital is more difficult for partnerships than for corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests. c. A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster growing company. d. The limited partners in a limited partnership have voting control, while the general partner has operating control over the business. Also, the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. e. A major disadvantage of all partnerships compared to all corporations is the fact that federal income taxes must be paid by the partners rather than by the firm itself.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

finance, and analysis of public information United States - OH - Default City - TBA Partnership form of organization Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:20 AM 10/31/2018 8:20 AM

17. Which of the following statements is CORRECT? a. Corporations are at a disadvantage relative to partnerships because they have to file more reports to state and federal agencies, including the Securities and Exchange Administration, even if they are not publicly owned. b. In a regular partnership, liability for the firm's debts is limited to the amount a particular partner has invested in the business. c. A fast-growth company would be more likely to set up as a partnership for its business organization than would a slow-growth company. d. Partnerships have difficulty attracting capital in part because of their unlimited liability, the lack of impermanence of the organization, and difficulty in transferring ownership. e. A major disadvantage of a partnership relative to a corporation as a form of business organization is the high cost and practical difficulty of its formation.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 18. Which of the following statements is CORRECT? a. Most businesses (by number and total dollar sales) are organized as partnerships or proprietorships because it is easier to set up and operate in one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, mainly because corporations have important tax advantages over proprietorships and partnerships. b. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations. c. Most business (measured by dollar sales) is conducted by corporations in spite of large corporations' often less favorable tax treatment, due to legal considerations related to ownership transfers and limited liability. d. Large corporations are taxed more favorably than sole proprietorships. e. Corporate stockholders are exposed to unlimited liability.

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Chapter 01: An Overview of Financial Management and the Financial Environment ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 19. Jane Doe, who has substantial personal wealth and income, is considering the possibility of starting a new business in the chemical waste management field. She will be the sole owner, and she has enough funds to finance the operation. The business will have a relatively high degree of risk, and it is expected that the firm will incur losses for the first few years.

However, the prospects for growth and positive future income look good, and Jane plans to have the firm pay out all of its income as dividends to her once it is well established. Which of the legal forms of business organization would probably best suit her needs? a. Proprietorship, because of ease of entry. b. S corporation, to gain some tax advantages and also to obtain limited liability. c. Partnership, but only if she needs additional capital. d. Regular corporation, because of the limited liability. e. In this situation, the various forms of organization seem equally desirable.

ANSWER: b RATIONALE: The S corporation would allow her to take early losses as deductions against her other income, hence save some taxes. Then, when the firm became profitable, she would receive dividends and pay taxes on them, but the firm itself would avoid corporate taxes and double taxation.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment DATE MODIFIED:

10/31/2018 8:20 AM

20. Which of the following statements is CORRECT? a. The corporate bylaws are a standard set of rules established by the state of incorporation. These rules are identical for all corporations in the state, and their purpose is to ensure that the firm's managers run the firm in accordance with state laws. b. The corporate charter is a standard document prescribed by the state of incorporation, and its purpose is to ensure that the firm's managers run the firm in accordance with state laws. 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. Companies must establish a home office, or domicile, in a particular state, and that state must be the one in which most of their business (sales, manufacturing, and so forth) is conducted. d. Attorney fees are generally involved when a company develops its charter and bylaws, but since these documents are voluntary, a new corporation can avoid these costs by deciding not to have either a charter or bylaws. e. The corporate charter is concerned with things like what business the company will engage in, whereas the bylaws are concerned with things like procedures for electing the board of directors.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.03 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate charter and bylaws KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 21. If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Value maximization Bloom’s: Knowledge 10/31/2018 8:20 AM 10/31/2018 8:20 AM

22. With which of the following statements would most people in business agree? a. The short-run profits of a corporation will almost always increase if the firm takes actions the government has determined are in the nation's best interests. b. Government agencies and firms almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. c. Although people's moral characters are probably developed before they get into a business school, it is still useful for business schools to cover ethics, including giving students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. d. Developing a formal set of rules defining ethical and unethical behavior is not useful for a large corporation.

Such rules generally can't be applied in many specific instances, so it is better to deal with ethical issues on a case-by-case basis. e. Because of the courage it takes to blow the whistle, "whistle blowers" are generally promoted more rapidly than other employees.

ANSWER: c RATIONALE: It is important to have a specific set of rules that all employees are expected to follow. This helps constrain actions, and it is also important to "prove" that the company is trying to do right if some employee does something wrong.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Ethics STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business ethics KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 23. The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize the stock price per share over the long run, which is the stock's intrinsic value. b. Maximize the firm's expected EPS. c. Minimize the chances of losses. d. Maximize the firm's expected total income. e. Maximize the stock price on a specific target date.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of firm KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 24. Which of the following statements is CORRECT? a. The financial manager's proper goal should be to attempt to maximize the firm's expected cash flows, since that will add the most to the individual shareholders' wealth. b. The financial manager should seek that combination of assets, liabilities, and capital that will generate the largest expected projected after-tax income over the relevant time horizon, generally the coming year. c. The riskiness inherent in a firm's earnings per share (EPS) depends on the characteristics of the projects the firm selects, and thus on the firm's assets. However, EPS is not affected by the manner in which those assets are financed. d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders. e. Large, publicly owned firms like IBM and GE are controlled by their management teams. Ownership is generally widely dispersed; hence managers have great freedom in how they run the firm. Managers may operate in stockholders' best interests, but they also may operate in their own personal best interests. As long as they stay within the law, there is no way to either force or motivate managers to act in the stockholders' best interests.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate goals and control KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment 25. Which of the following statements is CORRECT? a. Corporations generally are subject to more favorable tax treatment and fewer regulations than partnerships and sole proprietorships, which is why corporations do most of the business in the United States. b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value than are managers who do not face the threat of hostile takeovers. c. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm. d. Because of their simplified organization, it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations. e. Bond covenants are an effective way to resolve conflicts between shareholders and managers.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 26. Which of the following statements is CORRECT? a. A good goal for a firm's management is maximization of expected EPS. b. Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment. c. Because most stock ownership is concentrated in the hands of a relatively small segment of society, firms' actions to maximize their stock prices have little benefit to society. d. Corporations and partnerships have an advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited. e. The potential exists for agency conflicts between stockholders and managers.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Miscellaneous concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:20 AM 10/31/2018 8:20 AM

27. Which of the following statements is CORRECT? a. One disadvantage of operating as a corporation rather than as a partnership is that corporate shareholders are exposed to more personal liability than partners. b. There is no good reason to expect a firm's bondholders and stockholders to react differently to the types of new asset investments a firm makes. c. Bondholders are generally more willing than stockholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. d. Stockholders are generally more willing than bondholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. e. Relative to sole proprietorships, corporations generally face fewer regulations, which makes raising capital easier for corporations.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.04 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 28. If Firm A's business is to obtain savings from individuals and then invest them in financial assets issued by other firms or individuals, Firm A is a financial intermediary. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.05 - LO: 1-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

finance, and analysis of public information United States - OH - Default City - TBA Financial intermediaries Bloom’s: Knowledge 10/31/2018 8:20 AM 10/31/2018 8:20 AM

29. You recently sold 100 shares of your new company, XYZ Corporation, to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following statements best describes this transaction? a. This is an example of an exchange of physical assets. b. This is an example of a primary market transaction. c. This is an example of a direct transfer of capital. d. This is an example of a money market transaction. e. This is an example of a derivatives market transaction ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.05 - LO: 1-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial transactions KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 11/9/2018 3:38 PM 30. Debt is a less risky than equity because a debtholder's claim has priority to an equity holder's claim. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.06 - LO: 1-6 NATIONAL STANDARDS: United States - BUSPROG: Technology LOCAL STANDARDS: United States - AK - Default City - DISC - Financial claims TOPICS: Financial claims KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment DATE CREATED: DATE MODIFIED:

10/31/2018 8:20 AM 11/9/2018 3:34 PM

31. Which of the following statements is CORRECT? a. If expected inflation increases, interest rates are likely to increase. b. If individuals in general increase the percentage of their income that they save, interest rates are likely to increase. c. If companies have fewer good investment opportunities, interest rates are likely to increase. d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.07 - LO: 1-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 32. Suppose the U.S. Treasury announces plans to issue $50 billion of new bonds. Assuming the announcement was not expected, what effect, other things held constant, would that have on bond prices and interest rates? a. Prices and interest rates would both rise. b. Prices would rise and interest rates would decline. c. Prices and interest rates would both decline. d. There would be no changes in either prices or interest rates. e. Prices would decline and interest rates would rise.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.07 - LO: 1-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Security prices and interest rates Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:20 AM 10/31/2018 8:20 AM

33. Which of the following would be most likely to lead to higher interest rates on all debt securities in the economy? a. Households start saving a larger percentage of their income. b. The economy moves from a boom to a recession. c. The level of inflation begins to decline. d. Corporations step up their expansion plans and thus increase their demand for capital. e. The Federal Reserve uses monetary policy in an attempt to stimulate the economy.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.07 - LO: 1-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 34. Which of the following factors would be most likely to lead to an increase in interest rates in the economy? a. Households reduce their consumption and increase their savings. b. The Federal Reserve decides to try to stimulate the economy. c. There is a decrease in expected inflation. d. The economy falls into a recession. e. Most businesses decide to modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.

ANSWER: e RATIONALE: An increase in the demand for capital by businesses will increase interest rates in the economy.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.07 - LO: 1-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates United States - OH - Default City - TBA Interest rates Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:20 AM 10/31/2018 8:20 AM

35.

If an individual investor buys or sells a currently outstanding stock through a broker, this is a primary market transaction. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - OH - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates KEYWORDS: Bloom's: Knowledge DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 36. Recently, Hale Corporation announced the sale of 2.5 million newly issued shares of its stock at a price of $21 per share. Hale sold the stock to an investment banker, who in turn sold it to individual and institutional investors. This is a primary market transaction. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - OH - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 37. Which of the following is a primary market transaction?

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Chapter 01: An Overview of Financial Management and the Financial Environment a. You sell 200 shares of Johnson & Johnson stock on the NYSE through your broker. b. Johnson & Johnson issues 2,000,000 shares of new stock and sells them to the public through an investment banker. c. You buy 200 shares of Johnson & Johnson stock from your younger brother. You just give him cash and he gives you the stock⎯the trade is not made through a broker. d. One financial institution buys 200,000 shares of Johnson & Johnson stock from another institution. An investment banker arranges the transaction. e. You invest $10,000 in a mutual fund, which then uses the money to buy $10,000 of Johnson & Johnson shares on the NYSE. ANSWER: b POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: o Reflective Thinking - BUSPROG: Analytic skills: Statistics and Management Science STATE STANDARDS: United States - OH - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 38. Which of the following statements is CORRECT? a. If Apple issues additional shares of common stock through an investment banker, this would be a secondary market transaction. b. If you purchased 100 shares of Apple stock from your sister-in-law, this would be an example of a primary market transaction. c. The IPO market is a subset of the secondary market. d. Only institutions, and not individuals, can participate in derivatives market transactions. e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year.

ANSWER: a POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: o Reflective Thinking - BUSPROG: Analytic skills: Statistics and Management Science STATE STANDARDS: United States - OH - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 39. You recently sold 200 shares of Apple stock to your brother. The transfer was made through a broker, and the trade occurred on the NYSE. This is an example of: Copyright Cengage Learning. Powered by Cognero.

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Chapter 01: An Overview of Financial Management and the Financial Environment a. A futures market transaction. b. A primary market transaction. c. A secondary market transaction. d. A money market transaction. e. An over-the-counter market transaction.

ANSWER: c POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: o Reflective Thinking - BUSPROG: Analytic skills: Statistics and Management Science STATE STANDARDS: United States - OH - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 40. Which of the following statements is NOT CORRECT? a. When a corporation's shares are owned by a few individuals and are not traded on public markets, we say that the firm is "closely, or privately, held." b. "Going public" establishes a firm's true intrinsic value, and it also insures that a highly liquid market will always exist for the firm's shares. c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public," and the market for such stock is called the new issue market. d. Publicly owned companies have shares owned by investors who are not associated with management, and public companies must register with and report to a regulatory agency such as the SEC. e. It is possible for a firm to go public and yet not raise any additional new capital at the time.

ANSWER: b POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - OH - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information KEYWORDS: Bloom’s: Analysis DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM 41. Money markets are markets for a. Foreign stocks. b. Consumer automobile loans.

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Chapter 01: An Overview of Financial Management and the Financial Environment c. U.S. stocks. d. Short-term debt securities. e. Long-term bonds.

ANSWER: d POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.01.09 - LO:1-9 NATIONAL STANDARDS: United States - BUSPROG: o Reflective Thinking - BUSPROG: Analytic skills: Statistics and Management Science STATE STANDARDS: United States - OH - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing KEYWORDS: Bloom's: Comprehension DATE CREATED: 10/31/2018 8:20 AM DATE MODIFIED: 10/31/2018 8:20 AM

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Chapter 02: Financial Statements, Cash Flow, and Taxes 1. The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.01 - LO: 2-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual report KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 2. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.01 - LO: 2-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual report and expectations KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 3. Consider the balance sheet of Wilkes Industries as shown below. Because Wilkes has $800,000 of retained earnings, the company would be able to pay cash to buy an asset with a cost of $200,000.

Cash Inventory Accounts receivable Total CA Net fixed assets

$

50,000Accounts payable 200,000Accruals 250,000Total CL $ 500,000Debt $ 900,000Common stock

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$ 100,000 100,000 $ 200,000 200,000 200,000 Page 1

Chapter 02: Financial Statements, Cash Flow, and Taxes _________Retained earnings 800,000 Total assets $1,400,000Total L & E $1,400,000 a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings versus cash KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 4. On the balance sheet, total assets must always equal total liabilities and equity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 5. Assets other than cash 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 these assets are carried on the books. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: non-cash assets KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 6. Which of the following statements is CORRECT? a. A typical industrial company's balance sheet lists the firm's assets that will be converted to cash first, and then goes on down to list the firm's longest lived assets last. b. The balance sheet for a given year is designed to give us an idea of what happened to the firm during that year. c. The balance sheet for a given year tells us how much money the company earned during that year. d. The difference between the total assets reported on the balance sheet and the debts reported on this statement tells us the current market value of the stockholders' equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP). e. For most companies, the market value of the stock equals the book value of the stock as reported on the balance sheet.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 7. Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet? a. The company purchases a new piece of equipment. b. The company repurchases common stock. c. The company pays a dividend. d. The company issues new common stock. e. The company gives customers more time to pay their bills.

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Chapter 02: Financial Statements, Cash Flow, and Taxes ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 8. Which of the following items is NOT included in current assets? a. Short-term, highly liquid, marketable securities. b. Accounts receivable. c. Inventory. d. Bonds. e. Cash.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current assets KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 9. Which of the following items cannot be found on a firm's balance sheet under current liabilities? a. Accrued payroll taxes. b. Accounts payable. c. Short-term notes payable to the bank. d. Accrued wages. e. Cost of goods sold.

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Chapter 02: Financial Statements, Cash Flow, and Taxes ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current liabilities KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 10. Below are the year-end balance sheets for Wolken Enterprises: Assets: Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets

2020 $ 200,000 864,000 2,000,000 $3,064,000 6,000,000 $9,064,000

2019 $ 170,000 700,000 1,400,000 $2,270,000 5,600,000 $7,870,000

Liabilities and equity: Accounts payable $1,400,000 $1,090,000 Notes payable 1,600,000 1,800,000 Total current liabilities $3,000,000 $2,890,000 Long-term debt 2,400,000 2,400,000 Common stock 3,000,000 2,000,000 Retained earnings 664,000 580,000 Total common equity $3,664,000 $2,580,000 Total liabilities and equity $9,064,000 $7,870,000 Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year non-callable, long-term debt in 2019. As of the end of 2020, none of the principal on this debt had been repaid. Assume that the company's sales in 2019 and 2020 were the same. Which of the following statements must be CORRECT? a. Wolken increased its short-term bank debt in 2020. b. Wolken issued long-term debt in 2020. c. Wolken issued new common stock in 2020. d. Wolken repurchased some common stock in 2020. e. Wolken had negative net income in 2020.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:08 PM 11. On its 2019 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount was shown the following year in 2020. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. Dividends could have been paid in 2020, but they would have had to equal the earnings for the year. b. If the company lost money in 2020, they must have paid dividends. c. The company must have had zero net income in 2020. d. The company must have paid out half of its earnings as dividends. e. The company must have paid no dividends in 2020.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:11 PM 12. Below is the common equity section (in millions) of Fethe Industries' last two year-end balance sheets: 2020 2019 Common stock $2,000 $1,000 Retained earnings 2,000 2,340 Total common equity $4,000 $3,340 The company has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? a. The company's net income in 2019 was higher than in 2020. b. The company issued common stock in 2020. c. The market price of the company's stock doubled in 2020. d. The company had positive net income in both 2019 and 2020, but the company's net income in 2019 was Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes lower than it was in 2020. e. The company has more equity than debt on its balance sheet.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:14 PM 13. Tucker Electronic System's current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm's market and book values per share differ? a. $27.50 b. $28.88 c. $30.32 d. $31.83 e. $33.43 ANSWER: a RATIONALE: Shares outstanding 125,000 Price per share $52.50 Total book common equity $3,125,000 Book value per share $25.00 Difference between book and market values $27.50 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: market value vs. book value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes

DATE CREATED: DATE MODIFIED:

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

10/31/2018 8:22 AM 10/31/2018 8:22 AM

14. Hunter Manufacturing Inc.'s December 31, 2019 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2020, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/2020, assuming that Hunter neither issued nor retired any common stock during 2020? a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47 ANSWER: b RATIONALE: 12/31/2019 common equity $2,050,000 2020 net income $250,000 2020 dividends $100,000 2020 addition to retained earnings $150,000 12/31/2020 common equity $2,200,000 Shares outstanding 100,000 12/31/2020 BVPS $22.00 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.02 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: change in BVPS from RE addition KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:20 PM 15. The income statement shows the difference between a firm's income and its costs⎯i.e., its profits⎯during a specified period of time. However, not all reported income comes in the form or cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 16. The balance sheet is a financial statement that measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statements KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 17. Which of the following statements is CORRECT? a. The income statement for a given year is designed to give us an idea of how much the firm earned during that year. b. The focal point of the income statement is the cash account, because that account cannot be manipulated by "accounting tricks." c. The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow Generally Accepted Accounting Principles (GAAP). d. The reported income of two otherwise identical firms must be identical if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC). e. If a firm follows Generally Accepted Accounting Principles (GAAP), then its reported net income will be Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes identical to its reported net cash provided (used) by operating activities.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/9/2018 4:11 PM 18. Which of the following statements is CORRECT? a. The more depreciation a firm has in a given year, the higher its EPS, other things held constant. b. Typically, a firm's DPS should exceed its EPS. c. Typically, a firm's EBIT should exceed its EBITDA. d. If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share. e. If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EPS, DPS, BVPS, and stock price KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 19. Companies generate income from their "regular" operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes tax rate was 25%. How much was Lindley's operating income, or EBIT? a. $3,462 b. $3,644 c. $3,836 d. $4,038 e. $4,250 ANSWER: e RATIONALE: Sales $12,500 Operating costs excluding depr'n $7,250 Depreciation $1,000 Operating income (EBIT) $4,250 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: EBIT KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/9/2018 4:13 PM 20. Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 25%. How much was the firm's taxable income, or earnings before taxes (EBT)? a. $3,230.00 b. $3,400.00 c. $3,570.00 d. $3,748.50 e. $3,935.93 ANSWER: b RATIONALE: Bonds $8,000.00 Interest rate 7.50% Sales $12,500.00 Operating costs excluding depr'n $7,250.00 Depreciation $1,250.00 Operating income (EBIT) $4,000.00 Interest charges −$600.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes Taxable income $3,400.00 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: taxable income KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/9/2018 4:14 PM 21. Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 25%. How much was the firm's net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes. a. $3,789.87 b. $3,989.33 c. $4,199.30 d. $4,420.31 e. $4,641.33 ANSWER: d RATIONALE: Bonds $6,500 Interest rate 6.25% Tax rate 25% Sales $ 15,000 Operating costs excluding depr'n $ 7,500 Depreciation $ 1,200 Operating income (EBIT) $6,300.00 Interest charges −$ 406.25 Taxable income $5,893.75 Taxes −$1,473.44 Net income $4,420.31 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.03 - LO: 2-3 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: net after-tax income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/30/2018 12:14 PM 22. Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will always be equal to the firm's total retained earnings. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.04 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 23. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of stockholders' claims against the firm's existing assets. This implies that retained earnings are in fact stockholders' reinvested earnings. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.04 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Retained earnings Bloom’s: Comprehension 10/31/2018 8:22 AM 10/31/2018 8:22 AM

24. On 12/31/2020, Heaton Industries Inc. reported retained earnings of $675,000 on its balance sheet, and it reported that it had $172,500 of net income during the year. On its previous balance sheet, at 12/31/2019, the company had reported $555,000 of retained earnings. No shares were repurchased during 20205. How much in dividends did Heaton pay during 2020? a. $47,381 b. $49,875 c. $52,500 d. $55,125 e. $57,881 ANSWER: c RATIONALE: 12/31/2020 RE $675,000 12/31/2019 RE $555,000 Change in RE $120,000 Net income for 2020 $172,500 Dividends = net income − change $52,500 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.04 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of stockholders' equity: dividends KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:02 PM 25. Ullrich Printing Inc. paid out $21,750 of common dividends during the year. It ended the year with $187,500 of retained earnings versus the prior year's retained earnings of $132,250. How much net income did the firm earn during the year? a. $77,000 b. $80,850 c. $84,893 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes d. $89,137 e. $93,594 ANSWER: RATIONALE:

a Net income = The change in retained earnings plus the dividends paid: Current RE $187,500 Previous RE = Current RE − increment $132,250 Change in RE $55,250 Plus dividends paid $21,750 = Net income $77,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.04 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of stockholders' equity: NI KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 26. To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes 27. The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects changes in the firm's accounts over that period of time. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial stmts: time dimension KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 28. Which of the following statements is CORRECT? a. The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year. b. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders' equity. c. The balance sheet gives us a picture of the firm's financial position at a point in time. d. The income statement gives us a picture of the firm's financial position at a point in time. e. The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statements KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes 29. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash flow provided (used) by operations year, even though the cash on its balance sheet increased? a. The company repurchased 20% of its common stock. b. The company sold a new issue of bonds. c. The company made a large investment in new plant and equipment. d. The company paid a large dividend. e. The company issued preferred stock.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:16 PM 30. Analysts following Armstrong Products recently noted that the company's net cash flow from operations increased over the prior year, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation? a. The company issued new long-term debt. b. The company cut its dividend. c. The company made a large investment in a profitable new plant. d. The company sold a division and received cash in return. e. The company issued new common stock.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes DATE CREATED: DATE MODIFIED:

10/31/2018 8:22 AM 11/12/2018 6:19 PM

31. A security analyst obtained the following information from Prestopino Products' financial statements: Retained earnings at the end of the previous year were $700,000, but retained earnings at the end of the current year had declined to $320,000. ∙ The company does not pay dividends.

The company's depreciation expense is its only non-cash expense; it has no amortization ∙ charges. ∙ The company has no non-cash revenues. ∙ The company's net cash provided (used) by operations for the current year was $150,000.

On the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative net income in the current year. b. Prestopino's depreciation expense in the current year was less than $150,000. c. Prestopino had positive net income in the current year, but its income was less than its previous year's income. d. Prestopino's cash flow provided by operations in the current year must be higher than in the previous year. e. Prestopino's cash on the balance sheet at the end of the current year must be lower than the cash it had on the balance sheet at the previous year.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 2/3/2019 6:06 PM ∙

32. Which of the following statements is CORRECT? a. The statement of cash flows shows how much the firm's cash⎯the total of currency, bank deposits, and shortterm liquid securities (or cash equivalents)⎯increased or decreased during a given year. b. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. c. The statement of cash flows shows where the firm's cash is located; indeed, it provides a listing of all banks and brokerage houses where cash is on deposit. d. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital. e. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect cash obtained by selling new common stock.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 33. Which of the following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash. b. Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a decrease in accounts payable is reported as a use of cash. d. In the statement of cash flows, depreciation charges are reported as a use of cash. e. In the statement of cash flows, a decrease in inventories is reported as a use of cash.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 34. Lucy’s Music Emporium purchased $50 million in fixed assets in January and their accountant told them that they would have to depreciate the assets over 20 years (they use the same depreciation calculations for shareholder reporting and income tax purposes). In December they learned that their accountant did not have a college degree and fired him.

They hired a new accountant with a college degree and she told them that they could depreciate the assets over 15 years.

How would the new depreciation assumption affect the company's financial statements relative to the old assumption? a. The firm's net liabilities would increase. b. The firm's reported net fixed assets would increase.

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Chapter 02: Financial Statements, Cash Flow, and Taxes c. The firm's EBIT would increase. d. The firm's reported earnings per share would increase. e. The firm's cash position would increase, all else held equal.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:25 PM 35. Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating costs other than depreciation, and $1,300 of depreciation. The company had no amortization charges, it had $5,000 of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 25%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $750. By how much will net after-tax income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes. a. -534.38 b. -562.50 c. -590.63 d. -620.16 e. -651.16 ANSWER: b RATIONALE: This problem can be worked very easily⎯just multiply the increase in depreciation by (1 − T) to get the decrease in net income: Change in depreciation $750 Tax rate 25% Reduction in net income −$562.50 We can also get the answer a longer way, which explains things more clearly: Item Old New Change Bonds $5,000.00 $5,000.00 $0.00 Interest rate 6.5% 6.5% 0.0% Tax rate 25% 25% 0% Sales $10,500.00 $10,500.00 $0.00 Operating costs excluding depr'n $6,250.00 $6,250.00 $0.00 Depreciation $1,300.00 $2,050.00 $750.00 Operating income (EBIT) $2,950.00 $2,200.00 −$750.00 Interest charges $325.00 $325.00 $0.00 Taxable income $2,625.00 $1,875.00 −$750.00 Taxes $656.25 $468.75 −$187.50 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes Net income $1,968.75 $1,406.25 −$562.50 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statements KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 1/22/2019 7:39 PM 36. Which of the following statements is CORRECT? a. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative. b. Since depreciation is a source of funds, the more depreciation a company has, the larger its retained earnings will be, other things held constant. c. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. d. Common equity includes common stock and retained earnings, less accumulated depreciation. e. The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying dividends.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 37. Jessie's Bobcat Rentals' operations provided a negative net cash flow last year, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company's financial statements were prepared under generally accepted accounting principles?

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Chapter 02: Financial Statements, Cash Flow, and Taxes a. The company had high depreciation expenses. b. The company repurchased some of its common stock. c. The company dramatically increased its capital expenditures. d. The company retired a large amount of its long-term debt. e. The company sold some of its fixed assets.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:26 PM 38. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance? a. The company's operating income declined. b. The company's expenditures on fixed assets declined. c. The company's cost of goods sold increased. d. The company's depreciation and amortization expenses declined. e. The company's interest expense increased.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.05 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow from operations and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:21 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes 39. In accounting, emphasis is placed on determining net income in accordance with generally accepted accounting principles. In finance, the primary emphasis is also on net income because that is what investors use to value the firm.

However, a secondary financial consideration is cash flow, because cash is needed to operate the business. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow and net income KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 40. Which of the following statements is CORRECT? a. Depreciation and amortization are not cash charges, so neither of them has an effect on a firm's reported profits. b. The more depreciation a firm reports, the higher its tax bill, other things held constant. c. People sometimes talk about the firm's net cash provided (used) by operations, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line." d. Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction in the firm's net cash flow. e. Net cash provided (used) by operations is often defined as follows: Net cash flow provided (used) by operations = Net Income + Noncash Adjustments + Working Capital Adjustments.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation, amortization, and net cash flow from operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes DATE MODIFIED:

11/12/2018 6:09 PM

41. Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes. a. Companies' reported net incomes would decline. b. Companies' net operating profits after taxes (NOPAT) would decline. c. Companies' physical stocks of fixed assets would increase. d. Companies' free cash flows would increase. e. Companies' cash positions would decline.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:10 PM 42. JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash provided (used) by operations, assuming it had no amortization expense, added $200 to inventories, sold none of its fixed assets, and had a $200 increase in accounts payable? a. $4,831.31 b. $5,085.59 c. $5,353.25 d. $5,635.00 e. $5,916.75 ANSWER: d RATIONALE: Net income $4,750.00 Depreciation $885.00 - increase in inventories -$200.00 + increase in AP $200.00 NCF $5,635.00 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 2/3/2019 6:02 PM 43. EP Enterprises has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

Sales Costs Depreciation EBIT Interest expense EBT Taxes (25%) Net income a. $101.53 b. $106.88 c. $112.50 d. $118.13 e. $124.03 ANSWER: RATIONALE:

$1,800.00 1,400.00 250.00 $ 150.00 70.00 $ 80.00 20.00 $60.00

c EBIT Tax rate NOPAT =

$150.00 25% $112.50

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking TOPICS: Net operating working capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 1/22/2019 7:55 PM DATE MODIFIED: 1/22/2019 7:58 PM 44. Bae Inc. has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

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Chapter 02: Financial Statements, Cash Flow, and Taxes Sales Costs Depreciation EBIT Interest expense EBT Taxes (25%) Net income a. $427.62 b. $450.12 c. $473.81 d. $498.75 e. $525.00 ANSWER: RATIONALE:

$2,000.00 1,200.00 100.00 $ 700.00 200.00 $ 500.00 125.00 $375.00

e EBIT Tax rate NOPAT =

$700.00 25% $525.00

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: net cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 1/22/2019 7:42 PM 45. Total net operating capital is equal to net fixed assets. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total net operating capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 46. Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from its operations if it had no interest income or interest expense. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating profit after taxes (NOPAT) KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 47. The current cash flow from existing assets is highly relevant to the investor. However, since the value of the firm depends primarily upon its growth opportunities, profit projections from those opportunities are the only relevant future flows with which investors are concerned. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Future cash flows KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 48. For managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm's operations. Related to these modifications, which of the following statements is CORRECT? a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements. b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions' performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units. c. The standard statements provide useful information on the firm's individual operating units, but management needs more information on the firm's overall operations than the standard statements provide. d. The standard statements focus on cash flows, but managers are less concerned with cash flows than with accounting income as defined by GAAP. e. The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to "adjust" the results to make earnings look better.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Modifying acct data for managerial purposes KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes 49. Which of the following statements is CORRECT? a. A shortcut to calculate free cash flow (FCF) is defined as follows: FCF = Net income + Depreciation and Amortization. b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T) + Depreciation and Amortization − Capital expenditures required to sustain operations − Required changes in net operating working capital. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T)+ Depreciation and Amortization + Capital expenditures. e. Net cash provided (used) by operations is the same as free cash flow (FCF).

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation, amortization, and free cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:38 PM 50. Danielle's Sushi Shop last year had (1) a negative net cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? a. The company had a sharp increase in its depreciation and amortization expenses. b. The company had a sharp increase in its inventories. c. The company had a sharp increase in its accrued liabilities. d. The company sold a new issue of common stock. e. The company made a large capital investment early in the year.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

NCF, FCF, and cash Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:22 AM 10/31/2018 8:22 AM

51. Swinnerton Clothing Company's balance sheet showed total current assets of $2,250, all of which were required in operations. Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed by investors? a. $1,454 b. $1,530 c. $1,607 d. $1,687 e. $1,771 ANSWER: b RATIONALE: Current assets $2,250 Accounts payable $575 Accrued wages and taxes $145 Net operating working capital $1,530 Note that NOWC represents the current assets required in operations that are financed by investors, given that payables and accruals are generated spontaneously by operations and are thus "free."

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 52. NNR Inc.'s balance sheet showed total current assets of $1,875,000 plus $4,225,000 of net fixed assets. All of these assets were required in operations. The firm's current liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and common equity. What was NNR's total investor-provided operating capital? a. $4,694,128 b. $4,941,188 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes c. $5,201,250 d. $5,475,000 e. $5,748,750 ANSWER: RATIONALE:

d Current assets Net fixed assets Total assets (all are operating assets) Spontaneous "free" capital:

$1,875,000 $4,225,000 $6,100,000 Acc'ts payable $475,000 Accruals $150,000 Total investor-provided operating capital $5,475,000 Note that the total operating capital is the amount of the capital, or assets, that are required in operations and that must be financed by investors, given that payables and accruals are generated spontaneously by operations and do not have to be financed by investors.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total operating capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 53. TSW Inc. had the following data for last year: Net income = $800; Net operating profit after taxes (NOPAT) = $700; Total assets = $3,000; and Total operating capital = $2,000. Information for the just-completed year is as follows: Net income = $1,000; Net operating profit after taxes (NOPAT) = $925; Total assets = $2,600; and Total operating capital = $2,500. How much free cash flow did the firm generate during the just-completed year? a. $383 b. $425 c. $468 d. $514 e. $566 ANSWER: b RATIONALE: Prior Year Current Year NOPAT = EBIT(1 − T) $700 $925 Total operating capital $2,000 $2,500 FCF this year = NOPAT − Net investment in new operating capital FCF this year = $925 − $500 FCF this year = $425 POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 54. Rao Corporation has the following balance sheet. How much net operating working capital does the firm have?

Cash Short-term investments Accounts receivable Inventory Current assets Net fixed assets Total assets a. $54.00 b. $60.00 c. $66.00 d. $72.60 e. $79.86 ANSWER: RATIONALE:

$ 10Accounts payable Accruals 50Notes payable 40 Current liabilities $130Long-term debt 100Common equity Retained earnings $230Total liab. & equity

$ 20 20 50 $ 90 0 30 50 $230

b Net operating working capital = Operating current assets − Operating current liabilities NOWC = $100.00 − $40.00 NOWC = $60.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes 55. Tibbs Inc. had the following data for the most recent year: Net income = $300; Net operating profit after taxes (NOPAT) = $400; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating capital = $2,300. What was its return on invested capital (ROIC)? a. 14.91% b. 15.70% c. 16.52% d. 17.39% e. 18.26% ANSWER: d RATIONALE: NOPAT $400 Total operating capital $2,300 ROIC = NOPAT/Total operating capital ROIC = $400/$2,300 ROIC = 17.39% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on invested capital (ROIC) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:44 PM 56. Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have?

Cash Short-term investments Accounts receivable Inventory Current assets Gross fixed assets Accumulated deprec.

Net fixed assets Total assets a. $114.00 b. $120.00 c. $126.00 d. $132.30 e. $138.92 ANSWER: RATIONALE:

$ 20.00Accounts payable 50.00Accruals 20.00Notes payable 60.00 Current liabilities $150.00Long-term debt $140.00Common stock 40.00Retained earnings $100.00Total common equity $250.00Total liab. & equity

$ 30.00 50.00 30.00 $110.00 70.00 30.00 40.00 $ 70.00 $250.00

b Total op. capital = Operating current assets − Operating current liabilities + Net fixed assets Total operating capital = $100.00 − $80.00 + $100.00 Total operating capital = $120.00

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Chapter 02: Financial Statements, Cash Flow, and Taxes POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total operating capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 57. Wells Water Systems recently reported $8,250 of sales, $4,500 of operating costs other than depreciation, and $950 of depreciation. The company had no amortization charges, it had $3,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 25%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to spend $750 to buy new fixed assets and to invest $250 in net operating working capital. How much free cash flow did Wells generate? a. $2,050.00 b. $2,152.50 c. $2,260.13 d. $2,373.13 e. $2,491.79 ANSWER: a RATIONALE: Bonds $3,250.00 Interest rate 6.75% Tax rate 25% Required addition to net operating working capital $250.00 Required capital expenditures (fixed assets) $750.00 Sales $8,250.00 Operating costs excluding depr'n $4,500.00 Depreciation $950.00 Operating income (EBIT) $2,800.00 FCF = EBIT(1 − T) + Depr'n − Cap Ex − ΔNet Op WC FCF = $2,100 + $950 − $750 − $250 FCF = $2,050.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Income statement: free cash flow Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:22 AM 2/3/2019 5:45 PM

58. Last year, Michelson Manufacturing reported $10,250 of sales, $3,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 25%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause the firm's net after-tax income to change? Note that the company uses the same depreciation calculations for tax and stockholder reporting purposes. a. −$442.89 b. −$466.20 c. −$490.73 d. −$516.56 e. −$543.75 ANSWER: e RATIONALE: This problem can be worked very easily⎯just multiply the increase in depreciation by (1 − T) to get the decrease in net income, and then add to the change in income the change in depreciation to get the change in net cash flow: Change in depreciation $725 Tax rate 25.00% Reduction in net income = Change in Depr'n (1 − Tax rate) −$543.75 We can also get the answer the long way, which explains things in more detail: Old New Bonds $3,500 $3,500 Interest rate 6.50% 6.50% Tax rate 25% 25% Sales $10,250 $10,250 Operating costs excluding depr'n $3,500 $3,500 Depreciation $1,250 $1,975 Operating income (EBIT) $5,500 $4,775 Interest charges $228 $228 Taxable income $5,273 $4,548 Taxes $1,318 $1,137 Net income after taxes $3,954 $3,411

Change $0.00 $0.00 $0.00 $0.00 $0.00 $725.00 −$725.00 $0.00 −$725.00 −$181.25 −$543.75

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Changes in net income and NCF Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:22 AM 2/3/2019 5:53 PM

59. Bartling Energy Systems recently reported $9,250 of sales, $5,750 of operating costs other than depreciation, and $700 of depreciation. The company had no amortization charges, it had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 25%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital. By how much did the firm's net income exceed its free cash flow? a. $658.83 b. $693.50 c. $730.00 d. $766.50 e. $804.83 ANSWER: c RATIONALE: Bonds $3,200.00 Interest rate 5.00% Tax rate 25.00% Required capital expenditures (fixed assets) $1,250.00 Required addition to net operating working capital $300.00 Sales $9,250.00 Operating costs excluding depr'n $5,750.00 Depreciation $700.00 Operating income (EBIT) $2,800.00 Interest charges $160.00 Taxable income (EBT) $2,640.00 Taxes $660.00 Net income after taxes $1,980.00 FCF = EBIT(1 − T) + Depr'n − Cap Ex − ΔNet Op WC FCF = $2,100 + $700 − $1,250 − $300 FCF = Difference between net income and FCF =

$1,250.00 $730.00

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.07 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Income stmt: FCF vs. net income Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:22 AM 2/3/2019 5:58 PM

60. Which of the following statements is CORRECT? a. The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses. b. MVA gives us an idea about how much value a firm's management has added during the last year. c. MVA stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) + Book value of common equity. d. EVA stands for economic value added, and it is defined as follows: EVA = EBIT(1 − T) − (Investor-supplied op. capital) × (A − T cost of capital). e. EVA gives us an idea about how much value a firm's management has added over the firm's life.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.08 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MVA and EVA KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 61. Which of the following statements is CORRECT? a. One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital. b. If a firm reports positive net income, its EVA must also be positive. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital. e. Actions that increase reported net income will always increase net cash flow from operations.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.08 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EVA, CF, and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 6:27 PM 62. Over the years, Janjigian Corporation's stockholders have provided $15,250 of capital, part when they purchased new issues of stock and part when they allowed management to retain some of the firm's earnings. The firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How much value has Janjigian's management added to stockholder wealth over the years, i.e., what is Janjigian's MVA? a. $21,788 b. $22,935 c. $24,142 d. $25,413 e. $26,750 ANSWER: e RATIONALE: Total book value of equity $15,250 Stock price per share $42.00 Shares outstanding 1,000 Market value of equity 42,000 MVA = 26,750 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.08 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MVA KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 63. Barnes' Brothers has the following data for the year ending 12/31/2015: Net income = $600; Net operating profit after Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes taxes (NOPAT) = $700; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating capital = $2,100. Barnes' weighted average cost of capital is 10%. What is its economic value added (EVA)? a. $399.11 b. $420.11 c. $442.23 d. $465.50 e. $490.00 ANSWER: e RATIONALE: NOPAT $700 Total operating capital $2,100 WACC 10.00% EVA = NOPAT − Total operating capital × WACC EVA = $700.00 − $2,100.00 × 10.00% EVA = $490.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.08 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Economic Value Added (EVA) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 64. HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 9.5%, and the federal-plus-state income tax rate was 25%. What was HHH's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year? a. $2,098.31 b. $2,208.75 c. $2,325.00 d. $2,441.25 e. $2,563.31 ANSWER: c RATIONALE: Sales $12,500 Operating costs $7,025 Operating income (EBIT) $5,475 WACC 9.5% Tax rate 25% Investor-supplied capital $18,750 EVA = EBIT(1 − T) − Investor Capital × WACC EVA = $4,106.25 − $1,781.25 EVA = $2,325.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.08 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Economic Value Added (EVA) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 2/3/2019 6:10 PM 65. The fact that 50% of the interest income received by a corporation is excluded from its taxable income encourages firms to use more debt financing than they would in the absence of this tax law provision. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest income KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/9/2018 4:06 PM 66. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a taxdeductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 67. The interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense and dividends KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 68. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense and dividends Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Comprehension 10/31/2018 8:22 AM 10/31/2018 8:22 AM

69. Which of the following statements is CORRECT? a. All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income. b. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses. c. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code. d. Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm's income as personal income and pay taxes on that income. e. Congress recently changed the tax laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was first taxed on the income and stockholders were taxed again on the income when it was paid to them as dividends.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income tax system KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 70. Assume that Congress recently passed a provision that will enable Barton's Rare Books (BRB) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or tax rate. Prior to the new provision, BRB's net income after taxes was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BRB's financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. Net fixed assets on the balance sheet will decrease. b. The provision will reduce the company's free cash flow. c. The provision will increase the company's tax payments. d. Net fixed assets on the balance sheet will increase. e. The provision will increase the company's net income.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:54 PM 71. The LeMond Corporation just purchased a new production line. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. LeMond's tax liability for the year will be lower. b. LeMond's taxable income will be lower. c. LeMond's net fixed assets as shown on the balance sheet will be higher at the end of the year. d. LeMond's cash position will improve (increase). e. LeMond's reported net income after taxes for the year will be lower.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM 72. DeYoung Devices Inc., a new high-tech instrumentation firm, is building and equipping a new manufacturing facility.

Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change? a. The firm's reported net income would increase. b. The firm's operating income (EBIT) would increase.

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Chapter 02: Financial Statements, Cash Flow, and Taxes c. The firm's taxable income would increase. d. The firm's net cash flow provided (used) by operations would increase. e. The firm's tax payments would increase.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:59 PM 73. Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant.

Which of the following would occur? a. The company would have to pay less taxes. b. The company's taxable income would fall. c. The company's interest expense would remain constant. d. The company would have less common equity than before. e. The company's net income would increase.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.09 - LO: 2-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in leverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 10/31/2018 8:22 AM

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Chapter 02: Financial Statements, Cash Flow, and Taxes 74. Which of the following statements is CORRECT? a. The maximum federal tax rate on personal income can exceed 50%. b. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies' debt ratios to be lower than they would be if interest and dividends were both deductible. c. Interest paid to an individual is counted as income for tax purposes and taxed at the individual's regular tax rate, but dividends received are taxed at a maximum rate of 20%. d. The maximum federal tax rate on corporate income is 50%. e. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.10 - LO: 2-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income tax system KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:22 AM DATE MODIFIED: 11/12/2018 5:52 PM 75. Edwards Electronics recently reported $11,250 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 25%. How much was its net operating profit after taxes (NOPAT)? a. $2,748.96 b. $2,893.64 c. $3,045.94 d. $3,206.25 e. $3,375.00 ANSWER: e RATIONALE: Bonds $3,500.00 Interest rate 6.25% Tax rate 25.00% Sales $11,250.00 Operating costs excluding depr'n $5,500.00 Depreciation $1,250.00 Operating income (EBIT) $4,500.00 NOPAT = EBIT(1 - T) $3,375.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 02: Financial Statements, Cash Flow, and Taxes POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.02.06 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic TOPICS: Income statement: net cash flow KEYWORDS: Bloom's: Analysis DATE CREATED: 2/3/2019 6:19 PM DATE MODIFIED: 2/3/2019 6:24 PM

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Chapter 03: Analysis of Financial Statements 1. Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.01 - LO: 3 - 1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Ratio analysis KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 2. The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed. a. True b. False ANSWER: True RATIONALE: Many of the ratios show sales over some past period such as the last 12 months divided by an asset such as inventories as of a specific date. Assets like inventories vary at different times of the year for a seasonal business, thus leading to big changes in the ratio.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.10 - LO: 3-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet changes KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 3. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.10 - LO: 3-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limitations of ratio analysis KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 4. One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase. a. True b. False ANSWER: False RATIONALE: The key here is to recognize that if the CR is greater than 1.0, then a given increase in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to build the cash account would lower the CR. For example: Original New Old New CA/CL Plus $1 CA/CL CR CR 3/2 1/1 4/3 1.50 1.33 CR falls if initial CR is greater than 1.0 2/3 1/1 3/4 0.67 0.75 CR rises if initial CR is less than 1.0 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.10 - LO: 3-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limitations of ratio analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 5. One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements b. False ANSWER: RATIONALE:

False The key here is to recognize that if the CR is less than 1.0, then a given reduction in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were greater than 1.0. In the question, the initial CR is less than 1.0, so using cash to reduce current liabilities would lower the CR. If the CR were greater than 1.0, the statement would have been true. Here's an illustration: Original New Old New CA/CL Less $1 CA/CL CR CR 2/3 −1/−1 1/2 0.67 0.50 CR falls if initial CR is less than 1.0 3/2 −1/−1 2/1 1.5 2.0 CR rises if initial CR is greater than 1.0 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.10 - LO: 3-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limitations of ratio analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 6. Which of the following statements is CORRECT? a. "Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value. b. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of "window dressing." Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of "window dressing." c. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing." d. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of "window dressing." e. Using some of the firm's cash to reduce long-term debt is an example of "window dressing."

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.10 - LO: 3-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Window dressing Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 10/31/2018 8:24 AM

7. The current ratio and inventory turnover ratios both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 8. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easyto-use measures of a firm's liquidity position. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements DATE MODIFIED:

10/31/2018 8:24 AM

9. High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 10. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if A's quick ratio exceeds B's, then we can be certain that A's current ratio is also larger than that of B. a. True b. False ANSWER: False RATIONALE: This question can be answered by thinking carefully about the ratios: Demonstration that the first sentence is true: CR =

A>B

QR =

B>A

A:

1.67

0.67

B:

1.50

1.00

QR(B) > QR(A)

Demonstration that second sentence is false: CR =

A>B

QR =

B>A

A:

1.0

0.67

B:

1.5

0.50

QR(B) < QR(A)

POINTS: DIFFICULTY: QUESTION TYPE:

The key is inventory, which is in the CR but not in the QR. The firm with more inventory can have the higher CR but the lower QR. 1 Difficulty: Challenging True / False

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Chapter 03: Analysis of Financial Statements HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 11. Firms A and B have the same current ratio, 0.75, the same amount of sales and cost of goods sold, and the same amount of current liabilities. However, Firm A has a higher inventory turnover ratio than B. Therefore, we can conclude that A's quick ratio must be smaller than B's. a. True b. False ANSWER: False RATIONALE: Firm A has the higher inventory turnover, so given the same cost of goods, it must have less inventory. Thus, since the two firms have the same CR, then A must have the higher QR, not the lower one. Therefore, the statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 12. Considered alone, which of the following would increase a company's current ratio? a. An increase in accounts payable. b. An increase in net fixed assets. c. An increase in accrued liabilities. d. An increase in notes payable. e. An increase in accounts receivable.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 13. Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant? a. The total assets turnover decreases. b. The TIE declines. c. The DSO increases. d. The EBITDA coverage ratio increases. e. The current and quick ratios both decline.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 14. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? a. Use cash to increase inventory holdings. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. c. Use cash to repurchase some of the company's own stock. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

ANSWER: e POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 15. A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. Issue new common stock and use the proceeds to acquire additional fixed assets. b. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable. c. Issue new common stock and use the proceeds to increase inventories. d. Speed up the collection of receivables and use the cash generated to increase inventories. e. Use some of its cash to purchase additional inventories.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quick ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 16. Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio? a. Use cash to reduce accounts payable. b. Borrow using short-term notes payable and use the proceeds to reduce accruals. c. Borrow using short-term notes payable and use the proceeds to reduce long-term debt. d. Use cash to reduce accruals. e. Use cash to reduce short-term notes payable.

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Chapter 03: Analysis of Financial Statements ANSWER: RATIONALE:

c a is false, given that the initial CR > 1.0. b would leave the CR unchanged. c would indeed reduce the CR. d is false, given that the initial CR > 1.0. e is false, given that the initial CR > 1.0.

Original New Old New CA/CL Minus .5 CA/CL CR CR 1.9/1 0/0.5 1.9/1.5 1.90 1.27 CR falls if initial CR is greater than 1.0 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 17. Lincoln Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio? a. Use cash to reduce long-term bonds outstanding. b. Borrow using short-term notes payable and use the cash to increase inventories. c. Use cash to reduce accruals. d. Use cash to reduce accounts payable. e. Use cash to reduce short-term notes payable.

ANSWER: b RATIONALE: The key here is to recognize that if the CR is less than 1.0, then a given increase in both current assets and current liabilities would lead to an increase in the CR. The reverse would hold if the initial CR were greater than 1.0. Here the initial CR is less than 1.0, so borrowing on a short-term basis to build inventories would increase the CR. For example: Original New Old New CA/CL Plus $1 CA/CL CR CR 1/2 1/1 2/3 0.50 0.67 CR rises if initial CR is less than 1.0 All of the other statements are incorrect, although c, d, and e would be correct if the initial CR had been >1.0.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Current ratio Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 10/31/2018 8:24 AM

18. Lofland's has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so each plans to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions? a. The transaction would improve both firms' financial strength as measured by their current ratios. b. The transactions would raise Lofland's financial strength as measured by its current ratio but lower Smaland's current ratio. c. The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio. d. The transaction would have no effect on the firm' financial strength as measured by their current ratios. e. The transaction would lower both firm' financial strength as measured by their current ratios.

ANSWER: c RATIONALE: The key here is to recognize that if the CR is less than 1.0, then a given increase to both current assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than 1.0. Thus, the transaction would make Smaland look stronger but Lofland look weaker. Here's an illustration: Original New Old New CA/CL Plus $10 CA/CL CR CR CR falls because initial CR Lofland 20/10 10/10 30/20 2.00 1.50 is greater than 1.0 Original New Old New CA/CL Plus $10 CA/CL CR CR CR rises because initial CR Smaland 10/20 10/10 20/30 0.50 0.67 is less than 1.0 All of the statements except c are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 2016 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

19. Refer to the data for Pettijohn Inc.What is the firm's current ratio? a. 0.97 b. 1.08 c. 1.20 d. 1.33 e. 1.47 ANSWER: d RATIONALE: Current ratio = Current assets/Current liabilities = 1.33 POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 20. Refer to the data for Pettijohn Inc. What is the firm's quick ratio? a. 0.49 b. 0.61 c. 0.73 d. 0.87 e. 1.05 ANSWER: b RATIONALE: Quick ratio = (CA − Inventory)/CL = 0.61 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 21. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Asset management ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 22. A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover ratio KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 23. The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. False ANSWER: True RATIONALE: A high current ratio is consistent with a lot of inventory. A low inventory turnover is also consistent with a lot of inventory. If the CR exceeds industry norms and the turnover is below the norms, then the firm has more inventory than most other firms, given its sales. It could just be carrying a lot of good inventory, but it might also have a normal amount of "good" inventory plus some "bad" inventory that has not been written off. So the statement is true.

POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover ratio KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 24. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets. a. True b. False ANSWER: False RATIONALE: The FA turnover is Sales/FA, and it gives an indication of how effectively the firm utilizes its FA. The proportion of FA to TA is not relevant to this usage.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fixed assets turnover KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 25. Which of the following statements is CORRECT? a. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. b. A reduction in inventories held would have no effect on the current ratio. c. An increase in inventories would have no effect on the current ratio. d. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. e. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventories KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 26. Which of the following statements is CORRECT? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline. b. If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. c. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase. d. There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP).

These ratios measure entirely different things. e. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts receivable KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 27. Other things held constant, which of the following alternatives would increase a company's cash flow for the current year? a. Increase the number of years over which fixed assets are depreciated for tax purposes. b. Pay down the accounts payables. c. Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.

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Chapter 03: Analysis of Financial Statements d. Pay workers more frequently to decrease the accrued wages balance. e. Reduce the inventory turnover ratio without affecting sales or operating costs.

ANSWER: c RATIONALE: Lengthening depreciable lives would lower depreciation, increase taxable income and a. taxes, and thus lower cash flow. b. Paying down accounts payable would use cash and thus reduce cash flow.

Reducing the DSO would require collecting receivables faster, which would indeed c. increase cash flow. d. Decreasing accruals would lower cash flow. e. Reducing inventory turnover would mean increasing inventories, which would use cash.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 28. Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)? a. 2.03 b. 2.13 c. 2.25 d. 2.36 e. 2.48 ANSWER: d RATIONALE: Sales $52,000 Total assets $22,000 TATO 2.36 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Total assets turnover Bloom’s: Application TYPE: Multiple Choice: Problem 10/31/2018 8:24 AM 10/31/2018 8:24 AM

29. Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay.

The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant? a. $267.34 b. $281.41 c. $296.22 d. $311.81 e. $328.22 ANSWER: e RATIONALE: Rate of return on cash generated 8.0% Sales $100,000 A/R $11,500 Days in year 365 Sales/day $273.97 Company DSO 42.0 Industry DSO 27.0 Excess DSO 15.0 Cash flow from reducing the DSO $4,102.74 Alternative calculation: A/R at industry DSO $7,397.26 Change in A/R $4,102.74 Additional Net Income $328.22 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effect of lowering the DSO on net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 30. Heaton Corp. sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were $425,000, and its year-end receivables were $60,000. If its DSO is less than the 45-day credit period, then customers are paying on Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements time. Otherwise, they are paying late. By how much are customers paying early or late? Base your answer on this equation: DSO − Credit period = days early or late, and use a 365-day year when calculating the DSO. A positive answer indicates late payments, while a negative answer indicates early payments. a. 6.20 b. 6.53 c. 6.86 d. 7.20 e. 7.56 ANSWER: b RATIONALE: Credit period 45 Sales $425,000 Sales/Day $1,164 Receivables $60,000 DSO 51.53 Credit period − DSO = Days early (+) or late (−) 6.53 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Days sales outstanding (DSO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 31. Harper Corp.'s sales last year were $395,000, and its year-end receivables were $42,500. Harper sells on terms that call for customers to pay 30 days after the purchase, but many delay payment beyond Day 30. On average, how many days late do customers pay? Base your answer on this equation: DSO − Allowed credit period = Average days late, and use a 365-day year when calculating the DSO. a. 7.95 b. 8.37 c. 8.81 d. 9.27 e. 9.74 ANSWER: d RATIONALE: Sales $395,000 Sales/Day $1,082 Receivables $42,500 DSO 39.27 Credit period 30 Credit period − DSO = Days late 9.27 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO: days of free credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 32. Bonner Corp.'s sales last year were $415,000, and its year-end total assets were $355,000. The average firm in the industry has a total assets turnover ratio (TATO) of 2.4. Bonner's new CFO believes the firm has excess assets that can be sold so as to bring the TATO down to the industry average without affecting sales. By how much must the assets be reduced to bring the TATO to the industry average, holding sales constant? a. $164,330 b. $172,979 c. $182,083 d. $191,188 e. $200,747 ANSWER: c RATIONALE: Sales $415,000 Total assets $355,000 Target TATO 2.40 Target assets = Sales/Target TATO $172,917 Asset reduction $182,083 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total assets turnover ratio (TATO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements 33. Muscarella Inc. has the following balance sheet and income statement data: Cash Receivables Inventories Total CA Net fixed assets Total assets Sales Net income

$ 14,000Accounts payable 70,000Other current liabilities 210,000 Total CL $294,000Long-term debt 126,000Common equity $420,000 Total liab. and equity $280,000 $ 21,000

$ 42,000 28,000 $ 70,000 70,000 280,000 $420,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change? a. 4.28% b. 4.50% c. 4.73% d. 4.96% e. 5.21% ANSWER: b RATIONALE: Sales $280,000 Net income $21,000 Actual current ratio 4.20 Target current ratio 2.70 ORIGINAL BALANCE SHEET Cash $ 14,000Accounts payable $ 42,000 Other current Receivables $ 70,000 $ 28,000 liabilities Inventories $210,000Long-term debt $ 70,000 Net fixed assets $126,000Common equity $280,000 Total assets $420,000Total liab. and equity $420,000 NI/Equity = ROE: Inv. at target CR Reduction in inv & equity

7.50% $105,000 = inventories and common equity $105,000 decrease by this amount $175,000 12.00% 4.50%

New common equity New ROE ΔROE POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO and its effect on net income Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:24 AM 10/31/2018 8:24 AM

Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 2016 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

34. Refer to the data for Pettijohn Inc. What is the firm's days sales outstanding? Assume a 360-day year for this calculation. a. 48.17 b. 50.71 c. 53.38 d. 56.19 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements e. 59.14 ANSWER: e RATIONALE: DSO = Accounts receivable/(Sales/360) = 59.14 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 35. Refer to the data for Pettijohn Inc. What is the firm's total assets turnover? a. 0.90 b. 1.12 c. 1.40 d. 1.68 e. 2.02 ANSWER: c RATIONALE: Total assets turnover ratio = Sales/Total assets = 1.40 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 36. Refer to the data for Pettijohn Inc. What is the firm's inventory turnover ratio?

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Chapter 03: Analysis of Financial Statements a. 4.19 b. 4.40 c. 4.62 d. 4.85 e. 5.09 ANSWER: RATIONALE:

a Inventory turnover ratio = (Cost of goods sold except depreciation + Depreciation)/Inventory = 4.19 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.03 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:29 PM 37. Debt management ratios show the extent to which a firm's managers are attempting to magnify returns on owners' capital through the use of financial leverage. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt management ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 38. The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and shortCopyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements term debt obligations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: TIE ratio KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 39. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True b. False ANSWER: True RATIONALE: TIE = EBIT/Interest = (Sales − Op cost)/(Debt × Interest rate). If we know the op. costs, the amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target TIE. POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: TIE ratio KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 40. If a bank loan officer were considering a company's request for a loan, which of the following statements would you consider to be CORRECT? a. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.

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Chapter 03: Analysis of Financial Statements b. The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. c. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. e. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 41. Which of the following statements is CORRECT? a. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. c. A firm's use of debt will have no effect on its profit margin on sales. d. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales. e. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.

ANSWER: d RATIONALE: a is incorrect. The reverse is true. b is false, because the TIE also depends on the interest rate and EBIT. c is false, because interest affects the profit margin. d is correct, because the more interest the lower the profits, hence the lower the profit margin. e is simply incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Leverage effects Debt management Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 10/31/2018 8:24 AM

42. Hutchinson Corporation has zero debt⎯it is financed only with common equity. Its total assets are $410,000. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $155,800 b. $164,000 c. $172,200 d. $180,810 e. $189,851 ANSWER: b RATIONALE: Total assets $410,000 Target debt ratio 40% Debt to achieve target ratio = amount borrowed $164,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt ratio: find the debt, given the D/A ratio KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 43. Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500.

What was the firm's times interest earned (TIE) ratio? a. 4.72 b. 4.97 c. 5.23 d. 5.51 e. 5.80 ANSWER: e RATIONALE: Sales $435,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements Operating costs 362,500 Operating income (EBIT) 72,500 Interest charges $ 12,500 TIE ratio 5.80 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Times interest earned KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 44. Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio? a. $158,750 b. $166,688 c. $175,022 d. $183,773 e. $192,962 ANSWER: a RATIONALE: Total assets $625,000 Present debt $185,000 Target debt ratio 55% Target amount of debt $343,750 Change in amount of debt outstanding $158,750 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements DATE CREATED: DATE MODIFIED:

10/31/2018 8:24 AM 10/31/2018 8:24 AM

45. A new firm is developing its business plan. It will require $565,000 of assets, and it projects $452,800 of sales and $354,300 of operating costs for the first year. Management is quite sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. What is the maximum debt-to-assets ratio the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt ratio.) a. 47.33% b. 49.82% c. 52.45% d. 55.21% e. 58.11% ANSWER: e RATIONALE: Assets $565,000 Sales $452,800 Operating costs 354,300 Operating income (EBIT) $ 98,500 TIE 4.00 Maximum interest expense = EBIT/TIE $24,625 Interest rate 7.50% Max. debt = Max interest/Interest rate $328,333 Maximum debt ratio = Debt/Assets 58.11% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Max debt ratio consistent with given TIE ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 46. Ziebart Corp.'s EBITDA last year was $390,000 ( = EBIT + depreciation + amortization), its interest charges were $9,500, it had to repay $26,000 of long-term debt, and it had to make a payment of $17,400 under a long-term lease. The firm had no amortization charges. What was the EBITDA coverage ratio? a. 7.32 b. 7.70 c. 8.09 d. 8.49 e. 8.92 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements ANSWER: RATIONALE:

b EBITDA $390,000 Interest charges $9,500 Repayment of principal $26,000 Lease payments $17,400 Total financial charges $52,900 Funds avail for fin charges (EBITDA + Lease pmts) $407,400 EBITDA coverage 7.70 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EBITDA coverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Copyright Cengage Learning. Powered by Cognero.

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 2016 $58,800.0 Page 29

Chapter 03: Analysis of Financial Statements Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

47. Refer to the data for Pettijohn Inc. What is the firm's TIE? a. 1.73 b. 1.93 c. 2.14 d. 2.38 e. 2.62 ANSWER: d RATIONALE: TIE = EBIT/Interest charges = 2.38 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:28 PM 48. Refer to the data for Pettijohn Inc. What is the firm's EBITDA coverage? a. 3.03 b. 3.19 c. 3.36 d. 3.53 e. 3.70 ANSWER: c RATIONALE: EBITDA covg = (EBITDA + lease)/(Int + principal + lease) = 3.36 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.05 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:30 PM 49. Refer to the data for Pettijohn Inc. What is the firm's debt ratio (i.e., debt-to-assets ratio)? a. 33.87% b. 35.00% c. 36.40% d. 38.00% e. 40.00% ANSWER: e RATIONALE: Debt ratio = Total debt/Total assets = (Notes payable + Long-term bonds)/Total assets = ($5,880 + $10,920)/$42,000 = 40.0% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 50. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Profitability ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 51. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. a. True b. False ANSWER: False RATIONALE: BEP = EBIT/Assets. This is before the effects of leverage (interest) and taxes, so the statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Basic earning power ratio KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 52. Since the ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. a. True b. False ANSWER: False RATIONALE: EBIT = Sales revenues − Operating costs Net income = EBIT − Interest − Taxes = (EBIT − Interest) × (1 − T) ROA = Net income after taxes/Assets Two firms could have identical Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements EBITs but very different amounts of interest, different tax rates, and different assets, and thus very different ROAs. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ROA KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 53. Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio. a. True b. False ANSWER: True RATIONALE: The easiest way to think about this is to realize that you can borrow at a cost of 10% and invest the proceeds to earn 11%, you'll earn a surplus. If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase. Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage. The answer can also be seen by working out an example. The one below shows that leverage increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP. Firm A Firm B Assets $100Assets $100 Debt 30%Debt 0% Equity 70%Equity 100% BEP 15%BEP 15% 10%Interest rate, rd 10% Interest rate, rd Tax rate 25%Tax rate 25% EBIT = BEP × Assets 15EBIT = BEP × Assets 15.0 3Interest 0 Interest = wd (Assets)rd Taxable income 12Taxable income 15.0 Taxes 3Taxes 3.75 NI 9NI 11.25 ROE 12.86%ROE 11.25% POINTS: 1 DIFFICULTY: Difficulty: Challenging Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: BEP and ROE KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 12/4/2018 3:57 PM 54. A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger? a. Increase inventories while holding sales and cost of goods sold constant. b. Increase accounts receivable while holding sales constant. c. Increase EBIT while holding sales constant. d. Increase accounts payable while holding sales constant. e. Increase notes payable while holding sales constant.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 55. If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant. a. The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30. b. The division's basic earning power ratio is above the average of other firms in its industry. c. The division's total assets turnover ratio is below the average for other firms in its industry. d. The division's debt ratio is above the average for other firms in the industry. e. The division's inventory turnover is 6, whereas the average for its competitors is 8.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 56. Which of the following would indicate an improvement in a company's financial position, holding other things constant? a. The current and quick ratios both increase. b. The inventory and total assets turnover ratios both decline. c. The debt ratio increases. d. The profit margin declines. e. The EBITDA coverage ratio declines.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.04 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 57. Cordelion Communications is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? a. The times interest earned ratio will decrease. b. The ROA will decline. c. Taxable income will decrease.

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Chapter 03: Analysis of Financial Statements d. The tax bill will increase. e. Net income will decrease.

ANSWER: d RATIONALE: a The TIE will increase, not decrease. b is false because reducing debt will lower interest, raise income, and thus raise ROA. c is false for the above reason. d is true for the above reason. e is false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statement analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 58. Which of the following statements is CORRECT? a. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin. b. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio. c. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. d. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. e. An increase in the DSO, other things held constant, could be expected to increase the ROE. ANSWER: a RATIONALE: More debt would mean more interest, hence a lower NI, given a constant EBIT. This a. would lower the profit margin = NI/Sales. b. Sales fluctuations would have more effects on the DSO and S/Inventory ratios. c. ROE = ROA × Equity multiplier, so more debt, higher ROE for given ROA. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean d. an increase in receivables, hence a decline, not a rise, in the TATO. An increase in the DSO might increase or decrease ROE, depending on how it affected e. sales and costs.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Financial statement analysis Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 10/31/2018 8:24 AM

59. Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE. b. Given this information, Leaudy must have the higher ROE. c. Company Leaudy has a higher basic earning power ratio (BEP). d. Company Heidee has a higher basic earning power ratio (BEP). e. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE. ANSWER: a RATIONALE: The companies have the same EBIT and assets, hence the same BEP ratio. If the interest rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement a is correct. The others are all incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effects of financial leverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 60. Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales? a. 6.49% b. 6.83% c. 7.19% d. 7.55% e. 7.92% ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements RATIONALE:

Sales $320,000 Net income $23,000 Profit margin 7.19% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Profit margin on sales KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 61. Branch Corp.'s total assets at the end of last year were $315,000 and its net income after taxes was $22,750. What was its return on total assets? a. 7.22% b. 7.58% c. 7.96% d. 8.36% e. 8.78% ANSWER: a RATIONALE: Total assets $315,000 Net income $22,750 ROA 7.22% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on total assets (ROA) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 62. Chambliss Corp.'s total assets at the end of last year were $305,000 and its EBIT was 62,500. What was its basic Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements earning power (BEP)? a. 18.49% b. 19.47% c. 20.49% d. 21.52% e. 22.59% ANSWER: RATIONALE:

c Total assets $305,000 EBIT $62,500 BEP 20.49% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Basic earning power (BEP) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 63. Nikko Corp.'s total common equity at the end of last year was $305,000 and its net income after taxes was $60,000.

What was its ROE? a. 16.87% b. 17.75% c. 18.69% d. 19.67% e. 20.66% ANSWER: d RATIONALE: Common equity $305,000 Net income $60,000 ROE 19.67% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Return on equity (ROE) Bloom’s: Application TYPE: Multiple Choice: Problem 10/31/2018 8:24 AM 10/31/2018 8:24 AM

64. An investor is considering starting a new business. The company would require $475,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business? a. $52,230 b. $54,979 c. $57,873 d. $60,919 e. $64,125 ANSWER: e RATIONALE: Assets = equity $475,000 Target ROE 13.5% Required net income $64,125 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on equity (ROE): finding net income KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 65. LeCompte Corp. has $312,900 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $620,000, and its net income after taxes was $24,655. Stockholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 15%. What profit margin would LeCompte need in order to achieve the 15% ROE, holding everything else constant? a. 7.57% b. 7.95% c. 8.35% d. 8.76% e. 9.20% ANSWER: a RATIONALE: Total assets = equity $312,900 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements Sales $620,000 Net income $24,655 Target ROE 15.00% Net income req'd to achieve target ROE $46,935 Profit margin needed to achieve target ROE 7.57% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Profit margin and ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 66. Last year Urbana Corp. had $197,500 of assets, $307,500 of sales, $19,575 of net income, and a debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE? a. 9.32% b. 9.82% c. 10.33% d. 10.88% e. 11.42% ANSWER: d RATIONALE: Assets $197,500 Debt ratio 37.5% Debt $74,063 Equity $123,438 Sales $307,500 Old net income $19,575 New net income $33,000 New ROE 26.734% Old ROE 15.858% Increase in ROE 10.88% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Effect of reducing costs on the ROE Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:24 AM 10/31/2018 8:24 AM

67. Last year Altman Corp. had $205,000 of assets, $303,500 of sales, $18,250 of net income, and a debt-to-total-assets ratio of 41%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $152,500. Sales, costs, and net income would not be affected, and the firm would maintain the 41% debt ratio. By how much would the reduction in assets improve the ROE? a. 4.69% b. 4.93% c. 5.19% d. 5.45% e. 5.73% ANSWER: c RATIONALE: Old New Assets $205,000 $152,500 Sales $303,500 $303,500 Net income $18,250 $18,250 Debt ratio 41.00% 41.00% Debt $84,050 $62,525 Equity $120,950 $89,975 ROE 15.089% 20.283% Increase in ROE 5.19% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Asset reduction: turnover and ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 68. Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 25%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements ROE change in response to the change in the capital structure? a. 2.48% b. 2.76% c. 3.06% d. 3.40% e. 3.74% ANSWER: d RATIONALE: Interest rate Tax rate Assets Debt ratio Debt Equity Sales Operating costs EBIT Interest paid Taxable income Taxes Net income ROE Change in ROE

Old 8.2% 37% $195,000 27% $52,650 $142,350

New 8.2% 37% $195,000 45% $87,750 $107,250

$303,225 $267,500 $ 35,725 $ 4,317 $ 31,408 $7,852 $23,556 16.55%

$303,225 $267,500 $ 35,725 $ 7,196 $ 28,530 $7,132 $21,397 19.95% 3.40%

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ROE changing with debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:42 PM 69. For the coming year, Crane Inc. is considering two financial plans. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 25%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? a. 4.42% Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements b. 4.64% c. 4.87% d. 5.11% e. 5.37% ANSWER: RATIONALE:

a Work down the Plan A column, find the Max Debt, then use it to complete Plan B and the ROEs. Plan A Plan B Interest rate 8.80% 8.80% Tax rate 25% 25% Assets $200,000 $200,000 Debt ratio 25% Debt $50,000 $100,071 Equity $150,000 $99,929

Sales $301,770 $301,770Constant Operating costs $266,545 $266,545Constant EBIT $ 35,225 $ 35,225Constant Interest $ 4,400 $ 8,806 Taxable income $ 30,825 $ 26,419 Taxes $7,706 $6,605 Net income $ 23,119 $ 19,814 ROE 15.41% 19.83% TIE 8.01 Minimum TIE 4.00 Interest consistent with minimum TIE = EBIT/Min TIE $8,806 Max debt = Interest/interest rate $100,071 Change in ROE 4.42% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum debt constrained by TIE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:46 PM Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

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Chapter 03: Analysis of Financial Statements Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 2016 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

70. Refer to the data for Pettijohn Inc. What is the firm's ROA? a. 2.70% b. 2.97% c. 3.26% d. 3.59% e. 3.95% ANSWER: a RATIONALE: ROA = Net income/Total assets = 2.70% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 71. Refer to the data for Pettijohn Inc. What is the firm's ROE? a. 8.54% b. 8.99% c. 9.44% d. 9.91% e. 10.41% ANSWER: b RATIONALE: ROE = Net income/Common equity = 8.99% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 72. Refer to the data for Pettijohn Inc. What is the firm's BEP? a. 5.37% b. 5.65% c. 5.95% d. 6.24% e. 6.55% ANSWER: c RATIONALE: BEP = EBIT/Total assets = 5.95% POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 1/27/2019 4:47 PM 73. Refer to the data for Pettijohn Inc. What is the firm's profit margin? a. 1.40% b. 1.56% c. 1.73% d. 1.93% e. 2.12% ANSWER: d RATIONALE: Profit margin = Net income/Sales = 1.93% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 74. Refer to the data for Pettijohn Inc. What is the firm's dividends per share? a. $2.62 b. $2.91 c. $3.20 d. $3.53 e. $3.88 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements ANSWER: b RATIONALE: DPS = Common dividends paid/Shares outstanding = $2.91 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.02 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 75. Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value ratios KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 76. Companies A and C each reported the same earnings per share (EPS), but Company A's stock trades at a higher price.

Which of the following statements is CORRECT? a. Company A trades at a higher P/E ratio. b. Company A probably has fewer growth opportunities. c. Company A is probably judged by investors to be riskier. d. Company A must have a higher market-to-book ratio. e. Company A must pay a lower dividend.

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Chapter 03: Analysis of Financial Statements ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statement analysis KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 77. Which of the following statements is CORRECT? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b. If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be. d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA). e. If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 78. The Cavendish Company recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. Which of the following effects Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements would occur as a result of this action? a. The company's debt ratio increased. b. The company's current ratio increased. c. The company's times interest earned ratio decreased. d. The company's basic earning power ratio increased. e. The company's equity multiplier increased.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 79. Which of the following statements is CORRECT? a. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same. b. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same. c. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same. d. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio. e. If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate.

ANSWER: c RATIONALE: No reason for a to be true. No reason for b to be true. c must be true, as EPS and P will be the same. No reason for d to be true. e is wrong, because high risk and low growth lead to low P/Es. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Market value ratios Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 10/31/2018 8:24 AM

80. Vang Corp.'s stock price at the end of last year was $33.50 and its earnings per share for the year were $2.30. What was its P/E ratio? a. 13.84 b. 14.57 c. 15.29 d. 16.06 e. 16.86 ANSWER: b RATIONALE: Stock price $33.50 EPS $2.30 P/E 14.57 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Price/Earnings ratio (P/E) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 81. Lindley Corp.'s stock price at the end of last year was $33.50, and its book value per share was $25.00. What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48 d. 1.55 e. 1.63 ANSWER: a RATIONALE: Stock price $33.50 Book value per share $25.00 M/B ratio 1.34 POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Price/Earnings ratio (P/E) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 82. Emerson Inc.'s would like to undertake a policy of paying out 45% of its income. Its latest net income was $1,250,000, and it had 225,000 shares outstanding. What dividend per share should it declare? a. $2.14 b. $2.26 c. $2.38 d. $2.50 e. $2.63 ANSWER: d RATIONALE: Net income $1,250,000 Shares outstanding 225,000 Payout ratio 45% EPS $5.56 DPS $2.50 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EPS, DPS, and payout KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 83. Stewart Inc.'s latest EPS was $3.50, its book value per share was $22.75, it had 215,000 shares outstanding, and its debt-to-assets ratio was 46%. How much debt was outstanding? a. $3,393,738 b. $3,572,356 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements c. $3,760,375 d. $3,958,289 e. $4,166,620 ANSWER: RATIONALE:

e EPS $3.50 BVPS $22.75 Shares outstanding 215,000 Debt ratio 46.0% Total equity $4,891,250 Total assets $9,057,870 Total debt $4,166,620 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EPS, book value, and debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Copyright Cengage Learning. Powered by Cognero.

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 Page 53

Chapter 03: Analysis of Financial Statements Total liabilities and equity

$42,000.0

Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

2016 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

84. Refer to the data for Pettijohn Inc. What is the firm's EPS? a. $5.84 b. $6.15 c. $6.47 d. $6.80 e. $7.14 ANSWER: c RATIONALE: EPS = Net income/common shares outstanding = $6.47 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 85. Refer to the data for Pettijohn Inc. What is the firm's P/E ratio? a. 12.0 b. 12.6 c. 13.2 d. 13.9 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements e. 14.6 ANSWER: a RATIONALE: P/E ratio = Price per share/Earnings per share = 12.0 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 86. Refer to the data for Pettijohn Inc. What is the firm's book value per share? a. $61.73 b. $64.98 c. $68.40 d. $72.00 e. $75.60 ANSWER: d RATIONALE: BVPS = Common equity/Shares outstanding = $72.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 87. Refer to the data for Pettijohn Inc. What is the firm's market-to-book ratio?

Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements a. 0.56 b. 0.66 c. 0.78 d. 0.92 e. 1.08 ANSWER: e RATIONALE: Market/book ratio (M/B) = Price per share/BVPS = 1.08 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.06 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 88. Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of measuring changes in a firm's performance over time. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.07 - LO: 3-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trend analysis KEYWORDS: Bloom’s: Knowledge DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 89. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. a. True b. False ANSWER: False RATIONALE: Think about the DuPont equation: ROE = PM × TATO × Equity multiplier. Similar financing policies will lead to similar Equity multipliers. Moreover, competition in the capital markets will cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and drive returns down toward the average, given similar risks. To have similar ROEs, firms with relatively high PMs must have relatively low TATOs, and vice versa. Therefore, the statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 90. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667. a. True b. False ANSWER: True RATIONALE: Equity multiplier = Assets/Equity = 3.0, so Assets/Equity = 1/3.0 = 0.333. By definition, Equity/Assets + Debt/Assets = 1.00, so 0.333 + Debt/Assets = 1.0. Therefore, Debt/Assets = 1.0 − 0.333 = 0.667. Thus, the statement is true.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity multiplier KEYWORDS: Bloom’s: Comprehension DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements 91. Which of the following statements is CORRECT? a. All else equal, increasing the debt ratio will increase the ROA. b. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. c. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. d. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. e. Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effects of leverage KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 92. Which of the following statements is CORRECT? a. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease. b. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase. c. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE. d. The modified DuPont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. e. Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.

ANSWER: b RATIONALE: PM × TATO × Eq mult. = ROE Old 9% 1.0 1.666667 15% New 10% 0.9 2.5 23% We see that b is true, thus c must be false. We can also see that d, e, and a are all false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 93. You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT? a. Its total assets turnover must equal the industry average. b. Its total assets turnover must be above the industry average. c. Its return on assets must equal the industry average. d. Its TIE ratio must be below the industry average. e. Its total assets turnover must be below the industry average.

ANSWER: b RATIONALE: Thinking through the DuPont equation, we can see that if the firm's PM and Equity multiplier are below the industry average, the only way its ROE can exceed the industry average is if its equity multiplier exceeds the industry average. The following data illustrate this point: ROE = PM × TATO × Eq mult.

ROA Firm 30% 9% 2.0 1.67 18% Industry 25% 10% 1 2.50 10% The above demonstrates that b is correct, and that makes e and a incorrect. Now consider the following: NI/Assets = NI/Sales × Sales/Assets ROA = PM × TATO If its ROA were equal to the industry average, then with its low debt ratio (hence low equity multiplier) its ROE would also be below the industry average. So c is incorrect. With its debt ratio below the industry average, its interest charges should also be low, which would increase its TIE ratio, making d incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements 94. Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT? a. Heidee has lower operating income (EBIT) than Leaudy. b. Heidee has a lower total assets turnover ratio than Leaudy. c. Heidee has a lower equity multiplier than Leaudy. d. Heidee has a higher fixed assets turnover ratio than Leaudy. e. Heidee has a higher ROE than Leaudy.

ANSWER: e RATIONALE: Rule out all answers except e because they are false. Alternative answer explanation using the DuPont equation: ROE = PM × TATO × Eq mult. ROE = NI/S × S/TA × TA/Equity The first two terms are the same, but KB has higher equity multiplier, hence higher ROE. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 12/4/2018 4:35 PM 95. Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT? a. Heidee would have higher net income as shown on the income statement than Leaudy. b. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. c. Heidee would have a lower equity multiplier for use in the DuPont equation than Leaudy. d. Heidee would have to pay more in income taxes than Leaudy. e. Heidee would have lower net income as shown on the income statement than Leaudy.

ANSWER: e RATIONALE: More debt would mean more interest, hence a lower NI, given a constant EBIT, so e is correct. Also, we can rule out b and a, and Heidee would also have the higher multiplier, which rules out c. And with more interest, Heidee would have to pay less taxes, not more.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Financial statement analysis Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 10/31/2018 8:24 AM 12/4/2018 4:38 PM

96. Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Heidee has more net income than Leaudy. b. Heidee pays less in taxes than Leaudy. c. Heidee has a lower equity multiplier than Leaudy. d. Heidee has a higher ROA than Leaudy. e. Heidee has a higher times interest earned (TIE) ratio than Leaudy.

ANSWER: b RATIONALE: Under the stated conditions, Heidee would have more interest charges, thus lower taxable income and taxes. Thus, b is correct. All of the other statements are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage, taxes, and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 12/4/2018 4:39 PM 97. Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Heidee has a lower times interest earned (TIE) ratio than Leaudy. b. Heidee has a lower equity multiplier than Leaudy. c. Heidee has more net income than Leaudy. d. Heidee pays more in taxes than Leaudy. e. Heidee has a lower ROE than Leaudy.

ANSWER: a RATIONALE: Heidee has higher interest charges. Basic earning power equals EBIT/Assets, and since assets Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, Heidee higher interest charges means that its TIE must be lower. Thus, a is correct. All of the other statements are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage, taxes, and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 12/4/2018 4:40 PM 98. Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE? a. 12.79% b. 13.47% c. 14.18% d. 14.88% e. 15.63% ANSWER: c RATIONALE: Profit margin 5.25% TATO 1.50 Equity multiplier 1.80 ROE 14.18% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: basic calculation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements 99. Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and its year-end assets were $210,000.

The firm's total-debt-to-total-assets ratio was 42.5%. Based on the DuPont equation, what was Vaughn's ROE? a. 14.77% b. 15.51% c. 16.28% d. 17.10% e. 17.95% ANSWER: a RATIONALE: Sales $315,000 Assets $210,000 Net income $17,832 Debt ratio 42.5% Debt $89,250 Equity $120,750 Profit margin 5.66% TATO 1.50 Equity multiplier 1.74 ROE 14.77% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: basic calculation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 100. Last year Central Chemicals had sales of $205,000, assets of $127,500, a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $21,000 without affecting either sales or costs. Had it reduced its assets in this amount, and had the debt-to-assets ratio, sales, and costs remained constant, by how much would the ROE have changed? a. 1.81% b. 2.02% c. 2.22% d. 2.44% e. 2.68% ANSWER: b RATIONALE: Old New Sales $205,000 $205,000 Original assets $127,500 Reduction in assets $ 21,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements New assets $106,500 TATO 1.61 1.92 Profit margin 5.30% 5.30% Equity multiplier 1.20 1.20 ROE 10.23% 12.24% Change in ROE 2.02% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont eqn: effect of reducing assets on ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM 101. Last year Mason Inc. had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its sales were $195,000 and its net income was $10,549. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $5,250 without changing its sales, assets, or capital structure. Had it cut costs and increased its net income in this amount, by how much would the ROE have changed? a. 5.66% b. 5.95% c. 6.27% d. 6.58% e. 6.91% ANSWER: c RATIONALE: Old New Sales $195,000 $195,000 Original net income $ 10,549 $ 10,549 Increase in net income $0 $ 5,250 New net income $ 10,549 $ 15,799 Profit margin 5.41% 8.10% TATO 1.33 1.33 Equity multiplier 1.75 1.75 ROE 12.59% 18.86% Change in ROE 6.27% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA DuPont eqn: effect of reducing costs on ROE Bloom’s: Analysis TYPE: Multiple Choice: Problem 10/31/2018 8:24 AM 10/31/2018 8:24 AM

102. Last year Rosenberg Corp. had $195,000 of assets, $18,775 of net income, and a debt-to-total-assets ratio of 32%.

Now suppose the new CFO convinces the president to increase the debt ratio to 48%. Sales and total assets will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE? a. 4.36% b. 4.57% c. 4.80% d. 5.04% e. 5.30% ANSWER: a RATIONALE: Assets $195,000 Old debt ratio 32% Old debt $62,400 Old equity $132,600 New debt ratio 48% New debt $93,600 New Equity $101,400 Net income $18,775 New ROE 18.52% Old ROE 14.16% Increase in ROE 4.36% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: changing the debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM Pettijohn Inc. Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

2016 $ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 2016 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

103. Refer to the data for Pettijohn Inc. What is the firm's equity multiplier? a. 3.33 b. 3.50 c. 3.68 d. 3.86 e. 4.05 ANSWER: a RATIONALE: Equity multiplier = Total assets/Common equity = 3.33 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 03: Analysis of Financial Statements HAS VARIABLES: False PREFACE NAME: Pettijohn Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.03.08 - LO: 3-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice DATE CREATED: 10/31/2018 8:24 AM DATE MODIFIED: 10/31/2018 8:24 AM

Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 1. Starting to invest early for retirement increases the benefits of compound interest. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 2. Starting to invest early for retirement reduces the benefits of compound interest. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 3. A time line is meaningful even if all cash flows do not occur annually. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Time value of money United States - OH - Default City - TBA Compounding Bloom's: Remember 10/31/2018 8:26 AM 11/14/2018 12:18 PM

4. A time line is not meaningful unless all cash flows occur annually. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 5. Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 6. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 7. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 8. Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom's: Remember 10/31/2018 8:26 AM 11/14/2018 12:18 PM

9. Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 10. Some of the cash flows shown on a time line can be in the form of annuity payments but none can be uneven amounts. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 11. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 12. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 13. Suppose Sally Smith plans to invest $1,000. She can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be more than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.) a. True b. False ANSWER: True RATIONALE: Work out the numbers with a calculator: PV 1000FVA = $1,710.34 Rate on A 5%2 × FVA = $3,420.68 Rate on B 12%FVB = $3,478.55 Years 11FVB > 2 × FVA, so TRUE POINTS: DIFFICULTY:

1 Moderate

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Chapter 04: Time Value of Money QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Comparative compounding KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 14. Suppose Randy Jones plans to invest $1,000. He can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be somewhat less than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.) a. True b. False ANSWER: False RATIONALE: Work out the numbers with a calculator: PV 1000FVA = $1,710.34 Rate on A 5%2 × FVA = $3,420.68 Rate on B 12%FVB = $3,478.55 Years 11FVB > 2 × FVA, so FALSE POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Comparative compounding KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 15. Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? a. $205.83 b. $216.67 c. $228.07 d. $240.08 e. $252.08 ANSWER: d RATIONALE: N 8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money I/YR 8.5% PV $125 PMT $0 FV $240.08 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 16. How much would Roderick have after 6 years if he has $500 now and leaves it invested at 5.5% with annual compounding? a. $591.09 b. $622.20 c. $654.95 d. $689.42 e. $723.89 ANSWER: d RATIONALE: N 6 I/YR 5.5% PV $500 PMT $0 FV $689.42 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 17. JG Asset Services is recommending that you invest $1,500 in a 5-year certificate of deposit (CD) that pays 3.5% interest, compounded annually. How much will you have when the CD matures? a. $1,781.53 b. $1,870.61 c. $1,964.14 d. $2,062.34 e. $2,165.46 ANSWER: a RATIONALE: N 5 I/YR 3.5% PV $1,500 PMT $0 FV $1,781.53 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 18. Your bank offers a 10-year certificate of deposit (CD) that pays 6.5% interest, compounded annually. If you invest $2,000 in the CD, how much will you have when it matures? a. $3,754.27 b. $3,941.99 c. $4,139.09 d. $4,346.04 e. $4,563.34 ANSWER: a RATIONALE: N 10 I/YR 6.5% PV $2,000 PMT $0 FV $3,754.27 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Time value of money United States - OH - Default City - TBA FV of a lump sum Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

19. Cyberhost Corporation's sales were $225 million last year. If sales grow at 6% per year, how large (in millions) will they be 5 years later? a. $271.74 b. $286.05 c. $301.10 d. $316.16 e. $331.96 ANSWER: c RATIONALE: N 5 I/YR 6.0% PV $225.00 PMT $0.00 FV $301.10 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 20. Cochrane Associate's net sales last year were $525 million. If sales grow at 7.5% per year, how large (in millions) will they be 8 years later? a. $845.03 b. $889.51 c. $936.33 d. $983.14 e. $1,032.30 ANSWER: c RATIONALE: N 8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money I/YR 7.5% PV $525.00 PMT $0.00 FV $936.33 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 21. How much would $1, growing at 3.5% per year, be worth after 75 years? a. $12.54 b. $13.20 c. $13.86 d. $14.55 e. $15.28 ANSWER: b RATIONALE: N 75 I/YR 3.5% PV $1.00 PMT $0.00 FV $13.20 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 22. How much would $100, growing at 5% per year, be worth after 75 years?

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Chapter 04: Time Value of Money a. $3,689.11 b. $3,883.27 c. $4,077.43 d. $4,281.30 e. $4,495.37 ANSWER: RATIONALE:

b N 75 I/YR 5.0% PV $100.00 PMT $0.00 FV $3,883.27 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 23. Your bank offers a savings account that pays 3.5% interest, compounded annually. If you invest $1,000 in the account, then how much will it be worth at the end of 25 years? a. $2,245.08 b. $2,363.24 c. $2,481.41 d. $2,605.48 e. $2,735.75 ANSWER: b RATIONALE: N 25 I/YR 3.5% PV $1,000 PMT $0 FV $2,363.24 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA FV of a lump sum Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

24. Your bank offers a savings account that pays 3.5% interest, compounded annually. How much will $500 invested today be worth at the end of 25 years? a. $1,122.54 b. $1,181.62 c. $1,240.70 d. $1,302.74 e. $1,367.88 ANSWER: b RATIONALE: N 25 I/YR 3.5% PV $500 PMT $0 FV $1,181.62 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.02 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 25. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Time value of money United States - OH - Default City - TBA PV versus FV Bloom's: Remember 10/31/2018 8:26 AM 11/14/2018 12:18 PM

26. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV versus FV KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 27. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV versus FV KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 28. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV versus FV KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 29. The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a dollar KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 30. The present value of a future sum increases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a sum KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 31. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment? a. The discount rate decreases. b. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000. c. The discount rate increases. d. The riskiness of the investment's cash flows decreases. e. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effects of factors on PVs KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 32. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would increase the calculated value of the investment? a. The discount rate increases. b. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000. c. The discount rate decreases. d. The riskiness of the investment's cash flows increases. e. The total amount of cash flows remains the same, but more of the cash flows are received in the later years and less are received in the earlier years.

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Chapter 04: Time Value of Money ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effects of factors on PVs KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 33. Suppose a State of North Carolina bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today? a. $585.43 b. $614.70 c. $645.44 d. $677.71 e. $711.59 ANSWER: a RATIONALE: N 10 I/YR 5.5% PMT $0 FV $1,000.00 PV $585.43 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 34. Suppose a State of New Mexico bond will pay $1,000 eight years from now. If the going interest rate on these 8-year bonds is 5.5%, how much is the bond worth today? a. $651.60 b. $684.18 c. $718.39 d. $754.31 e. $792.02 ANSWER: a RATIONALE: N 8 I/YR 5.5% PMT $0 FV $1,000.00 PV $651.60 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 35. How much would $20,000 due in 50 years be worth today if the discount rate were 7.5%? a. $438.03 b. $461.08 c. $485.35 d. $510.89 e. $537.78 ANSWER: e RATIONALE: N 50 I/YR 7.5% PMT $0 FV $20,000 PV $537.78 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Time value of money United States - OH - Default City - TBA PV of a lump sum Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

36. You expect to receive $5,000 in 25 years. How much is it worth today if the discount rate is 5.5%? a. $1,067.95 b. $1,124.16 c. $1,183.33 d. $1,245.61 e. $1,311.17 ANSWER: e RATIONALE: N 25 I/YR 5.5% PMT $0 FV $5,000 PV $1,311.17 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 37. The going rate of interest on a 5-year treasury bond is 4.25%. You have one that will pay $2,500 five years from now.

How much is the bond worth today? a. $1,928.78 b. $2,030.30 c. $2,131.81 d. $2,238.40 e. $2,350.32 ANSWER: b RATIONALE: N 5 I/YR 4.25% PMT $0 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money FV $2,500.00 PV $2,030.30 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 38. Suppose a Google.com bond will pay $4,500 ten years from now. If the going interest rate on safe 10-year bonds is 4.25%, how much is the bond worth today? a. $2,819.52 b. $2,967.92 c. $3,116.31 d. $3,272.13 e. $3,435.74 ANSWER: b RATIONALE: N 10 I/YR 4.25% PMT $0 FV $4,500.00 PV $2,967.92 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.03 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 39. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 40. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 41. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by multiplying the periodic rate by the number of periods per year. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Periodic and nominal rates Bloom's: Understand 10/31/2018 8:26 AM 11/14/2018 12:18 PM

42. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Periodic and nominal rates KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 43. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or greater than the nominal rate on the deposit (or loan). a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective and nominal rates KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 44. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan).

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Chapter 04: Time Value of Money a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective and nominal rates KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 45. Your bank account pays a 5% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? a. The periodic rate of interest is 5% and the effective rate of interest is also 5%. b. The periodic rate of interest is 1.25% and the effective rate of interest is 2.5%. c. The periodic rate of interest is 5% and the effective rate of interest is greater than 5%. d. The periodic rate of interest is 1.25% and the effective rate of interest is greater than 5%. e. The periodic rate of interest is 2.5% and the effective rate of interest is 5%.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quarterly compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 46. Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? a. The periodic rate of interest is 8% and the effective rate of interest is also 8%.

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Chapter 04: Time Value of Money b. The periodic rate of interest is 2% and the effective rate of interest is 4%. c. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%. d. The periodic rate of interest is 4% and the effective rate of interest is less than 8%. e. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quarterly compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 47. At the end of 10 years, which of the following investments would have the highest future value? Assume that the effective annual rate for all investments is the same and is greater than zero. a. Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments). b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (just one payment). e. Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).

ANSWER: a RATIONALE: A dominates B because it provides the same total amount, but it comes faster, hence it can earn more interest over the 10 years. A also dominates C and E for the same reason, and it dominates D because with D no interest whatever is earned. We could also do these calculations to answer the question: A $4,382.79 Largest EFF% 10.00% 10 250 B $4,081.59 NOM% 9.76% 125 C $4,280.81 125 D $2,500.00 2500 E $3,984.36 250 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Time value of money United States - OH - Default City - TBA Time value concepts Bloom's: Analyze TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

10/31/2018 8:26 AM 11/14/2018 12:18 PM

48. Of the following investments, which would have the lowest present value? Assume that the effective annual rate for all investments is the same and is greater than zero. a. Investment A pays $250 at the end of every year for the next 10 years (a total of 10 payments). b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (just one payment). e. Investment E pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).

ANSWER: d RATIONALE: A is smaller than E and B is smaller than C because the money comes in later. A is smaller than B because a larger annuity is received later. So, now the choice comes down to either A or D. Since all of D is received at the end, this is the logical choice. We could also do these calculations to answer the question: A $1,536.14 EFF% 10.00% 10 250 B $1,573.63 NOM% 9.76% 125 C $1,650.44 125 D $963.86 Smallest 2500 E $1,689.76 250 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 49. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? a. The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity. b. The periodic interest rate is greater than 3%. c. The periodic rate is less than 3%. d. The present value would be greater if the lump sum were discounted back for more periods. e. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 50. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? a. The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity. b. The periodic interest rate is greater than 3%. c. The periodic rate is less than 3%. d. The present value would be greater if the lump sum were discounted back for more periods. e. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money KEYWORDS: OTHER: NOTES:

DATE CREATED: DATE MODIFIED:

Bloom's: Analyze TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

10/31/2018 8:26 AM 11/14/2018 12:18 PM

51. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit. b. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. c. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. d. A bank loan's nominal interest rate will always be equal to or less than its effective annual rate. e. If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 52. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit. b. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. c. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. d. A bank loan's nominal interest rate will always be equal to or greater than its effective annual rate. e. If an investment pays 10% interest, compounded quarterly, its effective annual rate will be greater than 10%.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 53. Which of the following statements is CORRECT? a. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. b. The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary annuity. c. If a loan has a nominal annual rate of 8%, then the effective rate can never be greater than 8%. d. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. e. The proportion of the payment that goes toward interest on a fully amortized loan increases over time.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 54. Which of the following statements is CORRECT? a. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

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Chapter 04: Time Value of Money b. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. c. If a loan has a nominal annual rate of 7%, then the effective rate will never be less than 7%. d. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. e. The proportion of the payment that goes toward interest on a fully amortized loan increases over time.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 55. Which of the following bank accounts has the highest effective annual return? a. An account that pays 8% nominal interest with daily (365-day) compounding. b. An account that pays 8% nominal interest with monthly compounding. c. An account that pays 8% nominal interest with annual compounding. d. An account that pays 7% nominal interest with daily (365-day) compounding. e. An account that pays 7% nominal interest with monthly compounding.

ANSWER: a RATIONALE: By inspection, we can see that a dominates b and c, and that d dominates e because, with the same interest rate, the account with the most frequent compounding has the highest EFF%.

Thus, the correct answer must be either a or d. Moreover, we can see by inspection that since a and d have the same compounding frequency yet a has the higher nominal rate, a must have the higher EFF%. You could also prove that a is the correct choice by calculating the EFF%s: a. 8.328% = (1 + 0.08/365)365−1 b. 8.300% = (1 + 0.08/12)12−1 c. 8.000% = (1 + 0.08/1)1−1 d. 7.250% = (1 + 0.07/365)365−1 e. 7.229% = (1 + 0.07/12)12−1 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 56. Which of the following bank accounts has the lowest effective annual return? a. An account that pays 8% nominal interest with daily (365-day) compounding. b. An account that pays 8% nominal interest with monthly compounding. c. An account that pays 8% nominal interest with annual compounding. d. An account that pays 7% nominal interest with daily (365-day) compounding. e. An account that pays 7% nominal interest with monthly compounding.

ANSWER: e RATIONALE: By inspection, we can see that c must have a lower EFF% than either a or b because they all pay the same nominal rate but c is compounded least frequently. Similarly, d and e pay the same rate, but e is compounded less frequently, hence e must have the lower EFF%. So, the correct answer must be either c or e. It is not obvious which of these two has the lower EFF%, so we must do a quick calculation to determine the correct response. As the following calculations show, e is the correct answer. a. 8.328% = (1 + 0.08/365)365−1 b. 8.300% = (1 + 0.08/12)12−1 c. 8.000% = (1 + 0.08/1)1−1 d. 7.250% = (1 + 0.07/365)365−1 e. 7.229% = (1 + 0.07/12)12−1 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 57. You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest? a. Bank 1; 6.1% with annual compounding.

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Chapter 04: Time Value of Money b. Bank 2; 6.0% with monthly compounding. c. Bank 3; 6.0% with annual compounding. d. Bank 4; 6.0% with quarterly compounding. e. Bank 5; 6.0% with daily (365-day) compounding.

ANSWER: e RATIONALE: By inspection, we can see that e dominates b, c, and d because, with the same interest rate, the account with the most frequent compounding has the highest EFF%. Thus, the correct answer must be either a or e. However, we cannot tell by inspection whether a or e provides the higher EFF%. We know that with one compounding period an EFF% is 6.1%, so we can calculate e's EFF%. It is 6.183%, so e is the correct answer. a. (1 + 0.061/12)12−1 = 6.100% e. (1 + 0.06/365)365−1 = 6.183% POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 58. What's the future value of $1,500 after 5 years if the appropriate interest rate is 6%, compounded semiannually? a. $1,819 b. $1,915 c. $2,016 d. $2,117 e. $2,223 ANSWER: c RATIONALE: Years 5 Periods/Yr 2 Nom. I/YR 6.0%

POINTS: DIFFICULTY: QUESTION TYPE:

N = Periods PMT I = I/Period PV FV = 1 Moderate Multiple Choice

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10 $0 3.0% $1,500Could be found using a calculator, an equation, or Excel. $2,016Note that we must first convert to periods and rate per period.

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Chapter 04: Time Value of Money HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV, semiannual compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 59. What's the present value of $4,500 discounted back 5 years if the appropriate interest rate is 4.5%, compounded semiannually? a. $3,089 b. $3,251 c. $3,422 d. $3,602 e. $3,782 ANSWER: d RATIONALE: Years 5 Periods/Yr 2 Nom. I/YR 4.5% FV $4,500 N = Periods 10 PMT $0 I = I/Period 2.25%Could be found using a calculator, the equation, or Excel.

PV = $3,602Note that we must first convert to periods and rate per period.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV, semiannual compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 60. What's the future value of $1,200 after 5 years if the appropriate interest rate is 6%, compounded monthly? a. $1,537.69 b. $1,618.62 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money c. $1,699.55 d. $1,784.53 e. $1,873.76 ANSWER: RATIONALE:

b Years Periods/Yr Nom. I/YR

5 12 6.0%

N = Periods 60 PMT $0 I/Period 0.5% PV $1,200Could be found using a calculator, the equation, or Excel.

FV $1,618.62Note that we must first convert to periods and rate per period.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV, monthly compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 61. What's the present value of $1,525 discounted back 5 years if the appropriate interest rate is 6%, compounded monthly? a. $969 b. $1,020 c. $1,074 d. $1,131 e. $1,187 ANSWER: d RATIONALE: Years 5 Periods/Yr 12 Nom. I/YR 6.0%

POINTS:

N = Periods PMT I/Period FV PV = $1,131 = FV/(1 + rPer)N PV = $1,131 1

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60 $0 0.5% $1,525

Found using a calculator or Excel Page 32

Chapter 04: Time Value of Money DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV, monthly compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 62. American Express and other credit card issuers must by law print the Annual Percentage Rate (APR) on their monthly statements. If the APR is stated to be 18.00%, with interest paid monthly, what is the card's EFF%? a. 18.58% b. 19.56% c. 20.54% d. 21.57% e. 22.65% ANSWER: b RATIONALE: APR = Nominal rate 18.00% Periods/yr 12 N−1 19.56% EFF% = (1 + (rNOM/N)) = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: APR vs. EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 63. Southwestern Bank offers to lend you $50,000 at a nominal rate of 6.5%, compounded monthly. The loan (principal plus interest) must be repaid at the end of the year. Woodburn Bank also offers to lend you the $50,000, but it will charge an annual rate of 7.0%, with no interest due until the end of the year. How much higher or lower is the effective annual rate charged by Woodburn versus the rate charged by Southwestern? a. 0.52% b. 0.44% Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money c. 0.36% d. 0.30% e. 0.24% ANSWER: RATIONALE:

d This problem can be worked using the interest conversion feature of a calculator or Excel. It could also be worked using the conversion formula. We used the conversion formula.

Nominal rate, Southwestern 6.5% Nominal rate, Woodburn 7.0% Periods/yr, Southwestern 12 Periods/yr, Woodburn 1 N−1 6.70% EFF% Southwestern = (1 + (rNOM/N)) = EFF% Woodburn 7.00% Difference 0.30% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Comparing EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 64. Suppose United Bank offers to lend you $10,000 for one year at a nominal annual rate of 8.00%, but you must make interest payments at the end of each quarter and then pay off the $10,000 principal amount at the end of the year. What is the effective annual rate on the loan? a. 8.24% b. 8.45% c. 8.66% d. 8.88% e. 9.10% ANSWER: a RATIONALE: Nominal I/YR 8.00% Periods/yr 4 N−1 8.24% EFF% = (1 + (rNOM/N)) = You could also find the EFF% as follows: Interest paid each quarter = Loan × rate/4 = Qtrly PMT = $200.00 Then find the IRR as a quarterly rate and convert to an annual rate. This procedure is obviously longer.

0 1 2 3 4 CFs: 10,000.00 −200.00 −200.00 −200.00 −200.00 −10,000.00 10,000.00 −200.00 −200.00 −200.00 −10,200.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money IRR (quarterly) = 2.00% Annual effective rate = 8.24% vs. nominal rate = 8.00% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nominal rate vs. EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 65. Suppose People's bank offers to lend you $10,000 for 1 year on a loan contract that calls for you to make interest payments of $250.00 at the end of each quarter and then pay off the principal amount at the end of the year. What is the effective annual rate on the loan? a. 8.46% b. 8.90% c. 9.37% d. 9.86% e. 10.38% ANSWER: e RATIONALE: Interest payment: $250.00 0 1 2 3 4 CFs: 10,000 −250 −250 −250 −250 −10,000 10,000 −250 −250 −250 −10,250 IRR (quarterly) = 2.50% Annual effective rate = 10.38% vs. nominal rate = 10.00% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nominal rate vs. EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 66. Pacific Bank pays a 4.50% nominal rate on deposits, with monthly compounding. What effective annual rate (EFF%) Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money does the bank pay? a. 3.72% b. 4.13% c. 4.59% d. 5.05% e. 5.56% ANSWER: RATIONALE:

c Nominal I/YR 4.50% Periods/yr 12 Periodic rate 0.38% 4.59% EFF% = (1 + (rNOM/N))N − 1 = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nominal rate vs. EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 67. Suppose your credit card issuer states that it charges a 15.00% nominal annual rate, but you must make monthly payments, which amounts to monthly compounding. What is the effective annual rate? a. 15.27% b. 16.08% c. 16.88% d. 17.72% e. 18.61% ANSWER: b RATIONALE: Nominal I/YR = APR 15.00% Periods/yr 12 N−1 16.08% EFF% = (1 + (rNOM/N)) = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Nominal rate vs. EFF percent Bloom's: Analyze TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

68. You just deposited $2,500 in a bank account that pays a 4.0% nominal interest rate, compounded quarterly. If you also add another $5,000 to the account one year (4 quarters) from now and another $7,500 to the account two years (8 quarters) from now, how much will be in the account three years (12 quarters) from now? a. $15,234.08 b. $16,035.88 c. $16,837.67 d. $17,679.55 e. $18,563.53 ANSWER: b RATIONALE: Interest rate 4.0% Periods/year 4 Years on Quarters Ending Quarterly rate 1.0% Deposit on Deposit Amount 1st deposit $2,500 3 12 $2,817.06 2nd deposit $5,000 2 8 $5,414.28 3rd deposit $7,500 1 4 $7,804.53 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Non-annual compounding KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 69. Partners Bank offers to lend you $50,000 at a nominal rate of 5.0%, simple interest, with interest paid quarterly. An offer to lend you the $50,000 also comes from Community Bank, but it will charge 6.0%, simple interest, with interest paid at the end of the year. What's the difference in the effective annual rates charged by the two banks? a. 1.56% b. 1.30% c. 1.09% d. 0.91% e. 0.72% ANSWER: d RATIONALE: Students must understand that "simple interest with interest paid quarterly" means that the Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money bank gets the interest at the end of each quarter, hence it can invest it, presumably at the same nominal rate. This results in the same effective rate as if it were stated as "6%, quarterly compounding."

Nominal rate, Partners 5.0% Periods/yr, Partners 4 Nominal rate, Community 6.0% Periods/yr, Community 1 EFF% Partners 5.09% EFF% Community 6.00% Difference 0.91% POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.15 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Comparing EFF percent KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 70. A "growing annuity" is a cash flow stream that grows at a constant rate for a specified number of periods. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.18 - LO: 4-18 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 71. A "growing annuity" is any cash flow stream that grows over time. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.18 - LO: 4-18 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Remember DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 72. You borrowed $50,000 which you must repay in 10 years. You plan to make an initial deposit today, then make 9 more deposits at the beginning of each the next 9 years, but with the deposits increasing at the inflation rate. You expect to earn 5% on your funds, and you expect a 3% inflation rate. To the nearest dollar, how large must your initial deposit be to enable you to reach your $50,000 target? a. $3,008 b. $3,342 c. $3,676 d. $4,044 e. $4,448 ANSWER: b RATIONALE: We can set up a table with an arbitrary initial deposit that grows at the inflation rate and is then compounded at the nominal rate for (N − t) years. The sum of the compounded amounts should total to $50,000. With an arbitrary initial amount the ending amount is not likely to be $50,000, so we use goal seek as shown in the completed dialog box to find the correct initial deposit. Inputs: Years 10 Amount Needed (FV) $50,000 Nominal rate earned on account 5.00% Inflation 3.00% 1.

Goal Seek approach: Use Goal Seek in the following table to determine the initial deposit. Start with $5,000 as the initial payment, but this will change to $3,341.94.

BOY Payment Period (t) Initial(1 + I)t 0 $3,341.94 1 $3,442.20 2 $3,545.47 3 $3,651.83 4 $3,761.39 5 $3,874.23 6 $3,990.45 7 $4,110.17 8 $4,233.47 Copyright Cengage Learning. Powered by Cognero.

Computed Value $5,443.67 $5,339.98 $5,238.27 $5,138.49 $5,040.62 $4,944.61 $4,850.42 $4,758.03 $4,667.40 Page 39

Chapter 04: Time Value of Money 9 N= 2.

$4,360.48 10

$4,578.50 $0.00

= Sum of the 10 compounded $50,000.00 values

Formula approach: Find the real rate 1.941748% = (1 + I1572)/(1 + I1573) −1 Find the PV of the required future amount, discounted at the inflation rate. This is our constant dollar future target. $37,204.70 = I1571/(1 + I1573)(I1570) Use a calculator or Excel to find the initial payment.

N = 10, I/YR = 1.941748, PV = 0, FV = −37204.70, and set to BEGIN mode.

This is consistent with the Goal Seek solution. $3,341.94 = PMT(H1593, I1570,0, −H1595,1)

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.18 - LO: 4-18 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 73. Your 75-year-old grandmother expects to live for another 15 years. She currently has $1,000,000 of savings, which is invested to earn a guaranteed 5% rate of return. If inflation averages 2% per year, how much can she withdraw (to the nearest dollar) at the beginning of each year and keep the withdrawals constant in real terms, i.e., growing at the same rate as inflation and thus enabling her to maintain a constant standard of living? a. $65,632 b. $72,925 c. $81,027 d. $89,130 e. $98,043 ANSWER: c RATIONALE: Inputs: Number of years = 15 5% Nominal interest rate, rNOM = Available to invest = Portfolio = $1,000,000 Inflation rate = 2% Step 1. Set up an "Amortization Table" to show exactly what's happening. We begin with Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money $1 million. But we immediately make the first withdrawal, hence have less than $1 million to invest. We don't know how much we can withdraw initially, so we make a "guess" of $50,000. We subtract the $50,000 from the initial portfolio and get $950,000, which is invested at 5% and thus earns $47,500. The earnings are added to the beginning balance, less the withdrawal, to produce the ending balance, which is carried forward to create the next beginning balance. This process is continued for 15 years.

We want to end up with a $0.00 ending balance. With the $50,000 initial withdrawal, we see that we end with more than zero. Therefore, we should make a larger initial withdrawal. We could just go through a series of trials and errors until Step 2. we found an initial withdrawal that produced the zero ending balance. The amount that does the trick is $81,027.42. Replace the $50,000 with 81027.42 to prove that this value "works" to within one penny.

BOY Beginning Amount Investable Ending Balance Withdrawn Funds Earnings Balance 1 $1,000,000.00 $81,027.42 $918,972.58 $45,948.63 $964,921.21 2 $964,921.21 $82,647.97 $882,273.24 $44,113.66 $926,386.90 3 $926,386.90 $84,300.93 $842,085.97 $42,104.30 $884,190.27 4 $884,190.27 $85,986.95 $798,203.33 $39,910.17 $838,113.49 5 $838,113.49 $87,706.69 $750,406.81 $37,520.34 $787,927.15 6 $787,927.15 $89,460.82 $698,466.33 $34,923.32 $733,389.64 7 $733,389.64 $91,250.04 $642,139.61 $32,106.98 $674,246.59 8 $674,246.59 $93,075.04 $581,171.55 $29,058.58 $610,230.13 9 $610,230.13 $94,936.54 $515,293.59 $25,764.68 $541,058.27 10 $541,058.27 $96,835.27 $444,223.00 $22,211.15 $466,434.15 11 $466,434.15 $98,771.97 $367,662.18 $18,383.11 $386,045.29 12 $386,045.29 $100,747.41 $285,297.87 $14,264.89 $299,562.77 13 $299,562.77 $102,762.36 $196,800.41 $9,840.02 $206,640.43 14 $206,640.43 $104,817.61 $101,822.82 $5,091.14 $106,913.96 15 $106,913.96 $106,913.96 $0.00 $0.00 $0.00 Using Goal Seek: 1. Put the pointer on the cell for the Ending Balance after the 15th withdrawal.

2. Click Tools>Goal Seek to get a dialog box, which you then fill out as shown to the right.

3. You will be at the "Set cell" because you put the pointer there initially.

Go down to the "To value to" cell. You want to get 0 as the ending balance, so enter 0 4. here.

Now move down to the "By changing cell" box, then click on the cell with the Year 1 5. withdrawal and select it.

Now click OK, and the initial withdrawal will change to $81,027, and the final balance 6. will go to $0.00. You could increase the decimals shown to see the extra digits Excel calculated.

Calculator solution: Step 1: Find the real rate of return, rr. rr = (1 + rNOM)/(1 + inflation) − 1 rr = (1.05)/(1.02) − 1 rr = 2.9412% Step 2: Copyright Cengage Learning. Powered by Cognero.

Use the PMT function in Excel or a calculator to find the initial amount to be withdrawn. Be sure to set the calculator to BEGIN mode, and make a similar adjustment to the Excel function.

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Chapter 04: Time Value of Money BEGIN N= I = rr = PV = PMT =

15 2.9411765% −1,000,000 $81,027.42 This is consistent with the value found using Goal Seek.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.18 - LO: 4-18 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 74. Scott and Linda have been saving to pay for their daughter Casie's college education. Casie just turned 10 at (t = 0), and she will be entering college 8 years from now (at t = 8). College tuition and expenses at State U. are currently $14,500 a year, but they are expected to increase at a rate of 3.5% a year. Ellen should graduate in 4 years⎯if she takes longer or wants to go to graduate school, she will be on her own. Tuition and other costs will be due at the beginning of each school year (at t = 8, 9, 10, and 11).

So far, Scott and Linda have accumulated $15,000 in their college savings account (at t = 0). Their long-run financial plan is to add an additional $5,000 in each of the next 4 years (at t = 1, 2, 3, and 4). Then they plan to make 3 equal annual contributions in each of the following years, t = 5, 6, and 7. They expect their investment account to earn 9%. How large must the annual payments at t = 5, 6, and 7 be to cover Casie's anticipated college costs? a. $1,965.21 b. $2,068.64 c. $2,177.51 d. $2,292.12 e. $2,412.76 ANSWER: e RATIONALE: This is a very difficult problem. It should only be used as a take-home assignment.

Current college cost/year $14,500 College cost inflation 3.5% Return on investment account 9.0% Payments at t = 1, 2, 3, and 4 $5,000 Account balance at t = 0 $15,000 Determine the cost of each year during college and its PV at t = 8, discounted at the 1. return on investment.

Cost PV at t = 8 Year 1 (t = 8) = Current cost × (1 + infl)8 = −19,093.73 −19,093.73 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money Year 2 (t = 9) = Prior year × (1 + infl) = −19,762.01 −18,130.29 Year 3 (t = 10) = Prior year × (1 + infl) = −20,453.68 −17,215.45 Year 4 (t = 11) = Prior year × (1 + infl) = −21,169.56 −16,346.79 Find PV (at t = 8) of all = amount needed at t = 8: −70,786.26 college costs Create a time line with those cash flows, plus the known initial CFs, as shown below.

2. Put X in for the unknown values for t = 5−7. We show the time line on two sets of rows.

Ours now has the solution value, but it didn't originally.

0 1 2 3 4 5 Known values; X for unknown: $15,000.00 $5,000.00 $5,000.00 $5,000.00 $5,000.00 X Solution value $2,412.76 for X: Cash flows: $15,000.00 $5,000.00 $5,000.00 $5,000.00 $5,000.00 $2,412.76 6 7 8 9 10 11 X X −$19,093.73 −$19,762.01 −$20,453.68 −$21,169.56 $2,412.76 $2,412.76 Cash flows, continued: $2,412.76 $2,412.76 −$19,093.73 −$19,762.01 −$20,453.68 −$21,169.56 3. We found the PV of the college costs (t = 8−11) at t = 8 above.

Their sum is shown to the right. −70,786.26 4. Find the FV of t = 0 & 4 positive CFs at t = 8 0 $15,000.00 $29,888.44 1 $5,000.00 $9,140.20 2 $5,000.00 $8,385.50 3 $5,000.00 $7,693.12 4 $5,000.00 $7,057.91 $62,165.16 5. Find the difference between the positive and negative t = 8 values: −$8,621.09 6.

Find PMT for a 3-year annuity due whose FV is equal to this difference:

$2,412.76

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.18 - LO: 4-18 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Saving for college KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 75. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money b. False ANSWER: RATIONALE:

True One could make up an example and see that the statement is true. Alternatively, one could simply recognize that the PV of an annuity declines as the discount rate increases and recognize that more frequent compounding increases the effective rate.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of an annuity KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 76. All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases. a. True b. False ANSWER: False RATIONALE: One could make up an example and see that the statement is false. Alternatively, one could simply recognize that the PV of an annuity declines as the discount rate increases and recognize that more frequent compounding increases the effective rate.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of an annuity KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 77. You are considering two equally risky annuities, each of which pays $15,000 per year for 20 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? a. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant. b. The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money than the future value of DUE. c. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. d. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. e. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annuities KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 78. You are considering two equally risky annuities, each of which pays $25,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? a. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant. b. A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ. c. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. d. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. e. The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD. ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Annuities Bloom's: Analyze TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

10/31/2018 8:26 AM 11/14/2018 12:18 PM

79. What is the PV of an ordinary annuity with 10 payments of $2,700 if the appropriate interest rate is 5.5%? a. $16,576 b. $17,449 c. $18,367 d. $19,334 e. $20,352 ANSWER: e RATIONALE: N 10 I/YR 5.5% PMT $2,700 FV $0.00 PV $20,352 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 80. What is the PV of an ordinary annuity with 5 payments of $4,700 if the appropriate interest rate is 4.5%? a. $16,806 b. $17,690 c. $18,621 d. $19,601 e. $20,633 ANSWER: e RATIONALE: N 5 I/YR 4.5% Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money PMT $4,700 FV $0.00 PV $20,633 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 81. Your friend offers to pay you an annuity of $2,500 at the end of each year for 3 years in return for cash today. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $5,493.71 b. $5,782.85 c. $6,087.21 d. $6,407.59 e. $6,744.83 ANSWER: e RATIONALE: N 3 I/YR 5.5% PMT $2,500 FV $0.00 PV $6,744.83 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 82. After receiving a reward for information leading to the arrest of a notorious criminal, you are considering investing it Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money in an annuity that pays $5,000 at the end of each year for 20 years. You could earn 5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $50,753 b. $53,424 c. $56,236 d. $59,195 e. $62,311 ANSWER: e RATIONALE: N 20 I/YR 5.0% PMT $5,000 FV $0.00 PV $62,311 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 83. An uncle of yours who is about to retire wants to sell some of his stock and buy an annuity that will provide him with income of $50,000 per year for 30 years, beginning a year from today. The going rate on such annuities is 7.25%. How much would it cost him to buy such an annuity today? a. $574,924 b. $605,183 c. $635,442 d. $667,214 e. $700,575 ANSWER: b RATIONALE: N 30 I/YR 7.25% PMT $50,000 FV $0.00 PV $605,183 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 84. What is the PV of an annuity due with 5 payments of $2,500 at an interest rate of 5.5%? a. $11,262.88 b. $11,826.02 c. $12,417.32 d. $13,038.19 e. $13,690.10 ANSWER: a RATIONALE: BEGIN Mode N 5 I/YR 5.5% PMT $2,500 FV $0.00 PV $11,262.88 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 85. A new investment opportunity for you is an annuity that pays $550 at the beginning of each year for 3 years. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $1,412.84 b. $1,487.20 c. $1,565.48 d. $1,643.75 e. $1,725.94 ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money RATIONALE:

BEGIN Mode N 3 I/YR 5.5% PMT $550 FV $0.00 PV $1,565.48 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 86. Your father is considering purchasing an annuity that pays $5,000 at the beginning of each year for 5 years. He could earn 4.5% on his money in other investments with equal risk. What is the most he should pay for the annuity? a. 20,701 b. $21,791 c. $22,938 d. $24,085 e. $25,289 ANSWER: c RATIONALE: BEGIN Mode N 5 I/YR 4.5% PMT $5,000 FV $0.00 PV $22,938 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money DATE CREATED: DATE MODIFIED:

10/31/2018 8:26 AM 11/14/2018 12:18 PM

87. Because your mother is about to retire, she wants to buy an annuity that will provide her with $75,000 of income a year for 20 years, with the first payment coming immediately. The going rate on such annuities is 5.25%. How much would it cost her to buy the annuity today? a. $825,835 b. $869,300 c. $915,052 d. $963,213 e. $1,011,374 ANSWER: d RATIONALE: BEGIN Mode N 20 I/YR 5.25% PMT $75,000 FV $0.00 PV $963,213 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 88. Now that your uncle has decided to retire, he wants to buy an annuity that will provide him with $85,000 of income a year for 25 years, with the first payment coming immediately. The going rate on such annuities is 5.15%. How much would it cost him to buy the annuity today? a. $1,063,968 b. $1,119,966 c. $1,178,912 d. $1,240,960 e. $1,303,008 ANSWER: d RATIONALE: BEGIN Mode N 25 I/YR 5.15% PMT $85,000 FV $0.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money PV $1,240,960 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 89. A salt mine you inherited will pay you $25,000 per year for 25 years, with the first payment being made today. If you think a fair return on the mine is 7.5%, how much should you ask for it if you decide to sell it? a. $284,595 b. $299,574 c. $314,553 d. $330,281 e. $346,795 ANSWER: b RATIONALE: BEGIN Mode N 25 I/YR 7.5% PMT $25,000 FV $0.00 PV $299,574 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 90. Geraldine was injured in a car accident, and the insurance company has offered her the choice of $25,000 per year for 15 years, with the first payment being made today, or a lump sum. If a fair return is 7.5%, how large must the lump sum Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money be to leave her as well off financially as with the annuity? a. $225,367 b. $237,229 c. $249,090 d. $261,545 e. $274,622 ANSWER: b RATIONALE: BEGIN Mode N 15 I/YR 7.5% PMT $25,000 FV $0.00 PV $237,229 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 91. What's the present value of a 4-year ordinary annuity of $2,250 per year plus an additional $3,000 at the end of Year 4 if the interest rate is 5%? a. $8,509 b. $8,957 c. $9,428 d. $9,924 e. $10,446 ANSWER: e RATIONALE: N 4 I/YR 5.0% PMT $2,250 FV $3,000 PV $10,446 Alternative setup: 0 1 2 3 4 $2,250 $2,250 $2,250 $2,250 $3,000 $2,250 $2,250 $2,250 $5,250 PV = $10,446.50 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.09 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ord. ann. & end. pmt.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 92. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 93. When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Amortization Bloom's: Understand 10/31/2018 8:26 AM 11/14/2018 12:18 PM

94. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 95. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 96. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan. a. True b. False ANSWER: False RATIONALE: There is no reason to think that this statement would always be true. The portion of the payment representing interest declines, while the portion representing principal repayment increases. Therefore, the statement is false. We could also work out some numbers to prove this point. Here's an example for a 3-year loan at a 10% and a 41.45% annual interest rate.

The interest component is not equal to the principal repayment component except at the high interest rate.

Original loan $1,000Original loan $1,000 Rate 10%Rate 41.45% Life 3Life 3 Payment $402.11Payment $640.98

1 2 3

Beg. Balance $1,000.00 $697.89 $365.56

Interest $100.00 $69.79 $36.56

Principal $302.11 $332.33 $365.56

End Bal. $697.89 1 $365.56 2 $0.00 3

Beg. Balance $1,000.00 $773.52 $453.15

Interest $414.50 $320.62 $187.83

Principal $226.48 $320.36 $453.15

End Bal. $773.52 $453.15 $0.00

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 97. Midway through the life of an amortized loan, the percentage of the payment that represents interest could be equal to, less than, or greater than to the percentage that represents repayment of principal. The proportions depend on the original life of the loan and the interest rate. a. True b. False ANSWER: True RATIONALE: This statement is true. The portion of the payment representing interest declines, while the portion representing principal repayment increases. The interest portion could be equal to, greater than, or less than the principal portion. We can work out some numbers to prove this point. Here's an example for a 3-year loan at a 10% and a 41.45% annual interest rate. The interest component is less than the principal at 10%, equal at about 41.45%, and greater at rates above 41.45%.

Original loan $1,000Original loan $1,000 Rate 10%Rate 41.45% Life 3Life 3 Payment $402.11Payment $640.98 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money

1 2 3

Beg. Balance $1,000.00 $697.89 $365.56

Interest $100.00 $69.79 $36.56

Principal $302.11 $332.33 $365.56

End. Bal. $697.89 1 $365.56 2 $0.00 3

Beg. Balance $1,000.00 $773.52 $453.15

Interest $414.50 $320.62 $187.83

Principal $226.48 $320.36 $453.15

End. Bal. $773.52 $453.15 $0.00

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Understand DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 98. A $250,000 loan is to be amortized over 8 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The proportion of interest versus principal repayment would be the same for each of the 8 payments. b. The annual payments would be larger if the interest rate were lower. c. If the loan were amortized over 10 years rather than 8 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 8-year amortization plan. d. The proportion of each payment that represents interest as opposed to repayment of principal would be lower if the interest rate were lower. e. The last payment would have a higher proportion of interest than the first payment.

ANSWER: d RATIONALE: a, b, and e can be ruled out as incorrect by simple reasoning. c is also incorrect because interest in the first year would be Loan amount × interest rate regardless of the life of the loan, so the interest payment would be identical for the first payment. Think about the situation where r = 0%, statement d is the "most logical guess." One could also set up an amortization schedule and change the numbers to confirm that only d is correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements Copyright Cengage Learning. Powered by Cognero.

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for this question.

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99. A $150,000 loan is to be amortized over 6 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The proportion of interest versus principal repayment would be the same for each of the 7 payments. b. The annual payments would be larger if the interest rate were lower. c. If the loan were amortized over 10 years rather than 6 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 6-year amortization plan. d. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were lower. e. The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher.

ANSWER: e RATIONALE: a, b, and d are obviously incorrect. c is also incorrect because interest in the first year would be Loan amount × interest rate regardless of the life of the loan. That makes e the "most logical guess." One could also set up an amortization schedule and change the numbers to confirm that only e is correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 100. Which of the following statements regarding a 20-year (240-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The outstanding balance declines at a slower rate in the later years of the loan's life. b. The remaining balance after three years will be $225,000 less one third of the interest paid during the first three years. c. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. d. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. e. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money now than it will be the first year.

ANSWER: c RATIONALE: c is the correct answer. Thinking through the question, the other answers can all be eliminated. One could also set up an amortization schedule to prove that only statement c is correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 101. Which of the following statements regarding a 15-year (180-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The outstanding balance declines at a faster rate in the later years of the loan's life. b. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. c. Because the outstanding balance declines over time, the monthly payments will also decline over time. d. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. e. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year.

ANSWER: a RATIONALE: a is the correct answer. Thinking through the question, the other answers can all be eliminated. One could also set up an amortization schedule to prove that only statement a is correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization Copyright Cengage Learning. Powered by Cognero.

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DATE CREATED: DATE MODIFIED:

Bloom's: Analyze TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

10/31/2018 8:26 AM 11/14/2018 12:18 PM

102. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 8% is CORRECT? a. Exactly 8% of the first monthly payment represents interest. b. The monthly payments will decline over time. c. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. d. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. e. The amount representing interest in the first payment would be higher if the nominal interest rate were 6% rather than 8%.

ANSWER: c RATIONALE: c is correct. b is clearly wrong, as are d and e. It is not obvious whether a is correct or not, but we could set up an example to see: Loan 100000Term 30 Rate 8%Periods/Year 12 Periodic rate 0.00666666667Total periods 360 Payment −$733.76Interest, Month 1 $666.67 Interest as % of total #360 payment: 1%Interest, Month 360 $7.25 Principal as % of total #360 payment 99%Principal, Month 360 $726.51 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 103. Which of the following statements regarding a 20-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? a. Exactly 10% of the first monthly payment represents interest.

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Chapter 04: Time Value of Money b. The monthly payments will increase over time. c. A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment. d. The total dollar amount of interest being paid off each month gets larger as the loan approaches maturity. e. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%.

ANSWER: c RATIONALE: c is correct. b is clearly wrong, as are d and e. It is not obvious whether a is correct or not, but we could set up an example to see: Loan 100000Term 20 Rate 10%Periods/Year 12 Periodic rate 0.00833333Total periods 240 Payment −$965.02Interest Month 1 $833.33 Interest as % of total payment: 86%,which is much larger than 10%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 104. Suppose you borrowed $12,000 at a rate of 9.0% and must repay it in 4 equal installments at the end of each of the next 4 years. How large would your payments be? a. $3,704.02 b. $3,889.23 c. $4,083.69 d. $4,287.87 e. $4,502.26 ANSWER: a RATIONALE: Years = N 4 I/YR 9.0% FV $0 Amount borrowed = PV $12,000 Payments = PMT $3,704.02Found with a calculator, as the PMT. POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: payment KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 105. Suppose you are buying your first home for $145,000, and you have $15,000 for your down payment. You have arranged to finance the remainder with a 30-year, monthly payment, amortized mortgage at a 6.5% nominal interest rate, with the first payment due in one month. What will your monthly payments be? a. $741.57 b. $780.60 c. $821.69 d. $862.77 e. $905.91 ANSWER: c RATIONALE: Years 30N 360 Payments/year 12Periodic rate 0.54% Nominal rate 6.50%PV $130,000 Purchase price $145,000FV $0.00 Down payment $15,000PMT $821.69 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: payment KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 106. Your cousin will sell you his coffee shop for $250,000, with "seller financing," at a 6.0% nominal annual rate. The terms of the loan would require you to make 12 equal end-of-month payments per year for 4 years, and then make an additional final (balloon) payment of $50,000 at the end of the last month. What would your equal monthly payments be? a. $4,029.37 b. $4,241.44 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money c. $4,464.67 d. $4,699.66 e. $4,947.01 ANSWER: RATIONALE:

e Monthly annuity, so interest must be calculated on a monthly basis.

Years 4Payments/year N 48Nominal rate PV $250,000I/period FV $50,000PMT POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: payment KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

12 6.0% 0.5% $4,947.01

107. Suppose you borrowed $14,000 at a rate of 10.0% and must repay it in 5 equal installments at the end of each of the next 5 years. How much interest would you have to pay in the first year? a. $1,200.33 b. $1,263.50 c. $1,330.00 d. $1,400.00 e. $1,470.00 ANSWER: d RATIONALE: I/YR 10.0% Years 5 Amount borrowed $14,000 Interest in Year 1 $1,400.00Simply multiply the rate times the amount borrowed.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: interest KEYWORDS: Bloom's: Analyze Copyright Cengage Learning. Powered by Cognero.

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TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

108. You plan to borrow $35,000 at a 7.5% annual interest rate. The terms require you to amortize the loan with 7 equal end-of-year payments. How much interest would you be paying in Year 2? a. $1,994.49 b. $2,099.46 c. $2,209.96 d. $2,326.27 e. $2,442.59 ANSWER: d RATIONALE: Find the required payment: N 7 I 7.5% PV $35,000 FV $0 PMT $6,608.01Found with a calculator or Excel.

Amortization schedule (first 2 years) Year Beg. Balance Payment Interest Principal End. Balance 1 35,000.00 6,608.01 2,625.00 3,983.01 31,016.99 2 31,016.99 6,608.01 2,326.27 4,281.74 26,735.25 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: interest KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 109. Your bank offers to lend you $100,000 at an 8.5% annual interest rate to start your new business. The terms require you to amortize the loan with 10 equal end-of-year payments. How much interest would you be paying in Year 2? a. $7,531 b. $7,927 c. $8,323 d. $8,740 e. $9,177 ANSWER: b RATIONALE: Find the required payment: N 10 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money I 8.5% PV $100,000 FV $0 PMT $15,241Found with a calculator or Excel.

Amortization schedule (first 2 years) Year Beg. Balance Payment Interest Principal 1 100,000 15,241 8,500 6,741 2 93,259 15,241 7,927 7,314 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: interest KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

End. Balance 93,259 85,945

110. Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. By how much would you reduce the amount you owe in the first year? a. $2,404.91 b. $2,531.49 c. $2,658.06 d. $2,790.96 e. $2,930.51 ANSWER: b RATIONALE: Interest rate 8.5% Years 5 Amount borrowed $15,000 Step 1: Find the PMT 3,806.49 Step 2: Find the 1st year's interest 1,275.00 Subtract the interest from the payment; this is repayment of Step 3: 2,531.49 principal POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: princ. repymt.

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Bloom's: Analyze TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

111. Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. How much would you still owe at the end of the first year, after you have made the first payment? a. $10,155.68 b. $10,690.19 c. $11,252.83 d. $11,845.09 e. $12,468.51 ANSWER: e RATIONALE: Interest rate 8.5% Years 5 Amount borrowed $15,000 Step 1: Find the PMT $3,806.49 Step 2: Find the 1st year's interest $1,275.00 Subtract the interest from the payment; this is repayment of Step 3: $2,531.49 principal Subtract the repayment of principal from the beginning amount Step 4: $12,468.51 owed POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: ending bal.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 112. Your business has just taken out a 1-year installment loan for $72,500 at a nominal rate of 11.0% but with equal endof-month payments. What percentage of the 2nd monthly payment will go toward the repayment of principal? a. 73.67% b. 77.55% c. 81.63% d. 85.93% e. 90.45% ANSWER: e RATIONALE: N 12 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 11.0% rNOM Per. r 0.9167% PV $72,500 PMT $6,407.67 FV $0% prin. = Prin2/PMT = 90.45% Amortization schedule (first 4 months) Month Beg. Balance Payment Interest Principal 1 72,500.00 6,407.67 664.58 5,743.09 2 66,756.91 6,407.67 611.94 5,795.73 3 60,961.18 6,407.67 558.81 5,848.86 4 55,112.32 6,407.67 505.20 5,902.47 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

Ending Balance 66,756.91 60,961.18 55,112.32 49,209.85

113. Your sister's pet supplies business obtained a 30-year amortized mortgage loan for $250,000 at a nominal annual rate of 7.0%, with 360 end-of-month payments. The firm can deduct the interest paid for tax purposes. What will the interest tax deduction be for for the first year of the loan? (Assume she took out the loan on January 1.) a. $17,419.55 b. $17,593.75 c. $17,769.68 d. $17,947.38 e. $18,126.85 ANSWER: a RATIONALE: Years 30Nominal r 7.00% Periods/yr 12I/period 0.5833% N (12 mo.)

360PMT $1,663.26 PV = Loan $250,000Interest, 2016 $17,419.55 FV $0 Amortization schedule (first 3 months) Year Beg. Balance Payment Interest Principal End. Balance 1 250,000.00 1,663.26 1,458.33 204.92 249,795.08 2 249,795.08 1,663.26 1,457.14 206.12 249,588.96 3 249,588.96 1,663.26 1,455.94 207.32 249,381.64 4 249,381.64 1,663.26 1,454.73 208.53 249,173.11 5 249,173.11 1,663.26 1,453.51 209.75 248,963.36 6 248,963.36 1,663.26 1,452.29 210.97 248,752.39 7 248,752.39 1,663.26 1,451.06 212.20 248,540.19 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 8 9 10 11 12

248,540.19 248,326.75 248,112.07 247,896.13 247,678.94

1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 19,959.07

1,449.82 1,448.57 1,447.32 1,446.06 1,444.79 17,419.55

213.44 214.68 215.94 217.20 218.46 2,539.52

248,326.75 248,112.07 247,896.13 247,678.94 247,460.48

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.17 - LO: 4-17 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: interest KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/29/2018 4:11 PM 114. Which of the following statements is CORRECT? a. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts. b. A time line is not meaningful unless all cash flows occur annually. c. Time lines are useful for visualizing complex problems prior to doing actual calculations. d. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. e. Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time lines KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 115. Which of the following statements is CORRECT? a. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts. b. A time line is not meaningful unless all cash flows occur annually. c. Time lines are not useful for visualizing complex problems prior to doing actual calculations. d. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. e. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time lines KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 116. Which of the following statements is CORRECT? a. Time lines cannot be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity. b. A time line is not meaningful unless all cash flows occur annually. c. Time lines are not useful for visualizing complex problems prior to doing actual calculations. d. Time lines can be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. e. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Time lines Bloom's: Analyze TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

10/31/2018 8:26 AM 11/14/2018 12:18 PM

117. Which of the following statements is CORRECT? a. A time line is not meaningful unless all cash flows occur annually. b. Time lines are not useful for visualizing complex problems prior to doing actual calculations. c. Time lines cannot be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities. e. Time lines can be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time lines KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 118. Suppose you earned a $275,000 bonus this year and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years? a. $28,532 b. $29,959 c. $31,457 d. $33,030 e. $34,681 ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money RATIONALE:

N 20 I/YR 8.25% PV $275,000 FV $0.00 PMT $28,532 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on ord. annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 119. Your aunt wants to retire and has $375,000. She expects to live for another 25 years and to earn 7.5% on her invested funds. How much could she withdraw at the end of each of the next 25 years and end up with zero in the account? a. $28,843.38 b. $30,361.46 c. $31,959.43 d. $33,641.50 e. $35,323.58 ANSWER: d RATIONALE: N 25 I/YR 7.5% PV $375,000 FV $0.00 PMT $33,641.50 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on ord. annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money 120. Your aunt wants to retire and has $375,000. She expects to live for another 25 years, and she also expects to earn 7.5% on her invested funds. How much could she withdraw at the beginning of each of the next 25 years and end up with zero in the account? a. $28,243.21 b. $29,729.70 c. $31,294.42 d. $32,859.14 e. $34,502.10 ANSWER: c RATIONALE: BEGIN Mode N 25 I/YR 7.5% PV $375,000 FV $0.00 PMT $31,294.42 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 121. You were left $100,000 in a trust fund set up by your grandfather. The fund pays 6.5% interest. You must spend the money on your college education, and you must withdraw the money in 4 equal installments, beginning immediately.

How much could you withdraw today and at the beginning of each of the next 3 years and end up with zero in the account? a. $24,736 b. $26,038 c. $27,409 d. $28,779 e. $30,218 ANSWER: c RATIONALE: BEGIN Mode N 4 I/YR 6.5% PV $100,000 FV $0.00 PMT $27,409 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 122. Suppose you inherited $275,000 and invested it at 8.25% per year. How much could you withdraw at the beginning of each of the next 20 years? a. $22,598.63 b. $23,788.03 c. $25,040.03 d. $26,357.92 e. $27,675.82 ANSWER: d RATIONALE: BEGIN Mode N 20 I/YR 8.25% PV $275,000 FV $0.00 PMT $26,357.92 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 123. Your uncle just won the weekly lottery, receiving $375,000, which he invested at a 7.5% annual rate. He now has decided to retire, and he wants to withdraw $35,000 at the end of each year, starting at the end of this year. What is the maximum number of whole payments that can be withdrawn before the account is exhausted, i.e., before the account Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money balance would become negative? (Hint: Round down to the nearest whole number.) a. 22 b. 23 c. 24 d. 25 e. 26 ANSWER: a RATIONALE: I/YR 7.5% PV −$375,000 PMT $35,000 FV $0.00 N 22.50 N rounded 22 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Years to deplete ord. ann.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 124. Your uncle has $300,000 invested at 7.5%, and he now wants to retire. He wants to withdraw $35,000 at the end of each year, beginning at the end of this year. He also wants to have $25,000 left to give you when he ceases to withdraw funds from the account. What is the maximum number of $35,000 withdrawals that he can make and still have at least $25,000 left in the account? (Hint: If your solution for N is not an integer, round down to the nearest whole number.) a. 12 b. 13 c. 14 d. 15 e. 16 ANSWER: b RATIONALE: I/YR 7.50% PV −$300,000 PMT $35,000 FV $25,000 N 13.48 N rounded 13 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Years to deplete ord. ann.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 125. Your Aunt Elsa has $500,000 invested at 6.5%, and she plans to retire. She wants to withdraw $40,000 at the beginning of each year, starting immediately. What is the maximum number of whole payments that can be withdrawn before the account is exhausted, i.e., before the account balance would become negative? (Hint: Round down to the nearest whole number.) a. 18 b. 19 c. 20 d. 21 e. 22 ANSWER: e RATIONALE: BEGIN Mode I/YR 6.5% PV −$500,000 PMT $40,000 FV $0.00 N 22.86 N rounded 22 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Years to deplete ann. due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 126. Your aunt has $500,000 invested at 5.5%, and she now wants to retire. She wants to withdraw $45,000 at the beginning of each year, beginning immediately. When she makes her last withdrawal (at the beginning of a year), she also wants to have enough left in the account so that you can make a final withdrawal of $50,000 at the end of that year (her last withdrawal is at the beginning of the year, your withdrawal is at the end of that same year). What is the maximum Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money number of $45,000 withdrawals that she can make and still have enough in the account so that you can make a $50,000 withdrawal at the end of the year of her last withdrawal? (Hint: If your solution for N is not an integer, round down to the nearest whole number.) a. 13 b. 14 c. 15 d. 16 e. 17 ANSWER: c RATIONALE: BEGIN Mode I/YR 5.5% PV −$500,000 PMT $45,000 FV $50,000 N 15.05 N rounded 15 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Years to deplete ann. due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 127. Suppose you just won the state lottery, and you have a choice between receiving $2,550,000 today or a 20-year annuity of $250,000, with the first payment coming one year from today. What rate of return is built into the annuity?

Disregard taxes. a. 7.12% b. 7.49% c. 7.87% d. 8.26% e. 8.67% ANSWER: b RATIONALE: N 20 PV $2,550,000 PMT $250,000 FV $0.00 I/YR 7.49% POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Int. rate implicit: annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 128. Your girlfriend just won the Florida lottery. She has the choice of $15,000,000 today or a 20-year annuity of $1,050,000, with the first payment coming one year from today. What rate of return is built into the annuity? a. 3.44% b. 3.79% c. 4.17% d. 4.58% e. 5.04% ANSWER: a RATIONALE: N 20 PV $15,000,000 PMT $1,050,000 FV $0.00 I/YR 3.44% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Int. rate implicit: annuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 129. Assume that you own an annuity that will pay you $15,000 per year for 12 years, with the first payment being made today. You need money today to open a new restaurant, and your uncle offers to give you $120,000 for the annuity. If you sell it, what rate of return would your uncle earn on his investment? a. 6.85% b. 7.21% c. 7.59% Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money d. 7.99% e. 8.41% ANSWER: RATIONALE:

e BEGIN Mode N 12 PV $120,000 PMT $15,000 FV $0.00 I/YR 8.41% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Int. rate implicit: annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 130. Your Green Investment Tips subscription is about to expire. You plan to subscribe to the magazine for the rest of your life, and you can renew it by paying $85 annually, beginning immediately, or you can get a lifetime subscription for $850, also payable immediately. Assuming that you can earn 6.0% on your funds and that the annual renewal rate will remain constant, how many years must you live to make the lifetime subscription the better buy? a. 7.48 b. 8.80 c. 10.35 d. 12.18 e. 14.33 ANSWER: e RATIONALE: Find N for an annuity due with the indicated terms to determine how long you must live to make the lifetime subscription worthwhile. BEGIN Mode Interest rate (I/YR) 6.0% Annual cost (PMT) $85 Lifetime subscription cost (PV) $850 Number of payments made (N) 14.33 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA N, lifetime vs. yearly Bloom's: Analyze TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

131. You agree to make 24 deposits of $500 at the beginning of each month into a bank account. At the end of the 24th month, you will have $13,000 in your account. If the bank compounds interest monthly, what nominal annual interest rate will you be earning? a. 7.62% b. 8.00% c. 8.40% d. 8.82% e. 9.26% ANSWER: a RATIONALE: BEGIN Mode N 24 PV $0 PMT $500 FV $13,000 I/MO 0.63% I/YR 7.62% POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.01 - LO: 4-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding I in annuity due KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 132. Which of the following statements is CORRECT? a. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. b. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. c. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. d. The cash flows for an annuity due must all occur at the ends of the periods. e. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money or once a month.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.06 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annuities KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 133. Which of the following statements is CORRECT? a. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. b. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. c. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. d. The cash flows for an annuity due must all occur at the beginning of the periods. e. The cash flows for an annuity may vary from period to period, but they must occur at regular intervals, such as once a year or once a month.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.06 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annuities KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money DATE MODIFIED:

11/14/2018 12:18 PM

134. Which of the following statements is CORRECT? a. If CF0 is positive and all the other CFs are negative, then you cannot solve for I. b. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. c. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. d. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is, essentially, a trial-and-error procedure that is easy with a computer or financial calculator but quite difficult otherwise. e. If you solve for I and get a negative number, then you must have made a mistake.

ANSWER: d POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.14 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Solving for I: uneven CFs KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 135. Which of the following statements is CORRECT? a. If CF0 is positive and all the other CFs are negative, then you can still solve for I. b. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. c. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. d. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the FV of the negative CFs. It is impossible to find the value of I without a computer or financial calculator. e. If you solve for I and get a negative number, then you must have made a mistake.

ANSWER: a POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LEARNING OBJECTIVES: FMTP.EHRH.20.04.14 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Solving for I: uneven CFs KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 136. Your sister paid $10,000 (CF at t = 0) for an investment that promises to pay $750 at the end of each of the next 5 years, then an additional lump sum payment of $10,000 at the end of the 5th year. What is the expected rate of return on this investment? a. 6.77% b. 7.13% c. 7.50% d. 7.88% e. 8.27% ANSWER: c RATIONALE: 0 1 2 3 4 5 CFs: −$10,000 $750 $750 $750 $750 $750 $10,000 −$10,000 $750 $750 $750 $750 $10,750 I is the discount rate that causes the PV of the inflows to equal the I/YR 7.50% initial negative CF, and is found with Excel's IRR function or by inputting the CFs into a calculator and pressing the IRR key.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.14 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Rate in uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 137. You are offered a chance to buy an asset for $7,250 that is expected to produce cash flows of $750 at the end of Year 1, $1,000 at the end of Year 2, $850 at the end of Year 3, and $6,250 at the end of Year 4. What rate of return would you earn if you bought this asset?

Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money a. 4.93% b. 5.19% c. 5.46% d. 5.75% e. 6.05% ANSWER: RATIONALE:

e CFs: I/YR

0 1 2 3 4 −$7,250 $750 $1,000 $850 $6,250 I is the discount rate that causes the PV of the positive inflows to equal the initial negative CF. I can be found using Excel's IRR 6.05% function or by inputting the CFs into a calculator and pressing the IRR key.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.14 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Rate in uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 138. You have just purchased a U.S. Treasury bond for $747.25. No payments will be made until the bond matures 5 years from now, at which time it will be redeemed for $1,000. What interest rate will you earn on this bond? a. 4.37% b. 4.86% c. 5.40% d. 6.00% e. 6.60% ANSWER: d RATIONALE: N 5 PV $747.25 PMT $0 FV $1,000.00 I/YR 6.00% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.04 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Time value of money United States - OH - Default City - TBA Finding I Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

139. You have purchased a U.S. Treasury bond for $3,000. No payments will be made until the bond matures 10 years from now, at which time it will be redeemed for $5,000. What interest rate will you earn on this bond? a. 3.82% b. 4.25% c. 4.72% d. 5.24% e. 5.77% ANSWER: d RATIONALE: N 10 PV $3,000.00 PMT $0 FV $5,000.00 I/YR 5.24% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.04 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding I KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 140. Ten years ago, Kronan Corporation earned $0.50 per share. Its earnings this year were $2.20. What was the growth rate in earnings per share (EPS) over the 10-year period? a. 15.17% b. 15.97% c. 16.77% d. 17.61% e. 18.49% ANSWER: b RATIONALE: N 10 PV $0.50 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money PMT $0 FV $2.20 I/YR 15.97% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.04 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growth rate KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 141. Wildwoods, Inc. earned $1.50 per share five years ago. Its earnings this year were $3.20. What was the growth rate in earnings per share (EPS) over the 5-year period? a. 15.54% b. 16.36% c. 17.18% d. 18.04% e. 18.94% ANSWER: b RATIONALE: N 5 PV $1.50 PMT $0 FV $3.20 I/YR 16.36% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.04 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growth rate KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 142. You have $5,000 invested in a bank that pays 3.8% annually. How long will it take for your funds to triple?

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Chapter 04: Time Value of Money a. 23.99 b. 25.26 c. 26.58 d. 27.98 e. 29.46 ANSWER: RATIONALE:

e I/YR 3.8% PV $5,000.00 PMT $0 FV $15,000.00 N 29.46 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.05 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding N KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 143. Your bank pays 4% interest annually. You have $2,500 invested in the bank. How long will it take for your funds to double? a. 14.39 b. 15.15 c. 15.95 d. 16.79 e. 17.67 ANSWER: e RATIONALE: I/YR 4.0% PV $2,500.00 PMT $0 FV $5,000.00 N 17.67 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.05 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Finding N Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

144. Brockman Corporation's earnings per share were $3.50 last year, and its growth rate during the prior 5 years was 9.0% per year. If that growth rate were maintained, how many years would it take for Brockman's EPS to triple? a. 9.29 b. 10.33 c. 11.47 d. 12.75 e. 14.02 ANSWER: d RATIONALE: I/YR 9.0% PV $3.50 PMT $0 FV $10.50 N 12.75 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.05 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding N KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 145. Your investment account pays 8.0%, compounded annually. If you invest $5,000 today, how many years will it take for your investment to grow to $9,140.20? a. 5.14 b. 5.71 c. 6.35 d. 7.05 e. 7.84 ANSWER: e RATIONALE: I/YR 8.0% PV $5,000.00 PMT $0 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money FV $9,140.20 N 7.84 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.05 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding N KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 146. Your investment advisor has recommended your invest in bonds that pay 6.0%, compounded annually. If you invest $10,000 today, how many years will it take for your investment to grow to $30,000? a. 12.37 b. 13.74 c. 15.27 d. 16.97 e. 18.85 ANSWER: e RATIONALE: I/YR 6.0% PV $10,000.00 PMT $0 FV $30,000.00 N 18.85 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.05 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding N KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 147. You are hoping to buy a new boat 3 years from now, and you plan to save $4,200 per year, beginning one year from today. You will deposit your savings in an account that pays 5.2% interest. How much will you have just after you make Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money the 3rd deposit, 3 years from now? a. $11,973 b. $12,603 c. $13,267 d. $13,930 e. $14,626 ANSWER: c RATIONALE: N 3 I/YR 5.2% PV $0.00 PMT $4,200 FV $13,266.56 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.07 - LO: 4-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 148. You want to buy new kitchen appliances 2 years from now, and you plan to save $8,200 per year, beginning one year from today. You will deposit your savings in an account that pays 6.2% interest. How much will you have just after you make the 2nd deposit, 2 years from now? a. $15,260 b. $16,063 c. $16,908 d. $17,754 e. $18,642 ANSWER: c RATIONALE: N 2 I/YR 6.2% PV $0.00 PMT $8,200 FV $16,908 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.07 - LO: 4-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Time value of money United States - OH - Default City - TBA FV of ordinary annuity Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

149. You would like to travel in South America 5 years from now, and you can save $3,100 per year, beginning one year from today. You plan to deposit the funds in a mutual fund that you think will return 8.5% per year. Under these conditions, how much would you have just after you make the 5th deposit, 5 years from now? a. $18,369 b. $19,287 c. $20,251 d. $21,264 e. $22,327 ANSWER: a RATIONALE: N 5 I/YR 8.5% PV $0.00 PMT $3,100 FV $18,369 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.07 - LO: 4-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of ordinary annuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 150. You want to purchase a motorcycle 4 years from now, and you plan to save $3,500 per year, beginning immediately.

You will make 4 deposits in an account that pays 5.7% interest. Under these assumptions, how much will you have 4 years from today? a. $16,112 b. $16,918 c. $17,763 d. $18,652 e. $19,584 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money ANSWER: RATIONALE:

a BEGIN Mode N I/YR PV PMT FV Alternative setup: 0 $3,500

4 5.7% $0.00 $3,500 $16,112 1 $3,500

2 $3,500

3 $3,500

4 FV = $16,112

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.08 - LO: 4-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of annuity due KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 151. You want to open a sushi bar 3 years from now, and you plan to save $7,000 per year, beginning immediately. You will make 3 deposits in an account that pays 5.2% interest. Under these assumptions, how much will you have 3 years from today? a. $20,993 b. $22,098 c. $23,261 d. $24,424 e. $25,645 ANSWER: c RATIONALE: BEGIN Mode N 3 I/YR 5.2% PV $0.00 PMT $7,000 FV $23,261 Alternative setup: 0 1 2 3 $7,000 $7,000 $7,000 $7,000 FV = $23,261 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.08 - LO: 4-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of annuity due KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 152. You plan to work for Strickland Corporation for 12 years after graduation and after that want to start your own business. You expect to save and deposit $7,500 a year for the first 6 years (t = 1 through t = 6) and $15,000 annually for the following 6 years (t = 7 through t = 12). The first deposit will be made a year from today. In addition, your grandmother just gave you a $25,000 graduation gift that you will deposit immediately (t = 0). If the account earns 9% compounded annually, how much will you have when you start your business 12 years from now? a. $238,176 b. $250,712 c. $263,907 d. $277,797 e. $291,687 ANSWER: d RATIONALE: There are 3 cash flow streams: the gift and the two annuities. The gift will grow for 12 years.

Then there is a 6-year annuity whose FV at the end of Year 6 will compound for an additional 6 years. Finally, there is a second 6-year annuity. The sum of the compounded values of those three sets of cash flows is the final amount.

Amount Amount at end of at end of Year 6 Year 12 Interest rate 9.0% 1st annuity $7,500$56,425 Compound @ 9% $ 94,630 2nd annuity $15,000NA $112,850 Gift $25,000NA $ 70,317 Total years 12 Annuity years 6Final amt: $277,797 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.08 - LO: 4-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV comb. CF lump sum & ann.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money DATE CREATED: DATE MODIFIED:

10/31/2018 8:26 AM 11/14/2018 12:18 PM

153. What's the present value of a perpetuity that pays $250 per year if the appropriate interest rate is 5%? a. $4,750 b. $5,000 c. $5,250 d. $5,513 e. $5,788 ANSWER: b RATIONALE: I/YR 5.0% PMT $250 PV $5,000 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.11 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a perpetuity KEYWORDS: Bloom's: Apply OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 154. A perpetuity pays $85 per year and costs $950. What is the rate of return? a. 8.95% b. 9.39% c. 9.86% d. 10.36% e. 10.88% ANSWER: a RATIONALE: Cost (PV) $950 PMT $85 I/YR 8.95% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.11 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Return on a perpetuity Bloom's: Apply TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

155. What annual payment must you receive in order to earn a 6.5% rate of return on a perpetuity that has a cost of $1,250? a. $77.19 b. $81.25 c. $85.31 d. $89.58 e. $94.06 ANSWER: b RATIONALE: Cost (PV) $1,250 I/YR 6.5% PMT $81.25Multiply Cost by I/YR. POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.11 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on a perpetuity KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 156. What is the present value of the following cash flow stream at a rate of 6.25%?

a. $411.57 b. $433.23 c. $456.03 d. $480.03 e. $505.30 ANSWER: RATIONALE:

e I/YR = 6.25% CFs:

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0 $0

1 $75

2 $225

3 $0

4 $300 Page 94

Chapter 04: Time Value of Money PV of CFs: $0 $71 $199 $0 $235 PV = $505.30 PV = $505.30 You can find the individual PVs and sum them. Alternately, you can automate the process using Excel or a calculator, by inputting the data into the cash flow register and pressing the NPV key.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.28-12 - LO: 28-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 157. What is the present value of the following cash flow stream at a rate of 12.0%?

a. $9,699 b. $10,210 c. $10,747 d. $11,284 e. $11,849 ANSWER: RATIONALE:

c I/YR = 12.0%

0 1 2 CFs: $0 $1,500 $3,000 PV of CFs: $0 $1,339 $2,392 PV = $10,747 Found using the Excel NPV function.

PV = $10,747 Found by summing individual PVs. PV = $10,747 Found using the calculator NPV key.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.28-12 - LO: 28-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of uneven cash flows KEYWORDS: Bloom's: Analyze Copyright Cengage Learning. Powered by Cognero.

3 $4,500 $3,203

4 $6,000 $3,813

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Chapter 04: Time Value of Money OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

158. What is the present value of the following cash flow stream at a rate of 8.0%?

a. $7,917 b. $8,333 c. $8,772 d. $9,233 e. $9,695 ANSWER: RATIONALE:

d I/YR = 8.0% CFs: PV of CFs: PV = $9,233 PV = $9,233

0 $750

1 $2,450

$750

$2,269

2 $3,175

3 $4,400

$2,722 $3,493 Found by summing individual PVs. Found with a calculator or Excel to automate the process. With a calculator, input the cash flows and I into the cash flow register, then press the NPV key.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.28-12 - LO: 28-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 159. You sold your motorcycle and accepted a note with the following cash flow stream as your payment. What was the effective price you received for the car assuming an interest rate of 6.0%?

a. $5,987 b. $6,286 c. $6,600 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money d. $6,930 e. $7,277 ANSWER: RATIONALE:

a I/YR = 6.0% 0 1 2 $0 $1,000 $2,000 $0 $943 $1,780 Found using the Excel NPV function.

Found by summing individual PVs. Found using the calculator NPV key.

CFs: PV of CFs: PV = $5,987 PV = $5,987 PV = $5,987 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.28-12 - LO: 28-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

3 $2,000 $1,679

4 $2,000 $1,584

160. At a rate of 6.5%, what is the future value of the following cash flow stream?

a. $526.01 b. $553.69 c. $582.83 d. $613.51 e. $645.80 ANSWER: RATIONALE:

e I/YR = 6.5% CFs: FV of CFs: FV = $645.80 FV = $645.80 FV = $645.80

POINTS:

PV of the stream: FV of the PV: 1

Copyright Cengage Learning. Powered by Cognero.

0 1 2 3 4 $0 $75 $225 $0 $300 $0 $91 $255 $0 $300 Found by summing individual FVs. Found with the NFV key in some calculators.

Found with a calculator by first finding the PV of the stream, then finding the FV of that PV. $501.99 $645.80

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Chapter 04: Time Value of Money DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.13 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of uneven cash flows KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 161. Billy Thornton borrowed $20,000 at a rate of 7.25%, simple interest, with interest paid at the end of each month. The bank uses a 360-day year. How much interest would Billy have to pay in a 30-day month? a. $120.83 b. $126.88 c. $133.22 d. $139.88 e. $146.87 ANSWER: a RATIONALE: Nominal I/YR 7.25%Days in month 30 Days/yr 360Daily rate 0.020139% Amount borrowed $20,000Interest per day $4.02778 Interest per month = Interest/day × 30 = $120.83 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.16 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Simple interest KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 162. Suppose you deposited $5,000 in a bank account that pays 5.25% with daily compounding based on a 360-day year.

How much would be in the account after 8 months, assuming each month has 30 days? a. $5,178.09 b. $5,436.99 c. $5,708.84 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money d. $5,994.28 e. $6,294.00 ANSWER: RATIONALE:

a

Nominal I/YR 5.25%Rate/day = rNOM/360 = Number of months 8Days = Months × 30 = Days in year 360 Days in month 30 Amount deposited $5,000 Ending amount $5,178.09 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.16 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fractional time periods KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

0.0146% 240

163. You are considering investing in a European bank account that pays a nominal annual rate of 18%, compounded monthly. If you invest $5,000 at the beginning of each month, how many months would it take for your account to grow to $250,000? Round fractional months up. a. 23 b. 27 c. 32 d. 38 e. 44 ANSWER: d RATIONALE: BEGIN Mode I/YR 18.0% Monthly annuity due, so interest must be calculated on monthly I/MO 1.5% basis. rNOM/12.

PV $0 PMT $5,000 FV $250,000 N 37.16Rounded up: 38 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Time value of money United States - OH - Default City - TBA N, ann. due, monthly comp.

Bloom's: Analyze TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

164. You are considering investing in a bank account that pays a nominal annual rate of 7%, compounded monthly. If you invest $3,000 at the end of each month, how many months will it take for your account to grow to $150,000? a. 39.60 b. 44.00 c. 48.40 d. 53.24 e. 58.57 ANSWER: b RATIONALE: I/YR 7.0% I/MO 0.583333%Monthly annuity, so interest must be calculated on monthly basis PV $0 PMT $3,000 FV $150,000 N 44.0021 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: N, ann. due, monthly comp.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 165. The store where you bought new home furnishings offers you two alternative payment plans. The first plan requires a $4,000 immediate up-front payment. The second plan requires you to make monthly payments of $137.41, payable at the end of each month for 3 years. What nominal annual interest rate is built into the monthly payment plan? a. 12.31% b. 12.96% c. 13.64% d. 14.36% e. 15.08% Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money ANSWER: RATIONALE:

d N 36 PV $4,000 PMT $137.41 FV $0 I/MO 1.20%Monthly annuity, so interest must be calculated on monthly basis I/YR = I/MO × 12 = 14.36% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Rate, ord. ann., monthly comp.

KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM 166. Your older brother turned 35 today, and he is planning to save $7,000 per year for retirement, with the first deposit to be made one year from today. He will invest in a mutual fund that's expected to provide a return of 7.5% per year. He plans to retire 30 years from today, when he turns 65, and he expects to live for 25 years after retirement, to age 90. Under these assumptions, how much can he spend each year after he retires? His first withdrawal will be made at the end of his first retirement year. a. $58,601 b. $61,686 c. $64,932 d. $68,179 e. $71,588 ANSWER: c RATIONALE: Interest rate 7.5% Years to retirement 30 Years in retirement 25 Amount saved per year $7,000 Step 1: Find the amount at age 65; use the FV function 723,796 Find the PMT for a 25-year ordinary annuity using the FV you Step 2: 64,932 just found as the PV. POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money Copyright Cengage Learning. Powered by Cognero.

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Chapter 04: Time Value of Money LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Retirement planning Bloom's: Analyze TYPE: Multiple Choice: Problem 10/31/2018 8:26 AM 11/14/2018 12:18 PM

167. Julian and Jonathan are twin brothers (and so were born on the same day). Today, both turned 25. Their grandfather began putting $2,500 per year into a trust fund for Julian on his 20th birthday, and he just made a 6th payment into the fund. The grandfather (or his estate's trustee) will make 40 more $2,500 payments until a 46th and final payment is made on Julian's 65th birthday. The grandfather set things up this way because he wants Julian to work, not be a "trust fund baby," but he also wants to ensure that Julian is provided for in his old age.

Until now, the grandfather has been disappointed with Jonathan and so has not given him anything. However, they recently reconciled, and the grandfather decided to make an equivalent provision for Jonathan. He will make the first payment to a trust for Jonathan today, and he has instructed his trustee to make 40 additional equal annual payments until Jonathan turns 65, when the 41st and final payment will be made. If both trusts earn an annual return of 8%, how much must the grandfather put into Jonathan's trust today and each subsequent year to enable him to have the same retirement nest egg as Julian after the last payment is made on their 65th birthday? a. $3,726 b. $3,912 c. $4,107 d. $4,313 e. $4,528 ANSWER: a RATIONALE: Jonathan's retirement Julian's retirement account account No. of payments thus far, Payment today 1 including today's payment 6 Number of remaining payments 40 40 N = total payments 46N 41 I/YR 8.0%I/YR 8.0% PV $0PV $0 PMT $2,500FV = Jonathan's FV = $1,046,065 FV Julian's FV = $1,046,065PMT $3,726 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retirement planning KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM Copyright Cengage Learning. Powered by Cognero.

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168. You are in negotiations to make a 7-year loan of $25,000 to DeVille Corporation. To repay you, DeVille will pay $2,500 at the end of Year 1, $5,000 at the end of Year 2, and $7,500 at the end of Year 3, plus a fixed but currently unspecified cash flow, X, at the end of each year from Year 4 through Year 7. You are confident the payments will be made, since DeVille is essentially riskless. You regard 8% as an appropriate rate of return on a low risk but illiquid 7-year loan. What cash flow must the investment provide at the end of each of the final 4 years, that is, what is X? a. $4,271.67 b. $4,496.49 c. $4,733.15 d. $4,969.81 e. $5,218.30 ANSWER: c RATIONALE: This is a relatively difficult problem for an efficient calculator solution or classroom exam, but it is appropriate for a challenging take-home or online exam.

I/YR = 8% 0 1 2 3 4 5 −$25,000 $2,500 $5,000 $7,500 X X Calculator solution: Use the CF register to find the NPV of the 4 known cash flows, Step 1.

CF0 to CF3: Step 2.

Find the FV of this NPV at the end of period 3, i.e., compound the NPV you found for 3 years.

Step 3.

Now find the PMT for a 4-year annuity with this PV. POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.04.10 - LO: 4-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CF for given return KEYWORDS: Bloom's: Analyze OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 10/31/2018 8:26 AM DATE MODIFIED: 11/14/2018 12:18 PM

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6 X

7 X

−$12,444.75 −$15,676.80 $4,733.15

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Chapter 05: Bonds, Bond Valuation, and Interest Rates 1. If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Issuing bonds KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 3. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sinking funds KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 4. A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds provide compensation to investors in the form of capital appreciation. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Zero coupon bond KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating-rate debt Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates KEYWORDS: DATE CREATED: DATE MODIFIED:

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6. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond. a. True b. False ANSWER: False RATIONALE: The callable bond will be called if rates fall far enough below the coupon rate, but it will not be called otherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higher yields than noncallable bonds, regardless of the slope of the yield curve.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 7. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income bond KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 8. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF. a. True b. False ANSWER: False RATIONALE: The sinking fund would give Bond SF a lower average maturity, and it would also lower its risk. Therefore, Bond SF should have a lower, not a higher, yield.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sinking funds KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 9. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floatingrate debt shifts interest rate risk to companies, it offers no advantages to issuers. a. True b. False ANSWER: False RATIONALE: Floating rates can benefit issuers if rates decline, so a company that thinks rates are likely to fall would want to issue such bonds.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating-rate debt KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 10. Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect their required rate of return?

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Chapter 05: Bonds, Bond Valuation, and Interest Rates a. There is no reason to expect a change in the required rate of return. b. The required rate of return would decline because the bond would then be less risky to a bondholder. c. The required rate of return would increase because the bond would then be more risky to a bondholder. d. It is impossible to say without more information. e. Because of the call premium, the required rate of return would decline.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 11. Which of the following statements is CORRECT? a. Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature. b. A sinking fund provision makes a bond more risky to investors at the time of issuance. c. Sinking fund provisions never require companies to retire their debt; they only establish "targets" for the company to reduce its debt over time. d. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price. e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sinking funds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DATE MODIFIED:

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12. Nicholas Industries can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Nicholas could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Nicholas would have to pay on the convertible, callable bond? a. It could be less than, equal to, or greater than 6%. b. Greater than 6%. c. Exactly equal to 8%. d. Less than 6%. e. Exactly equal to 6%.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.02 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible, callable bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 13. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discounted cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 14. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond prices and interest rates KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 15. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond premiums and discounts KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 16. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%. a. True b. False ANSWER: True RATIONALE: The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy the bond.

POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value–annual payment KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 17. Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par? a. Adding a call provision. b. The rating agencies change the bond's rating from Baa to Aaa. c. Making the bond a first mortgage bond rather than a debenture. d. Adding a sinking fund. e. Adding additional restrictive covenants that limit management's actions.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond coupon rate KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 18. The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par.

Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT? a. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. b. Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year. c. Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. d. Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to stay the same, and Bond C's price is expected to increase. e. Bond A's current yield will increase each year.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates ANSWER: RATIONALE:

c Note that Bond B sells at par, so the required return on all these bonds is 10%. B's price will remain constant; A will sell initially at a discount and will rise, and C will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond C would be less sensitive to interest rate changes; i.e., it has less interest rate risk. Perhaps it has less default risk.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 19. Kessen Inc.'s bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond's price? a. $923.22 b. $946.30 c. $969.96 d. $994.21 e. $1,019.06 ANSWER: a RATIONALE: N 7 I/YR 8.5% PMT $70 FV $1,000 PV $923.22 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM Copyright Cengage Learning. Powered by Cognero.

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20. Noncallable bonds that mature in 10 years were recently issued by Sternglass Inc. They have a par value of $1,000 and an annual coupon of 5.5%. If the current market interest rate is 7.0%, at what price should the bonds sell? a. $829.21 b. $850.47 c. $872.28 d. $894.65 e. $917.01 ANSWER: d RATIONALE: Coupon rate 5.5% PMT $55 N 10 I/YR 7.0% FV $1,000 PV $894.65 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 21. One year ago Lerner and Luckmann Co. issued 15-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 14 years to maturity? a. $1,077.01 b. $1,104.62 c. $1,132.95 d. $1,162.00 e. $1,191.79 ANSWER: e RATIONALE: Par value $1,000 Coupon rate 7.5% N 14 I/YR 5.5% PMT $75 FV $1,000 PV $1,191.79 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.03 - LO: 5-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: annual coupons KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 22. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.) a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 23. Which of the following statements is CORRECT? a. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. b. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline. c. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates. d. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates. e. You hold two bonds. One is a 10-year, zero coupon, issue and the other is a 10-year bond that pays a 6% Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline.

ANSWER: e POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 24. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? a. Market interest rates rise sharply. b. Market interest rates decline sharply. c. The company's financial situation deteriorates significantly. d. Inflation increases significantly. e. The company's bonds are downgraded.

ANSWER: b POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 25. A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT? a. The bond is currently selling at a price below its par value. b. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. c. The bond should currently be selling at its par value.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates d. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. e. If market interest rates decline, the price of the bond will also decline.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 26. An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both bonds have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT? a. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. b. The prices of both bonds would increase by the same amount. c. One bond's price would increase, while the other bond's price would decrease. d. The prices of the two bonds would remain constant. e. The prices of both bonds will decrease by the same amount.

ANSWER: a RATIONALE: We can tell by inspection that b, c, d, and e are all incorrect. That leaves answer a as the only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that a is correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates 27. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT? a. The prices of both bonds will remain unchanged. b. The price of Bond A will decrease over time, but the price of Bond B will increase over time. c. The prices of both bonds will increase by 7% per year. d. The prices of both bonds will increase over time, but the price of Bond A will increase by more. e. The price of Bond B will decrease over time, but the price of Bond A will increase over time.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields and prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 28. Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year T-bond has an 8% annual coupon.

Assume also that the yield curve is flat, and all Treasury securities have a 10% yield to maturity. Which of the following statements is CORRECT? a. If interest rates decline, the prices of both bonds will increase, but the 10-year bond would have a larger percentage increase in price. b. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium. c. The 10-year bond would sell at a premium, while the 15-year bond would sell at par. d. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall. e. If interest rates decline, the prices of both bonds will increase, but the 15-year bond would have a larger percentage increase in price.

ANSWER: e RATIONALE: We can tell by inspection that b, c, and d are all incorrect. That leaves answers a and e as the only possibly correct statements. Also, recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates.

Thus, the 15-year, 8% coupon bond should be more sensitive to a decline in rates. Finally, we can do some calculations to confirm that e is the correct answer: Current situation Rates decline 10-year 15-year 10-year 15-year Par 1000 1000 1000 1000 Maturity 10 15 10 15 Coup rate 12% 8% 12% 8% YTM 10.00% 10.00% 9.00% 9.00% Ann coup 120 80 120 80 Price $1,122.89 $847.88 $1,192.53 $919.39 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates % Gain POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effect of interest rate on bond prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

6.2%

8.4%

29. A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently sells for $875. If the yield to maturity remains at its current rate, what will the price be 5 years from now? a. $839.31 b. $860.83 c. $882.90 d. $904.97 e. $927.60 ANSWER: c RATIONALE: First find the YTM at this time, then use the YTM with the other data to find the bond's price 5 years hence.

Par value $1,000 Coupon rate 8.50%Value in 5 years N 25N 20 PV $875I/YR 9.86% PMT $85PMT $85 FV $1,000FV $1,000 I/YR 9.86%PV $882.90 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.04 - LO: 5-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value in future time periods KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates 30. Rogoff Co.'s 15-year bonds have an annual coupon rate of 9.5%. Each bond has face value of $1,000 and makes semiannual interest payments. If you require an 11.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $891.00 b. $913.27 c. $936.10 d. $959.51 e. $983.49 ANSWER: a RATIONALE: Par value $1,000 Coupon rate 9.5% Periods/year 2 Yrs to maturity 15 N = periods 30 Annual rate 11.0% Periodic rate 5.50% PMT/period $47.50 FV $1,000 PV $891.00 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.05 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: semiannual coupons KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 31. Haswell Enterprises' bonds have a 10-year maturity, a 6.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 4.75%, based on semiannual compounding. What is the bond's price? a. 1,063.09 b. 1,090.35 c. 1,118.31 d. 1,146.27 e. 1,174.93 ANSWER: c RATIONALE: Par value $1,000 Coupon rate 6.25% Periods/year 2 Yrs to maturity 10 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates N = periods 20 Annual rate 4.75% Periodic rate 2.38% PMT/period $31.25 FV $1,000 PV $1,118.31 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.05 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: semiannual coupons KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 32. CMS Corporation's balance sheet as of today is as follows: Long-term debt (bonds, at par) Preferred stock Common stock ($10 par) Retained earnings Total debt and equity

$10,000,000 2,000,000 10,000,000 4,000,000 $26,000,000

The bonds have a 4.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 12%, so the bonds now sell below par. What is the current market value of the firm's debt? a. $5,276,731 b. $5,412,032 c. $5,547,332 d. $7,706,000 e. $7,898,650 ANSWER: b RATIONALE: Calculate the price of each bond: Coupon rate 4.0% Par value $1,000 Maturity (Yrs) 10 Periods/Yr. 2 YTM 12.0% N 20 I/YR 6.0% PMT $20.00 FV $1,000 PV $541.20 Determine the number of bonds: Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates Book value on balance sheet Par value Number of bonds = Book value/Par value Calculate the market value of bonds: Mkt value = PV × Number of bonds = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.05 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value of semiannual bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

$10,000,000 $1,000 10,000

$5,412,032

33. McCurdy Co.'s Class Q bonds have a 12-year maturity, $1,000 par value, and a 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their par value. McCurdy's Class P bonds have the same risk, maturity, and par value, but the P bonds pay a 5.75% annual coupon. Neither bond is callable. At what price should the annual payment bond sell? a. $943.98 b. $968.18 c. $993.01 d. $1,017.83 e. $1,043.28 ANSWER: c RATIONALE: These two bonds should provide the same EFF%. Therefore, we can find the EFF% for the semiannual bond and then use it as the YTM for the annual payment bond. At the calculated price, the two bonds will have YTMs with the same EFF%. Note too that the semiannual payment bond must have a higher price than the annual bond because then it receives the same cash flow, but faster. Therefore Bond A must sell at a price below the $1,000 par value at which S sells.

Semiannual bond Annual bond Par value $1,000Par value $1,000 Coupon rate = Nominal rate 5.75%Coupon rate 5.75% Payment per period $28.75Pmt/Period $57.50 Years to maturity 12Yrs to maturity 12 Periods/year 2Periods/year 1 Total periods 24Total periods 12 EFF% 5.833%EFF% = YTM 5.833% Price $1,000.00Price $993.01 POINTS: 1 DIFFICULTY: Challenging Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.05 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: effective rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 34. Reinegar Corporation is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Reinegar issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds. a. 4,228 b. 4,337 c. 4,448 d. 4,562 e. 4,676 ANSWER: d RATIONALE: The par bond has a coupon rate of 10% and a periodic rate of 5%, and it sells at par.

Therefore, the going nominal rate must be 10%. The OID bond must provide the same EFF%, because it is equally risky. Therefore, it must be evaluated with the parameters shown below to find its price, which is then used to find the number of bonds issued.

Bond A: Issued at par Bond B: Issued at a discount (OID bonds) Par value $1,000Par value $1,000 Coupon rate 10.00%Coupon rate 6.25% Maturity yrs 25Maturity yrs 25 Periods/year 2Periods/year 2 N 50N 50 Periodic rate 5.00%Periodic rate 5.00% PMT $50.00PMT $31.25 PV = Price $1,000.00PV = Price $657.70 Funds needed $3,000,000 Number of bonds 4,561.34 Rounded up 4,562 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.05 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Bond valuation: original issue discount bonds Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:00 AM 11/16/2018 8:56 AM

35. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? a. The bond is selling below its par value. b. The bond is selling at a discount. c. If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price. d. The bond's current yield is greater than 9%. e. If the yield to maturity remains constant, the bond's price one year from now will be higher than its current price.

ANSWER: c POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 36. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is NOT CORRECT? a. The bond's yield to maturity is 9%. b. The bond's current yield is 9%. c. If the bond's yield to maturity remains constant, the bond will continue to sell at par. d. The bond's current yield exceeds its capital gains yield. e. The bond's expected capital gains yield is positive.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Bond yields Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

37. Which of the following statements is CORRECT? a. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par. b. All else equal, if a bond's yield to maturity increases, its price will fall. c. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. d. All else equal, if a bond's yield to maturity increases, its current yield will fall. e. A zero coupon bond's current yield is equal to its yield to maturity.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 38. Stephenson Co.'s 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT? a. The bond's current yield exceeds its yield to maturity. b. The bond's yield to maturity is greater than its coupon rate. c. The bond's current yield is equal to its coupon rate. d. If the yield to maturity stays constant until the bond matures, the bond's price will remain at $850. e. The bond's coupon rate exceeds its current yield.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Bond yields Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

39. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT? a. If the yield to maturity remains at 8%, then the bond's price will decline over the next year. b. The bond's coupon rate is less than 8%. c. If the yield to maturity increases, then the bond's price will increase. d. If the yield to maturity remains at 8%, then the bond's price will remain constant over the next year. e. The bond's current yield is less than 8%.

ANSWER: a RATIONALE: Answers b, c, and d are clearly wrong, and answer a is clearly correct. Answer e is also wrong, but this is not obvious to most people. We can demonstrate that e is incorrect by using the following example.

Par $1,000 YTM 8.00% Maturity 10 Price $1,100 Payment $94.90 Coupon rate 9.49% Current yield 8.63%The current yield is greater than 8%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 40. Which of the following statements is CORRECT? a. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss. b. On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest. c. If a coupon bond is selling at par, its current yield equals its yield to maturity.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates d. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B. e. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 41. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. b. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond. c. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium. d. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 42. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT? a. The bond has a current yield greater than 8%.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates b. The bond sells at a discount. c. The bond's required rate of return is less than 7.5%. d. If the yield to maturity remains constant, the price of the bond will decline over time. e. The bond sells at a price below par.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 43. Bonds A and B are 15-year, $1,000 face value bonds. Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT? a. One year from now, Bond A's price will be higher than it is today. b. Bond A's current yield is greater than 8%. c. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. d. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. e. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 44. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates a. The total yield on a bond is derived from dividends plus changes in the price of the bond. b. Bonds are riskier than common stocks and therefore have higher required returns. c. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. d. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant. e. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 45. Which of the following statements is CORRECT? a. If rates fall after its issue, a zero coupon bond could trade at a price above its par value. b. If rates fall rapidly, a zero coupon bond's expected appreciation could become negative. c. If a firm moves from a position of strength toward financial distress, its bonds' yield to maturity would probably decline. d. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates 46. Which of the following statements is CORRECT? a. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy. b. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices. c. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield. d. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss. e. The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 47. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. b. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity. c. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If a coupon bond is selling at a premium, then the bond's current yield is zero.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

48. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, and an 8% yield to maturity. Which of the following statements is CORRECT? a. Bond A trades at a discount, whereas Bond B trades at a premium. b. If the yield to maturity for both bonds remains at 8%, Bond A's price one year from now will be higher than it is today, but Bond B's price one year from now will be lower than it is today. c. If the yield to maturity for both bonds immediately decreases to 6%, Bond A's bond will have a larger percentage increase in value. d. Bond A's current yield is greater than that of Bond B. e. Bond A's capital gains yield is greater than Bond B's capital gains yield.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond rates and prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 49. Which of the following statements is CORRECT? a. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. b. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used. c. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not.

The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. d. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond. e. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not.

The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 50. Which of the following statements is CORRECT? a. A bond is likely to be called if its market price is below its par value. b. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called. c. A bond is likely to be called if its market price is equal to its par value. d. A bond is likely to be called if it sells at a discount below par. e. A bond is likely to be called if its coupon rate is below its YTM. ANSWER: b RATIONALE: A bond would not be called unless the current rate was below the YTM. The investor would get the funds, then reinvest at the new market rate. Thus, the investor would end up earning less than the YTM, even after receiving the call premium.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 51. Which of the following statements is CORRECT? a. A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. b. If a bond sells at par, then its current yield will be less than its yield to maturity. c. If a bond sells for less than par, then its yield to maturity is less than its coupon rate. d. A discount bond's price declines each year until it matures, when its value equals its par value. e. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond.

ANSWER: a RATIONALE: Answer b is incorrect because a bond selling at par must have a current yield equal to its YTM. Answer c is incorrect because a bond selling at below par must have a YTM > the coupon rate. Answer d is incorrect because a discount bond's price must rise over time.

Answer e is incorrect because a premium bond must have a negative capital gains yield. That leaves Answer a as the only possibly correct answer. Note that YTM = Cur Yld +/− Cap gains Yld., so Cur Yld = YTM +/− Cap gain yld. The cap gains yld will be positive or negative depending on whether the coupon rate is above or below the YTM. That means that the Cur yld must either equal the YTM or be between the YTM and the coupon rate. a's correctness is also demonstrated below: Par bond Premium Discount Par 1000 1000 1000 Maturity 10 10 10 Coup rate 10% 11% 9% YTM 10.00% 10.00% 10.00% Ann coup $100.00 $110.00 $90.00 Price $1,000.00 $1,061.45 $938.55 Equal to or between YTM Cur Yield 10.00% 10.36% 9.59% and coupon rate.

Cap gain 0.00% −0.36% 0.41% POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current yield and yield to maturity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 52. Which of the following statements is CORRECT? a. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. b. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. c. If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity value. d. If a bond's yield to maturity exceeds its coupon rate, the bond's current yield must be less than its coupon rate. e. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of the bond's coupon rates.

ANSWER: c POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields and prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 53. Curtis Corporation's noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity? a. 6.20% b. 6.53% c. 6.87% d. 7.24% e. 7.62% ANSWER: e RATIONALE: N 15 PV $1,165 PMT $95 FV $1,000 I/YR 7.62% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 54. Sommers Co.'s bonds currently sell for $1,080 and have a par value of $1,000. They pay a $100 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,125. What is their yield to maturity (YTM)? a. 8.56% b. 9.01% c. 9.46% Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates d. 9.93% e. 10.43% ANSWER: RATIONALE:

b N 15 PV $1,080 PMT $10 FV $1,000 I/YR 9.01%= YTM POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 55. Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is the yield to maturity on these bonds? a. 5.56% b. 5.85% c. 6.14% d. 6.45% e. 6.77% ANSWER: b RATIONALE: Coupon rate 7.25% N 13 PV = Price $1,125 PMT $72.50 FV = Par $1,000 I/YR 5.85%= YTM POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:00 AM 11/16/2018 8:56 AM

56. Meacham Enterprises' bonds currently sell for $1,280 and have a par value of $1,000. They pay a $135 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,050. What is their yield to call (YTC)? a. 6.39% b. 6.72% c. 7.08% d. 7.45% e. 7.82% ANSWER: d RATIONALE: N 5 PV $1,280 PMT $135 FV $1,050 I/YR = YTC 7.45% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to call KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 57. Perry Inc.'s bonds currently sell for $1,150. They have a 6-year maturity, an annual coupon of $85, and a par value of $1,000. What is their current yield? a. 7.39% b. 7.76% c. 8.15% d. 8.56% e. 8.98% ANSWER: a RATIONALE: N 6 PV $1,150 PMT $85 FV $1,000 Current yield = 7.39% Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 58. Currently, Bruner Inc.'s bonds sell for $1,250. They pay a $120 annual coupon, have a 15-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM.) a. 2.11% b. 2.32% c. 2.55% d. 2.80% e. 3.09% ANSWER: a RATIONALE: If held to maturity: If called in 5 years: N = Maturity 15N = Call 5 PV $1,250PV $1,250 PMT $120PMT $120 FV = Par $1,000FV = Call Price $1,050 I/YR = YTM 8.91%I/YR = YTC 6.81% Difference: 2.11% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yields to maturity and call KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DATE MODIFIED:

11/16/2018 8:56 AM

59. Gilligan Co.'s bonds currently sell for $1,150. They have a 6.75% annual coupon rate and a 15-year maturity, and are callable in 6 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future.

Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds, the YTC or the YTM? a. 3.92% b. 4.12% c. 4.34% d. 4.57% e. 4.81% ANSWER: e RATIONALE: If the coupon rate exceeds the YTM, then it is likely that the bonds will be called and replaced with new, lower coupon bonds. In that case, the YTC will be earned. Otherwise, one should expect to earn the YTM. If held to maturity If called Par value $1,000 Par value $1,000 Coupon 6.75% Coupon 6.75% N 15 N 6 PV $1,150.00 PV $1,150.00 PMT $67.50 PMT $67.50 FV $1,000.00 FV $1,067.50 I/YR 5.28%YTM I/YR 4.81%YTC Expected rate of return: 4.81%YTC POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yields to maturity and call KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 60. Field Industries' outstanding bonds have a 25-year maturity and $1,000 par value. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $850. What is the bond's nominal (annual) coupon interest rate? a. 6.27% b. 6.60% c. 6.95% d. 7.32% Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates e. 7.70% ANSWER: RATIONALE:

e First, use the data provided to find the dollar coupon payment per 6 months, then multiply by 2 to get the annual coupon, and then divide by the par value to find the coupon rate. One could use the indicated data and solve for the price. It would be $850, which confirms the rate.

Par value $1,000 Maturity 25 Periods/year 2 N 50 YTM 9.25% Periodic rate 4.63% PV $850.00 PMT $38.50 Coupon rate = 7.70% POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Determining the coupon rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 61. Jerome Corporation's bonds have 15 years to maturity, an 8.75% coupon paid semiannually, and a $1,000 par value.

The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,050. What is the bond's nominal yield to call? a. 5.01% b. 5.27% c. 5.54% d. 5.81% e. 6.10% ANSWER: b RATIONALE: First, use the given data to find the bond's current price. Then use that price to find the YTC. Coupon rate 8.75%Yrs to call 6 YTM 6.50%Call price $1,050.00 Maturity 15 Par value $1,000 Periods/year 2Determine the bond's YTC Determine the bond's price N 12 PMT/period $43.75PV $1,213.55 N 30PMT $43.75 I/YR 3.25%FV $1,050.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates FV $1,000.00I/YR PV = Price $1,213.55Nom. YTC POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.06 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yields to maturity and call KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

2.64% 5.27%

62. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings are as follows: T-bond = 7.72% AAA = 8.72%

A = 9.64% BBB = 10.18%

The differences in rates among these issues were most probably caused primarily by: a. Tax effects. b. Default risk differences. c. Maturity risk differences. d. Inflation differences. e. Real risk-free rate differences.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.07 - LO: 5-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 63. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5year bonds is 0.4%. What is the real risk-free rate, r*? a. 2.59% Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates b. 2.88% c. 3.20% d. 3.52% e. 3.87% ANSWER: RATIONALE:

c

rT-bond IP Included in both bonds MRP Included in both bonds r* POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.08 - LO: 5-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real risk-free rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

5.50% 1.90% 0.40% 3.20%

64. The Gergen Group's 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 2.80%, the default risk premium for Gergen's bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Gergen's bonds is LP = 1.25%, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on 5-year bonds? a. 1.40% b. 1.55% c. 1.71% d. 1.88% e. 2.06% ANSWER: b RATIONALE: Maturity 5 6.85% rKrockett 4.75% rT-bond r* Included in both bonds 2.80% LP Included in corp. only 1.25% DRP Included in corp. only 0.85% MRP Included in both bonds 0.40% IP 1.55% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates LEARNING OBJECTIVES: FMTP.EHRH.20.05.09 - LO: 5-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inflation premium (IP) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 65. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mortgage bond KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 66. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt coupon rate KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DATE MODIFIED:

11/16/2018 8:56 AM

67. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond ratings and required returns KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 68. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Restrictive covenants KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 69. Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. b. If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates c. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. d. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan. e. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.

ANSWER: a RATIONALE: On statement a, note that if only $500,000 of 1st mortgage bonds were secured by $1 million of property, each of those bonds would be less risky than if there were $1 million of bonds backed by the $1 million of property. Note too that the cost of the total $1 million of debt would be an average of the cost of the mortgage bonds and the debentures, and that cost could be higher, lower, or the same as if only mortgage bonds or debentures were used.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costs of types of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 70. Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond?

1.

2.

3.

4.

5.

6.

Fixed assets are used as security for a bond.

A given bond is subordinated to other classes of debt.

The bond can be converted into the firm's common stock.

The bond has a sinking fund.

The bond has a call provision.

The indenture contains covenants that prevent the use of additional debt. a. 1, 4, 6 b. 1, 2, 3, 4, 6 c. 1, 2, 3, 4, 5, 6 d. 1, 3, 4, 5, 6 e. 1, 3, 4, 6 ANSWER: e POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Bond indenture Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

71. Suppose International Digital Technologies decides to raise a total of $200 million, with $100 million as long-term debt and $100 million as common equity. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT? a. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures. b. In this situation, we cannot tell for sure how, or whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two. c. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures. d. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds. e. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm's total dollar interest charges will be.

ANSWER: b RATIONALE: The higher the percentage of mortgage bonds, the less the collateral backing each bond, so the bonds' risk and thus required return would be higher. Also, the higher the percentage of mortgage bonds, the less free assets would be backing the debentures, so their risk and required return would also be higher. However, mortgage bonds are less risky than debentures, so mortgage bond rates are lower than rates on debentures. We end up with a situation where the greater the percentage of mortgage bonds, the higher the rate on both types of bonds, but the average cost to the company could be higher, lower, or constant. Note that we could draw a graph of the situation, with % mortgage on the horizontal axis and rates on the vertical axis, then the graph would look like the WACC graph in the cost of capital chapter.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Types of debt and their relative costs Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

72. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? a. 1.90% b. 2.09% c. 2.30% d. 2.53% e. 2.78% ANSWER: a RATIONALE: T-bond yield 6.20% Corporate yield 8.50% MRP Included in both bonds 1.30% LP Included in corporate 0.40% DRP 1.90% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default risk premium (DRP) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 73. Chandler Co.'s 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Chandler's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Chandler's bonds? a. 0.99% b. 1.10% c. 1.21% d. 1.33% e. 1.46% ANSWER: b RATIONALE: Maturity 5 Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates rKeys' rT-bond r* Included in both bonds IP Included in both bonds LP Included in corp. only MRP Included in both bonds DRP POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.11 - LO: 5-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default risk premium (DRP) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

7.00% 5.15% 3.00% 1.75% 0.75% 0.40% 1.10%

74. Squire Inc.'s 5-year bonds yield 6.75%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Squire's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Squire's bonds? a. 0.49% b. 0.55% c. 0.61% d. 0.68% e. 0.75% ANSWER: e RATIONALE: Maturity 5 6.75% rNie 4.80% rT-bond r* Included in both bonds 2.75% IP Included in both bonds 1.65% DRP Included in corp. only 1.20% MRP Included in both bonds 0.40% LP 0.75% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.12 - LO: 5-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Liquidity premium (LP) Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:00 AM 11/16/2018 8:56 AM

75. A bond that had a 20-year original maturity 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, and they cannot be called.) a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 76. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates 77. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False ANSWER: True RATIONALE: The reason for this is that more of the cash flows of a low-coupon bond comes late in the bond's life (as the maturity payment), and later cash flows are impacted most heavily by changing market rates.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Prices and interest rates KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 78. Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%? a. 20-year, 10% coupon bond. b. 20-year, 5% coupon bond. c. 1-year, 10% coupon bond. d. 20-year, zero coupon bond. e. 10-year, zero coupon bond.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 79. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price?

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Chapter 05: Bonds, Bond Valuation, and Interest Rates a. A 1-year bond with a 15% coupon. b. A 3-year bond with a 10% coupon. c. A 10-year zero coupon bond. d. A 10-year bond with a 10% coupon. e. An 8-year bond with a 9% coupon.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 80. Which of the following bonds has the greatest interest rate price risk? a. A 10-year, $1,000 face value, zero coupon bond. b. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments. c. All 10-year bonds have the same price risk since they have the same maturity. d. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 81. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value? a. A 1-year bond with an 8% coupon. b. A 10-year bond with an 8% coupon.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates c. A 10-year bond with a 12% coupon. d. A 10-year zero coupon bond. e. A 1-year zero coupon bond.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 82. Which of the following statements is CORRECT? a. All else equal, long-term bonds have less interest rate price risk than short-term bonds. b. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. c. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. d. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. e. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest vs. reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 83. Which of the following statements is CORRECT? a. Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. b. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. c. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates risk but less reinvestment rate risk. d. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. e. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest vs. reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 84. Which of the following statements is NOT CORRECT? a. All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. b. If a bond is selling at its par value, its current yield equals its yield to maturity. c. If a bond is selling at a premium, its current yield will be greater than its yield to maturity. d. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons. e. If a bond is selling at a discount to par, its current yield will be less than its yield to maturity.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 85. Which of the following statements is CORRECT? a. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. b. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. c. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. d. Reinvestment rate risk is worse from an investor's standpoint than interest rate price risk if the investor has a short investment time horizon. e. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 86. You are considering three different bonds for your portfolio. Each bond has a 10-year maturity and a yield to maturity of 10%. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon.

Which of the following statements is CORRECT? a. Bond X has the greatest reinvestment rate risk. b. If market interest rates decline, all of the bonds will have an increase in price, and Bond Z will have the largest percentage increase in price. c. If market interest rates remain at 10%, Bond Z's price will be 10% higher one year from today. d. If market interest rates increase, Bond X's price will increase, Bond Z's price will decline, and Bond Y's price will remain the same. e. If the bonds' market interest rates remain at 10%, Bond Z's price will be lower one year from now than it is today.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

87. Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. Bond A's price exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than its par value. Which of the following statements is CORRECT? a. Bond A has the most interest rate risk. b. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year. c. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline. d. Bond C sells at a premium over its par value. e. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 88. Which of the following statements is CORRECT? a. A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else equal). b. The total return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year. c. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond. d. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%. e. 10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon bonds.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 89. Which of the following statements is CORRECT? a. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate price risk than a 10% coupon bond. b. A 10-year coupon bond would have more reinvestment rate risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment rate risk. c. A 10-year coupon bond would have more interest rate price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of interest rate price risk. d. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate price risk than a 10% coupon bond. e. A zero coupon bond of any maturity will have more interest rate price risk than any coupon bond, even a perpetuity.

ANSWER: a POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate and reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 90. Assuming all else is constant, which of the following statements is CORRECT? a. For any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate. b. From a corporate borrower's point of view, interest paid on bonds is not tax-deductible. c. Price sensitivity as measured by the percentage change in price due to a given change in the required rate of return decreases as a bond's maturity increases. d. For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates e. A 20-year zero coupon bond has more reinvestment rate risk than a 20-year coupon bond.

ANSWER: d RATIONALE: It is relatively easy to eliminate b, c, and e. When choosing between a and d, think about the graph that shows the relationship between a bond's price and the going interest rate. This curve is concave, indicating that at any interest rate, the decline in price from an increase in rates is less than the gain in price from a similar interest rate decline. It would be easy to confirm this statement with an example.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.10 - LO: 5-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 91. Which of the following statements is CORRECT? a. Liquidity premiums are generally higher on Treasury than corporate bonds. b. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. c. Default risk premiums are generally lower on corporate than on Treasury bonds. d. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. e. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.13 - LO: 5-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Term structure of interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 92. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates a. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. b. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. c. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. d. The yield curve can never be downward sloping. e. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope.

ANSWER: e RATIONALE: The slope of the yield curve depends primarily on expected inflation and the MRP. The greater the expected increase in inflation, and the higher the MRP, the steeper the slope of the yield curve. If inflation is expected to decline, then even if the MRP is positive, the curve could still have a downward slope.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.13 - LO: 5-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 93. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that a. The economy is not in a recession. b. Long-term bonds are a better buy than short-term bonds. c. Maturity risk premiums could help to explain the yield curve's upward slope. d. Long-term interest rates are more volatile than short-term rates. e. Inflation is expected to decline in the future.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.13 - LO: 5-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates DATE CREATED: DATE MODIFIED:

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94. Which of the following statements is CORRECT? a. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. b. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. c. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted. e. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.13 - LO: 5-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 95. Bonds for two companies were just issued: Short Corp.'s bonds will mature in 5 years, and Long Corp.'s bonds will mature in 15 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the Treasury yield curve is based only on expectations about future inflation, i.e., that the maturity risk premium is zero for T-bonds. Under these conditions, which of the following statements is correct? a. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield. b. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. c. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. d. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. e. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have the lower yield.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.13 - LO: 5-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Corporate yield curve Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

96. Junk bonds are high risk, high yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.14 - LO: 5-14 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Junk bond KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 97. Which of the following statements is CORRECT? a. Subordinated debt has less default risk than senior debt. b. Convertible bonds have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. c. Junk bonds typically provide a lower yield to maturity than investment-grade bonds. d. A debenture is a secured bond that is backed by some or all of the firm's fixed assets. e. Junior debt is debt that has been more recently issued, and in bankruptcy it is paid off after senior debt because the senior debt was issued first.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.14 - LO: 5-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of debt KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

98. Which of the following statements is CORRECT? a. An indenture is a bond that is less risky than a mortgage bond. b. The expected return on a corporate bond will generally exceed the bond's yield to maturity. c. If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. d. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated. e. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

ANSWER: e POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.15 - LO: 5-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds, default risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 99. Which of the following statements is CORRECT? a. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. b. Once a firm declares bankruptcy, it must then be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and lawyer fees. c. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds. d. A firm with a sinking fund that gave it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate. e. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the debt until the bonds mature.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.15 - LO: 5-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Miscellaneous concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 8:56 AM

100. Which of the following statements is CORRECT? a. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%. b. The price of a discount bond will increase over time, assuming that the bond's yield to maturity remains constant. c. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. d. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized. e. The total return on a bond during a given year consists only of the coupon interest payments received.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.15 - LO: 5-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM 101. Which of the following statements is NOT CORRECT? a. The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero. b. All else equal, senior debt has less default risk than subordinated debt. c. A company's bond rating is affected by its financial ratios and provisions in its indenture. d. Under Chapter 11 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off its debt according to the seniority of the debt as spelled out in the Act. e. All else equal, secured debt is less risky than unsecured debt.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 05: Bonds, Bond Valuation, and Interest Rates HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.05.15 - LO: 5-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default and bankruptcy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 8:56 AM

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Chapter 06: Risk and Return 1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 2. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 3. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 4. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 5. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return DATE MODIFIED:

11/16/2018 9:08 AM

6. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio return KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 7. Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 8. An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 9. Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and expected returns KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 10. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Knowledge 8/9/2018 10:59 AM 11/16/2018 9:08 AM

11. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a welldiversified portfolio. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 12. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML and risk aversion KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 13. If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock market equilibrium KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 14. If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock market equilibrium KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 15. For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Stock market equilibrium Bloom’s: Knowledge 8/9/2018 10:59 AM 11/16/2018 9:08 AM

16. Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium. a. True b. False ANSWER: False RATIONALE: If one condition holds, then the other must also hold.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock market equilibrium KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 17. Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Variance KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return DATE MODIFIED:

11/16/2018 9:08 AM

18. "Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 19. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 20. Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk prem. and risk aversion KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 21. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 22. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Beta coefficients Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

23. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 24. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 25. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 26. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 27. Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Portfolio risk Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

28. A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 29. The distributions of rates of return for Companies AA and BB are given below: State of the Economy Boom Normal Recession

Probability of This State Occurring 0.2 0.6 0.2

AA 30% 10% −5%

BB −10% 5% 50%

We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB. a. True b. False ANSWER: False RATIONALE: The stocks have the same expected returns, but BB does badly in booms and well in recessions. Therefore, it would do more to reduce risk.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Portfolio risk and return Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

30. Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cor. coefficient and risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 31. Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Company-specific risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 33. We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 34. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Diversification effects Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

35. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.11 - LO: 6-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 36. Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return 37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in beta KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 38. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in beta KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 39. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Reflective Thinking United States - AK - DISC: Risk and return United States - OH - Default City - TBA SML Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

40. The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 41. If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return 42. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 43. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 44. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions. a. True b. False ANSWER: False RATIONALE: The slope and intercept of the SML are determined by the market, generally not the actions of a single firm. However, managers can influence their firms' beta, and thus their firms' required returns.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 45. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 46. If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA CAPM and inflation Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

47. Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 48. Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0. a. True b. False ANSWER: True RATIONALE: Both portfolios would be twice as risky as a portfolio of average stocks. Their risks would decline if they added b = 1.0 stocks, as those stocks would move the portfolios' betas toward 1.0.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Comprehension 8/9/2018 10:59 AM 11/16/2018 9:08 AM

49. The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False ANSWER: False RATIONALE: The CAPM is a single-period model, and it does not take account of securities' maturities.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 50. If markets are in equilibrium, which of the following conditions will exist? a. Each stock's expected return should equal its required return as seen by the marginal investor. b. All stocks should have the same expected return as seen by the marginal investor. c. The expected and required returns on stocks and bonds should be equal. d. All stocks should have the same realized return during the coming year. e. Each stock's expected return should equal its realized return as seen by the marginal investor.

ANSWER: a RATIONALE: Statement a is true, because if the expected return does not equal the required return, then markets are not in equilibrium.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

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Chapter 06: Risk and Return DATE CREATED: DATE MODIFIED:

8/9/2018 10:59 AM 11/16/2018 9:08 AM

51. You are considering investing in one of the these three stocks: Stock A B C

Standard Deviation 20% 10% 12%

Beta 0.59 0.61 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; B. b. B; A. c. C; A. d. C; B. e. A; A. ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 52. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly risk averse and has asked for your advice. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter? a. Stock A. b. Stock B. c. Neither A nor B, as neither has a return sufficient to compensate for risk. d. Add A, since its beta must be lower. e. Either A or B, i.e., the investor should be indifferent between the two.

ANSWER: b RATIONALE: With only 4 stocks in the portfolio, unsystematic risk matters, and B has less.

POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 53. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE? a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. b. The beta of an "average stock," or "the market," can change over time, sometimes drastically. c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. d. All of the statements above are true. e. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 54. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securities?

(Assume market equilibrium.) a. Stock B must be a more desirable addition to a portfolio than A. b. Stock A must be a more desirable addition to a portfolio than B. c. The expected return on Stock A should be greater than that on B. d. The expected return on Stock B should be greater than that on A. e. When held in isolation, Stock A has more risk than Stock B. ANSWER: c POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 55. Which of the following statements is CORRECT? a. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. b. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. c. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. d. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. e. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 56. Which of the following statements is CORRECT? a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of −0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5year period. b. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move. c. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks. d. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on lowbeta stocks will rise while those on high-beta stocks will decline. e. Paid-in-Full Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Paid-in-Full's revenues, profits, and stock price tend to rise during recessions. This suggests that Paidin-Full Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 57. Which of the following statements is CORRECT? a. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. b. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. c. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. d. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future. e. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Beta coefficients Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

58. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct. a. In equilibrium, the expected return on Stock B will be greater than that on Stock A. b. When held in isolation, Stock A has more risk than Stock B. c. Stock B would be a more desirable addition to a portfolio than A. d. In equilibrium, the expected return on Stock A will be greater than that on B. e. Stock A would be a more desirable addition to a portfolio then Stock B. ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 59. Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPM? a. Stock Y's realized return during the coming year will be higher than Stock X's return. b. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount. c. Stock Y's return has a higher standard deviation than Stock X. d. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y. e. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 60. Consider the following average annual returns for Stocks A and B and the Market. Which of the possible answers best describes the historical betas for A and B? Years Market 1 0.03 2 −0.05 3 0.01 4 −0.10 5 0.06 a. bA > +1; bB = 0.

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

b. bA = 0; bB = −1. c. bA < 0; bB = 0. d. bA < −1; bB = 1. e. bA > 0; bB = 1.

ANSWER: RATIONALE:

c First, note that B's beta must be zero, so either a or c must be correct. Second, note that A's returns are highest when the market's returns are negative and lowest when the market's returns are positive. This indicates that A's beta is negative. Thus, c must be correct.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 61.

Which of the following statements is CORRECT? a. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

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Chapter 06: Risk and Return b. An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks. c. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. d. An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks. e. An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 62. Which of the following statements is CORRECT? a. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. b. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. c. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. d. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate. e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and beta Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

63. Recession, inflation, and high interest rates are economic events that are best characterized as being a. company-specific risk factors that can be diversified away. b. among the factors that are responsible for market risk. c. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. d. irrelevant except to governmental authorities like the Federal Reserve. e. systematic risk factors that can be diversified away.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 64. Which of the following statements is CORRECT? a. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. b. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. c. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. d. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Risk and return United States - OH - Default City - TBA Risk and port. divers.

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

65. Which of the following statements is CORRECT? a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. b. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. c. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. e. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and port. divers.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 66. Which of the following statements is CORRECT? a. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. b. A two-stock portfolio will always have a lower beta than a one-stock portfolio. c. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. d. A stock with an above-average standard deviation must also have an above-average beta. e. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.

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Chapter 06: Risk and Return ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.05 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk, return, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 67. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1.

Stock A B C

Expected Return 10% 10% 12%

Standard Deviation 20% 10% 12%

Beta 1.0 1.0 1.4

Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT? a. Portfolio AB's coefficient of variation is greater than 2.0. b. Portfolio AB's required return is greater than the required return on Stock A. c. Portfolio ABC's expected return is 10.66667%. d. Portfolio ABC has a standard deviation of 20%. e. Portfolio AB has a standard deviation of 20%.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return 68. Which of the following statements is CORRECT? a. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable. b. If a stock has a negative beta, its expected return must be negative. c. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5. d. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns. e. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. return, CAPM, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 69. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks? a. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. b. The beta of the portfolio is less than the average of the betas of the individual stocks. c. The beta of the portfolio is equal to the average of the betas of the individual stocks. d. The beta of the portfolio is larger than the average of the betas of the individual stocks. e. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

70. If you randomly select stocks and add them to your portfolio, which of the following statements best describes what you should expect? a. Adding more such stocks will increase the portfolio's expected rate of return. b. Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk. c. Adding more such stocks will have no effect on the portfolio's risk. d. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk. e. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 71. Charlie and Lucinda each have $50,000 invested in stock portfolios. Charlie's has a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Lucinda's has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Charlie's and Lucinda's portfolios is zero. If Charlie and Lucinda marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio? a. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. b. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. c. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. d. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%. e. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 72. The two stocks in your portfolio, X and Y, have independent returns, so the correlation between them, rXY is zero.

Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. Which of the following statements best describes the characteristics of your 2-stock portfolio? a. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. b. Your portfolio has a beta equal to 1.6, and its expected return is 15%. c. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. d. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. e. Your portfolio has a standard deviation of 30%, and its expected return is 15%.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 73. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? a. The expected return of your portfolio is likely to decline. b. The diversifiable risk will remain the same, but the market risk will likely decline. c. Both the diversifiable risk and the market risk of your portfolio are likely to decline. d. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. e. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 74. Ann has a portfolio of 20 average stocks, and Tom has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. The required return on Ann's portfolio will be lower than that on Tom's portfolio because Ann's portfolio will have less total risk. b. Tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Ann's portfolio, but the required (and expected) returns will be the same on both portfolios. c. If the two portfolios have the same beta, their required returns will be the same, but Ann's portfolio will have less market risk than Tom's. d. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. e. Ann's portfolio will have less diversifiable risk and also less market risk than Tom's portfolio.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 75. Stocks A and B are quite similar: Each has an expected return of 12%, a beta of 1.2, and a standard deviation of 25%.

The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT? a. Portfolio P has a standard deviation that is greater than 25%. b. Portfolio P has an expected return that is less than 12%.

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Chapter 06: Risk and Return c. Portfolio P has a standard deviation that is less than 25%. d. Portfolio P has a beta that is less than 1.2. e. Portfolio P has a beta that is greater than 1.2.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 76. Stocks A, B, and C are similar in some respects: Each has an expected return of 10% and a standard deviation of 25%.

Stocks A and B have returns that are independent of one another; i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another; i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT? a. Portfolio AC has an expected return that is greater than 25%. b. Portfolio AB has a standard deviation that is greater than 25%. c. Portfolio AB has a standard deviation that is equal to 25%. d. Portfolio AC has a standard deviation that is less than 25%. e. Portfolio AC has an expected return that is less than 10%.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 77. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return the two stocks have a correlation coefficient of +0.6. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT? a. The portfolio's expected return is 15%. b. The portfolio's standard deviation is greater than 20%. c. The portfolio's beta is greater than 1.2. d. The portfolio's standard deviation is 20%. e. The portfolio's beta is less than 1.2.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 78. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Portfolio P's expected return is equal to the expected return on Stock A. b. Portfolio P's expected return is less than the expected return on Stock B. c. Portfolio P's expected return is equal to the expected return on Stock B. d. Portfolio P's expected return is greater than the expected return on Stock C. e. Portfolio P's expected return is greater than the expected return on Stock B. ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return DATE MODIFIED:

11/16/2018 9:08 AM

79. In a portfolio of three randomly selected stocks, which of the following could NOT be true; i.e., which statement is false? a. The standard deviation of the portfolio is greater than the standard deviation of one or two of the stocks. b. The beta of the portfolio is lower than the lowest of the three betas. c. The beta of the portfolio is equal to one of the three stock's betas. d. The beta of the portfolio is equal to 1. e. The standard deviation of the portfolio is less than the standard deviation of each of the stocks if they were held in isolation.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 80. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A. b. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. c. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B. d. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B. e. Stock B's required return is double that of Stock A's.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

81. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT? a. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. c. Portfolio AB's expected return is 11.0%. d. Portfolio AB's beta is less than 1.2. e. Portfolio AB's standard deviation is 17.5%.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 82. You have a portfolio P that consists of 50% Stock X and 50% Stock Y. Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Given this information, which of the following statements is CORRECT? a. The required return on Portfolio P is equal to the market risk premium (rM − rRF). b. Portfolio P has a beta of 0.7. c. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. d. Portfolio P has the same required return as the market (rM). e. Portfolio P has a standard deviation of 20%.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Risk and return United States - OH - Default City - TBA Port. risk & ret. relationships Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

83. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) a. The effect of a change in the market risk premium depends on the slope of the yield curve. b. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 84. In historical data, we see that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last? a. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. b. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. c. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, largecompany stocks. d. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. e. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return Treasury bills.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 85. Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk premium (rM − rRF), is expected to fall. Given this forecast, which of the following statements is CORRECT? a. The required return on all stocks will remain unchanged. b. The required return will fall for all stocks, but it will fall more for stocks with higher betas. c. The required return for all stocks will fall by the same amount. d. The required return will fall for all stocks, but it will fall less for stocks with higher betas. e. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 86. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT? a. Stock B's required rate of return is twice that of Stock A. b. If Stock A's required return is 11%, then the market risk premium is 5%.

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Chapter 06: Risk and Return c. If Stock B's required return is 11%, then the market risk premium is 5%. d. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's. e. If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 87. Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes? a. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. b. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. c. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. d. The required returns on all stocks have fallen by the same amount. e. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return 88. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? a. If a stock's beta doubled, its required return under the CAPM would also double. b. If a stock's beta doubled, its required return under the CAPM would more than double. c. If a stock's beta were 1.0, its required return under the CAPM would be 5%. d. If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%. e. If a stock has a negative beta, its required return under the CAPM would be less than 5%.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 89. Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB. b. If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount. c. Since the market is in equilibrium, the required returns of the two stocks should be the same. d. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase. e. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

90. Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT? a. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium. b. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease. c. The required returns on all three stocks will increase by the amount of the increase in the market risk premium. d. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase. e. The required return of all stocks will remain unchanged since there was no change in their betas.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 91. Which of the following statements is CORRECT? a. Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. b. If a company's beta were cut in half, then its required rate of return would also be halved. c. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase. d. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise. e. If a company's beta doubles, then its required rate of return will also double.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 92. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. If a stock has a negative beta, its required return must also be negative. b. An index fund with beta = 1.0 should have a required return less than 11%. c. If a stock's beta doubles, its required return must also double. d. An index fund with beta = 1.0 should have a required return greater than 11%. e. An index fund with beta = 1.0 should have a required return of 11%.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM, beta, and req. return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 93. Which of the following statements is CORRECT? a. Lower beta stocks have higher required returns. b. A stock's beta indicates its diversifiable risk. c. Diversifiable risk cannot be completely diversified away. d. Two securities with the same stand-alone risk must have the same betas. e. The slope of the security market line is equal to the market risk premium.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 94. Which of the following statements is CORRECT? a. If the risk-free rate rises, then the market risk premium must also rise. b. If a company's beta is halved, then its required return will also be halved. c. If a company's beta doubles, then its required return will also double. d. The slope of the security market line is equal to the market risk premium, (rM − rRF). e. Beta is measured by the slope of the security market line.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 95. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Stock B has a higher required rate of return than Stock A. b. Portfolio P has a standard deviation of 22.5%. c. More information is needed to determine the portfolio's beta. d. Portfolio P has a beta of 1.0. e. Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 96. Dixon Food's stock has a beta of 1.4, while Clark Café's stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM − rRF), equals 4%. Which of the following statements is CORRECT? a. If the market risk premium increases but the risk-free rate remains unchanged, Dixon's required return will increase because it has a beta greater than 1.0 but Clark's required return will decline because it has a beta less than 1.0. b. Since Dixon's beta is twice that of Clark's, its required rate of return will also be twice that of Clark's. c. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. d. If the market risk premium decreases but the risk-free rate remains unchanged, Dixon's required return will decrease because it has a beta greater than 1.0 and Clark's will also decrease, but by more than Dixon's because it has a beta less than 1.0. e. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Dixon since it has a higher beta.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 97. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT? a. Stock Y must have a higher expected return and a higher standard deviation than Stock X. b. If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount. c. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y. d. If expected inflation declines but the market risk premium is unchanged, then the required return on both Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return stocks will decrease but the decrease will be greater for Stock Y. e. A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 98. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur? a. The required return would decrease by the same amount for both Stock A and Stock B. b. The required return would increase for Stock A but decrease for Stock B. c. The required return on Portfolio P would remain unchanged. d. The required return would increase for Stock B but decrease for Stock A. e. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A. ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 99. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?

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Chapter 06: Risk and Return a. The required return on both stocks would increase by 1%. b. The required return on Portfolio P would remain unchanged. c. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. d. The required return for Stock A would fall, but the required return for Stock B would increase. e. The required return on Portfolio P would increase by 1%.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 100. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? a. The required return on a stock with beta > 1.0 will increase. b. The return on "the market" will remain constant. c. The return on "the market" will increase. d. The required return on a stock with beta < 1.0 will decline. e. The required return on a stock with beta = 1.0 will not change.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 101. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return a. The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers. b. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed relationship to continue on into the future. c. If investors become less risk averse, the slope of the Security Market Line will increase. d. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. e. The slope of the SML is determined by the value of beta.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 102. How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse? a. The x-axis intercept would decline, and the slope would increase. b. The y-axis intercept would increase, and the slope would decline. c. The SML would be affected only if betas changed. d. Both the y-axis intercept and the slope would increase, leading to higher required returns. e. The y-axis intercept would decline, and the slope would increase.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 10:59 AM 11/16/2018 9:08 AM

103. Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT? a. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. b. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. c. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. d. The required return of all stocks will fall by the amount of the decline in the market risk premium. e. The required return of all stocks will increase by the amount of the increase in the risk-free rate.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 104. Suppose that Federal Reserve actions have caused an increase in the risk-free rate, rRF. Meanwhile, investors are afraid of a recession, so the market risk premium, (rM − rRF), has increased. Under these conditions, with other things held constant, which of the following statements is most correct? a. The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. b. Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. c. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. d. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks. e. The required return on all stocks would increase by the same amount.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 105. Which of the following statements is CORRECT? a. The slope of the Security Market Line is beta. b. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. c. If a stock's beta doubles, its required rate of return must also double. d. If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. e. If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML, CAPM, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 106. Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return will decline for stocks whose betas are less than 1.0. b. The required rate of return on the market, rM, will not change as a result of these changes. c. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk d. The required rate of return on a riskless bond will decline. e. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML and risk aversion KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 107. Which of the following statements is CORRECT? a. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. b. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations. c. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks. d. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant. e. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML, CAPM, and port. risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 108. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels, a. The past realized rate of return must be equal to the expected future rate of return; that is, . b. The required rate of return must equal the past realized rate of return; that is, r = .

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Chapter 06: Risk and Return c. The expected rate of return must be equal to the required rate of return; that is, = r. d. All of the above statements must hold for equilibrium to exist; that is = r = . e. None of the above statements is correct.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 109. Which of the following statements is CORRECT? a. Portfolio diversification reduces the variability of returns on an individual stock. b. 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. c. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. d. A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio. e. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 110. You observe the following information regarding Companies X and Y: Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return ∙ Company X has a higher expected return than Company Y. ∙ Company X has a lower standard deviation of returns than Company Y. ∙ Company X has a higher beta than Company Y. Given this information, which of the following statements is CORRECT? a. Company X has a lower coefficient of variation than Company Y. b. Company X has less market risk than Company Y. c. Company X's returns will be negative when Y's returns are positive. d. Company X's stock is a better buy than Company Y's stock. e. Company X has more diversifiable risk than Company Y. ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk measures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 111. Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT? a. Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. b. Portfolio P has more market risk than Stock A but less market risk than B. c. Stock A should have a higher expected return than Stock B as viewed by the marginal investor. d. Portfolio P has a coefficient of variation equal to 2.5. e. Portfolio P has a standard deviation of 25% and a beta of 1.0.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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112. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then a. the past realized return must be equal to the expected return during the same period. b. the required return must equal the realized return in all periods. c. the expected return must be equal to both the required future return and the past realized return. d. the expected future returns must be equal to the required return. e. the expected future return must be less than the most recent past realized return.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 113. Which of the following are the factors for the Fama-French model? a. The excess market return, a debt factor, and a book-to-market factor. b. The excess market return, a size factor, and a debt. c. A debt factor, a size factor, and a book-to-market factor. d. The excess market return, an industrial production factor, and a book-to-market factor. e. The excess market return, a size factor, and a book-to-market factor.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.08 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fama-French model KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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114. Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT? a. The required return on the market is 10%. b. The portfolio's required return is less than 11%. c. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%. d. If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by more than 2%. e. If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the market, which is 11%.

ANSWER: c RATIONALE: c is correct. The portfolio's beta is 1.08. Therefore, if the market risk premium increases by 2.0% the portfolio's required return will increase by 2.16%.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 115. Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM − rRF, is 6%. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT? a. Since the two stocks have zero correlation, Portfolio AB is riskless. b. Stock B's beta is 1.0000. c. Portfolio AB's required return is 11%. d. Portfolio AB's standard deviation is 25%. e. Stock A's beta is 0.8333.

ANSWER: e RATIONALE: e is correct. Stock A's required return is 10% = 5% + b(6%), so b = 5%/6% = 0.83333.

POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 116. Portfolio AB was created by investing in a combination of Stocks A and B. Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT? a. Stock A has more market risk than Stock B but less stand-alone risk. b. Portfolio AB has more money invested in Stock A than in Stock B. c. Portfolio AB has the same amount of money invested in each of the two stocks. d. Portfolio AB has more money invested in Stock B than in Stock A. e. Stock A has more market risk than Portfolio AB. ANSWER: b RATIONALE: b is correct. Beta P = %A(1.2) + %B(1.4) = 1.25. If 50% is in each stock, then we would have Beta P = 0.5(1.2) + 0.5(1.4) = 1.3. But beta P < 1.3, so more money must be invested in the low beta stock, A. POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 117. Which of the following statements is CORRECT? a. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an averagerisk stock will not change. b. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. c. There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. d. Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF. e. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds.

ANSWER: d POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 118. Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return? a. 9.41% b. 9.65% c. 9.90% d. 10.15% e. 10.40% ANSWER: c RATIONALE: Prob Conditions Prob.

Return × Return Good 0.50 25.0% 12.50% Average 0.30 10.0% 3.00% Poor 0.20 −28.0% −5.60% 1.00 9.90% = Expected return POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Expected return Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 10:59 AM 11/16/2018 9:08 AM

119. Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return? a. 7.72% b. 8.12% c. 8.55% d. 9.00% e. 9.50% ANSWER: d RATIONALE: Prob.

Conditions Prob.

Return × Return Good 0.25 30.0% 7.50% Average 0.50 12.0% 6.00% Poor 0.25 −18.0% −4.50% 1.00 9.00% = Expected return POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 120. Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta? a. 0.65 b. 0.72 c. 0.80 d. 0.89 e. 0.98 ANSWER: e RATIONALE: Weight Company Investment Weight Beta × beta Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return X Y

$ 35,000 $ 65,000 $100,000

0.35 0.65 1.00

1.50 0.70

0.53 0.46 0.98

= Portfolio beta

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 121. Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta? a. 1.17 b. 1.23 c. 1.29 d. 1.35 e. 1.42 ANSWER: a RATIONALE: Port.

Weight Company Investment weight Beta × beta Stock A $ 37,500 0.375 0.75 0.28 Stock B $ 62,500 0.625 1.42 0.89 $100,000 1.00 1.17 = Portfolio beta POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 122. Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. He is in the Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock? a. 10.64%; 1.17 b. 11.20%; 1.23 c. 11.76%; 1.29 d. 12.35%; 1.36 e. 12.97%; 1.42 ANSWER: b RATIONALE: Old portfolio return 11.0% Old portfolio beta 1.20 New stock return 13.0% New stock beta 1.50 % of portfolio in new stock = $ in New/($ in Old + $ in New) = $10,000/$100,000 = 10% 11.20% New expected portfolio return = rp = 0.1 × 13% + 0.9 × 11% = 1.23 New expected portfolio beta = bp = 0.1 × 1.50 + 0.9 × 1.20 = POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 123. Calculate the required rate of return for Everest Expeditions Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. a. 10.29% b. 10.83% c. 11.40% d. 12.00% e. 12.60% ANSWER: d RATIONALE: Real rate (r*): 3.00% IP: 4.00% 5.00% RPM: Beta: 1.00 12.00% Required return = rRF + b(RPM) = r* + IP + b(RPM) = Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 124. Zacher Co.'s stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? a. 11.36% b. 11.65% c. 11.95% d. 12.25% e. 12.55% ANSWER: c RATIONALE: Beta 1.40 Risk-free rate 4.25% Market risk premium 5.50% Required return 11.95% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 125. Nystrand Corporation's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium? a. 5.80% b. 5.95% Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return c. 6.09% d. 6.25% e. 6.40% ANSWER: RATIONALE:

a Use the SML to determine the market risk premium with the given data. rs= rRF + bStock × RPM 12.25%= 5.00% + 1.25 × RPM 7.25%= RPM × 1.25 5.80%= RPM POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 126. Martin Ortner holds a $200,000 portfolio consisting of the following stocks: Stock A B C D Total

Investment $50,000 50,000 50,000 50,000 $200,000

Beta 0.95 0.80 1.00 1.20

What is the portfolio's beta? a. 0.938 b. 0.988 c. 1.037 d. 1.089 e. 1.143 ANSWER: b RATIONALE: Stock A B C D Total POINTS: 1

Investment $ 50,000 $ 50,000 $ 50,000 $ 50,000 $200,000

Copyright Cengage Learning. Powered by Cognero.

Percentage 25.00% 25.00% 25.00% 25.00% 100.00%

Beta 0.95 0.80 1.00 1.20

Product 0.238 0.200 0.250 0.300 0.988

= Portfolio beta

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Chapter 06: Risk and Return DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 127. Sherrie Hymes holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875.

Stock A B C D Total

Investment $50,000 50,000 50,000 50,000 $200,000

Beta 0.50 0.80 1.00 1.20

If Sherrie replaces Stock A with another stock, E, which has a beta of 1.50, what will the portfolio's new beta be? a. 1.07 b. 1.13 c. 1.18 d. 1.24 e. 1.30 ANSWER: b RATIONALE: Original Portfolio Stock Investment Percentage Beta Product A $ 50,000 25.00% 0.50 0.125 B $ 50,000 25.00% 0.80 0.200 C $ 50,000 25.00% 1.00 0.250 D $ 50,000 25.00% 1.20 0.300 E Total $200,000 100.00% 0.875 New Portfolio Stock Percentage Beta Product A B 25.00% 0.80 0.200 C 25.00% 1.00 0.250 D 25.00% 1.20 0.300 E 25.00% 1.50 0.375 Total New Portfolio beta = 1.125 Alternative solution: (bE − bA)(%A) + bOld = 1.125 POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 128. Megan Ross holds the following portfolio: Stock A B C D Total

Investment $150,000 50,000 100,000 75,000 $375,000

Beta 1.40 0.80 1.00 1.20

What is the portfolio's beta? a. 1.06 b. 1.17 c. 1.29 d. 1.42 e. 1.56 ANSWER: b RATIONALE: Stock Investment Percentage Beta A $150,000 40.00% 1.40 B $ 50,000 13.33% 0.80 C $100,000 26.67% 1.00 D $ 75,000 20.00% 1.20 Total $375,000 100.00% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM Copyright Cengage Learning. Powered by Cognero.

Product 0.56 0.11 0.27 0.24 1.17

= Portfolio beta

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Chapter 06: Risk and Return DATE MODIFIED:

11/16/2018 9:08 AM

129. Paul McLaren holds the following portfolio: Stock A B C D Total

Investment $150,000 50,000 100,000 75,000 $375,000

Beta 1.40 0.80 1.00 1.20

Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change? a. −0.190 b. −0.211 c. −0.234 d. −0.260 e. −0.286 ANSWER: d RATIONALE: Original New Stock Investment Percentage Beta Product Beta Product A $150,000 40.00% 1.400 0.560 0.750 0.300 B $ 50,000 13.33% 0.800 0.107 0.800 0.107 C $100,000 26.67% 1.000 0.267 1.000 0.267 D $ 75,000 20.00% 1.200 0.240 1.200 0.240 New b Total $375,000 100.00% Old b = 1.173 0.913 = Change in beta = New − Old = −0.260 Alternative solution: (bE − bA) × %A = −0.260 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 130. Jenna holds a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each. The portfolio's beta is 1.12. Jenna plans to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 1.80. What will the portfolio's new beta be? a. 1.286 b. 1.255 c. 1.224 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return d. 1.194 e. 1.165 ANSWER: RATIONALE:

e % in each stock: 5% Old stock's beta: 0.90 New stock's beta: 1.80 Old port. beta: 1.12 New beta = (bNew − bOld) × %A + bOld = 1.165 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 131. Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.) a. 14.38% b. 14.74% c. 15.11% d. 15.49% e. 15.87% ANSWER: a RATIONALE: Risk-free rate 5.50% Old market risk premium 4.75% Old required return 11.75% 1.32 b = (Old return − rRF)/Old RPM New market risk premium 6.75% 14.38% New required return = rRF + b(RPM) = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA CAPM: required rate of return Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 10:59 AM 11/16/2018 9:08 AM

132. Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.) a. 2.75% b. 2.89% c. 3.05% d. 3.21% e. 3.38% ANSWER: e RATIONALE: Beta: A 0.70 Beta: B 1.20 Market return 11.00% Risk-free rate 4.25% Market risk premium 6.75% 8.98% Required return A = rRF + bA(RPM) = 12.35% Required return B = rRF + bB(RPM) = Difference 3.38% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 133. Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.) a. 8.76% b. 8.98% c. 9.21% d. 9.44% e. 9.68% Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return ANSWER: RATIONALE:

c Beta: A Beta: B A's required return Risk-free rate RPM = (A's return − rRF)/betaA = B's required return = rRF + b(RPM) = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM

1.30 0.80 12.00% 4.75% 5.58% 9.21%

134. Barker Corp. has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Barker's required rate of return? a. 9.43% b. 9.67% c. 9.92% d. 10.17% e. 10.42% ANSWER: d RATIONALE: Real risk-free rate, r* 2.00% Expected inflation, IP 3.00% 4.70% Market risk premium, RPM Beta, b 1.10 Risk-free rate = r* + IP = 5.00% 10.17% Required return = rRF + b(RPM) = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 10:59 AM 11/16/2018 9:08 AM

135. Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%.

Based on the SML, what is the firm's required return? a. 13.51% b. 13.86% c. 14.21% d. 14.58% e. 14.95% ANSWER: e RATIONALE: Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills. rs= rRF + RPM 13.00%= 6.50% + RPM 6.50%= RPM Use the SML to determine the firm's required return using the RPM calculated above. rs= rRF + RPM × b = 6.50% + 6.50% × 1.30 = 14.95% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 136. Gardner Electric has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return? a. 11.34% b. 11.63% c. 11.92% d. 12.22% Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return e. 12.52% ANSWER: RATIONALE:

b Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills. Also, note that the dividend growth rate is not needed. rs= rRF + RPM 12.50%= 5.25% + RPM RPM= 7.25%

Use SML to determine the firm's required return using RPM calculated above. rs= rRF + RPM × b = 5.25% + 7.25% × 0.88 = 11.63% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 137. Consider the following information and then calculate the required rate of return for the Universal Investment Fund, which holds 4 stocks. The market's required rate of return is 13.25%, the risk-free rate is 7.00%, and the Fund's assets are as follows: Stock Investment A $ 200,000 B $ 300,000 C $ 500,000 D $1,000,000 a. 9.58% b. 10.09% c. 10.62% d. 11.18% e. 11.77% ANSWER: e RATIONALE: rM

Beta 1.50 −0.50 1.25 0.75

13.25% 7.00% rRF Find portfolio beta: $ 200,000 $ 300,000

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Weight 0.100 0.150

Beta 1.50 −0.50

Product 0.1500 −0.0750 Page 72

Chapter 06: Risk and Return $ 500,000 0.250 1.25 0.3125 $1,000,000 0.500 0.75 0.3750 $2,000,000 1.000 0.7625 Find RPM = rM − rRF = 6.25% rs = rRF + b(RPM) = 11.77% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM

= portfolio beta

138. Data for Atwill Corporation is shown below. Now Atwill acquires some risky assets that cause its beta to increase by 30%. In addition, expected inflation increases by 2.00%. What is the stock's new required rate of return?

Initial beta 1.00 10.20% Initial required return (rs) 6.00% Market risk premium, RPM Percentage increase in beta 30.00% Increase in inflation premium, IP 2.00% a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02% ANSWER: a RATIONALE: Old beta Old rs = rRF + b(RPM) RPM Percentage increase in beta Increase in IP Find new beta after increase = Find old rRF: Old rs = rRF+ b(RPM): 10.2% = rRF + 1.0(6.0%): rRF = 10.2% − 6.0% = Find new rRF: Old rRF + increase in IP = Find new rs = new rRF + new beta(RPM) POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

1.00 10.20% 6.00% 30.00% 2.00% 1.30 4.20% 4.20% 6.20% 14.00%

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Chapter 06: Risk and Return HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 139. Fiske Roofing Supplies' stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.) a. 10.36% b. 10.62% c. 10.88% d. 11.15% e. 11.43% ANSWER: a RATIONALE: Beta 1.23 Risk-free rate 4.30% Required return on stock 11.75% 6.06% RPM = (rStock − rRF)/beta 10.36% Required return on market = rRF + RPM = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on the market KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 140. Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be? a. 1.17 b. 1.23 c. 1.29 Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return d. 1.36 e. 1.43 ANSWER: RATIONALE:

c Number of stocks Percent in each stock = 1/number of stocks = Portfolio beta Stock that's sold Stock that's bought Change in portfolio's beta = 0.125 × (b2 − b1) = New portfolio beta POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.06 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM

8 12.500% 1.25 1.00 1.35 0.0438 1.29

141. Returns for the Alcoff Company over the last 3 years are shown below. What's the standard deviation of the firm's returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.)

Year 2010 2009 2008 a. 20.08% b. 20.59% c. 21.11% d. 21.64% e. 22.18% ANSWER: RATIONALE:

Return 21.00% −12.50% 25.00%

b This is a relatively technical problem. It should be used only if calculations are emphasized in class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Deviation Squared Year Return from Mean Deviation 2010 21.00% 9.83% 0.97% 2009 −12.50% −23.67% 5.60% 2008 25.00% 13.83% 1.91% Sum sqd Expected return 11.17% 8.48% deviations

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Chapter 06: Risk and Return 4.24%

Sum/(N − 1)

SQRT = α = 20.59% 20.59% with Excel POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.04 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Std. dev., historical returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 142. Stuart Company's manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.)

Economic Conditions Strong Normal Weak a. 17.69% b. 18.62% c. 19.55% d. 20.52% e. 21.55% ANSWER: RATIONALE:

Prob.

30% 40% 30%

Return 32.0% 10.0% −16.0%

b This is a relatively technical problem. It should be used only if calculations are emphasized in class, or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Economic Return Dev. from Squared Sqd. dev.

Conditions Prob.

This state Mean Dev. × Prob Strong 30% 32.0% 23.20% 10.24% 3.07% Normal 40% 10.0% 1.20% 0.01% 0.01% Weak 30% −16.0% −24.80% 6.15% 1.85% 100% 8.8% Variance 4.92% α = Sqrt of variance 18.62% 18.62% by Excel POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.02 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Std. dev., prob. data Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 10:59 AM 11/16/2018 9:08 AM

143. Assume that your cousin holds just one stock, Eastman Chemical Bonding (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for Wilder's Creations and Buildings (WCB). Both companies have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Year 2011 2012 2013 2014 2015 Average return = Standard deviation = a. 3.29% b. 3.46% c. 3.65% d. 3.84% e. 4.03% ANSWER: RATIONALE:

ECB 40.00% −10.00% 35.00% −5.00% 15.00%

15.00% 22.64%

15.00% 22.64%

d This is a relatively technical problem. It should be used only if calculations are emphasized in class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Portfolio Year ECB WCB % ECB: 60% ECB/WCB 2011 40.00% 40.00% 40.00% 2012 −10.00% 15.00% 0.00% 2013 35.00% −5.00% 19.00% 2014 −5.00% −10.00% −7.00% 2015 15.00% 35.00% 23.00% Average return = Standard deviation =

POINTS: DIFFICULTY: QUESTION TYPE:

WCB 40.00% 15.00% −5.00% −10.00% 35.00%

Reduction in the SD vs. ECB's SD: 1 Challenging Multiple Choice

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15.00% 22.64%

15.00% 22.64%

15.00% 18.80%

3.84%

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Chapter 06: Risk and Return HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.04 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk reduction KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 144. The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.) a. 8.83% b. 9.05% c. 9.27% d. 9.51% e. 9.74% ANSWER: a RATIONALE: % of New Port.

Old funds (millions) $10.00 66.67% New funds (millions) $5.00 33.33% Total portfolio $15.00 100.00% Req'd return, old stocks 9.50% Risk-free rate 4.20% Market risk premium: rP = rRF + b(RPM) >> 9.5% = 5.30% 4.2% + 1.05(RPM) RPM = (9.5% − 4.2%)/1.05 = 5.05% New portfolio: Old portfolio's beta New stocks' beta New portfolio beta New portfolio required return = rRF + New beta(RPM) = POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

1.05 0.65 0.9167 8.8270%

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Chapter 06: Risk and Return STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Portfolio beta Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 10:59 AM 11/16/2018 9:08 AM

145. Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. Hazel expects to receive an additional $60 million, which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%.

What must the average beta of the new stocks be to achieve the target required rate of return? a. 1.68 b. 1.76 c. 1.85 d. 1.94 e. 2.04 ANSWER: b RATIONALE: Old funds (millions) $ 40.00 40.00% New funds (millions) $ 60.00 60.00% Total new funds $100.00 100.00% Beta on existing portfolio Risk-free rate Market risk premium Desired required return

1.00 4.25% 6.00% 13.00%13% = rRF + b(RPM); b = (13% − rRF)/RPM 1.4583beta = (Return − Risk-free)/RPM Required new bp Required beta, new stocks 1.76Req. b = (Old$/Total$) × Old b + (New$/Total$) × New b Beta on new stocks = (Req. b − (Old$/Total$) × Old b)/(New$/Total$) POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 146. Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return (and require) on this fund?

Stock A B C D

Amount $1,075,000 675,000 750,000 500,000 $3,000,000 a. 10.56% b. 10.83% c. 11.11% d. 11.38% e. 11.67% ANSWER: RATIONALE:

Beta 1.20 0.50 1.40 0.75

c Company Stock A Stock B Stock C Stock D

Required market return Risk free rate Market risk premium = rMarket − rRF =

Amount $1,075,000 675,000 750,000 500,000

Weight 0.358 0.225 0.250 0.167

Beta 1.20 0.50 1.40 0.75

Wt × beta 0.43 0.11 0.35 0.13

$3,000,000

1.000

bPortfolio =

1.02

Intermediate step

11.00% 5.00% 6.00%

Portfolio's required return = 11.11% rRF + b(RPM) = POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. beta and req. ret.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM 147. DHF Company has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points). Neither betas nor the risk-free rate change. What would DHF's new required return be? a. 14.89% b. 15.68% Copyright Cengage Learning. Powered by Cognero.

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Chapter 06: Risk and Return c. 16.50% d. 17.33% e. 18.19% ANSWER: RATIONALE:

c This problem requires some algebra: CCC's beta CCC's initial required return Percentage increase in required market return Initial required return on the market New required return on the market

1.50 12.00% 30.0% 10.00% 13.00%

Now for the algebra: rStock = rRF + b(RPM) = rRF + 1.5(RPM) rMarket = rRF + b(RPM) = rRF + 1.0(RPM) Now insert known data and transpose: 12% = rRF + 1.5(RPM) >> 12% − rRF = 1.5(RPM) 10% = rRF + (RPM) >> 10% − rRF = 1.0(RPM) Now subtract the second equation from the first. rRF and one of the RPMs cancel, leaving: 2% = 0.5(RPM) 4.00% Now solve for RPM: RPM = 2%/0.5 6.00% Now find the risk-free rate: rRF = Initial rMarket − RPM = 10% − 4% = 7.00% New RPM = New required return on the market − rRF 16.50% Now find the new return on CCC = rRF + b(new RPM) = POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.06.07 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 10:59 AM DATE MODIFIED: 11/16/2018 9:08 AM

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Chapter 07: Corporate Valuation and Stock Valuation 1. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.01 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proxy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.01 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 3. If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.01 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 4. The preemptive right is important to shareholders because it a. will result in higher dividends per share. b. is included in every corporate charter. c. protects the current shareholders against a dilution of their ownership interests. d. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. e. allows managers to buy additional shares below the current market price.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.01 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 5. Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.02 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Classified stock Bloom’s: Knowledge 8/9/2018 11:02 AM 8/9/2018 11:02 AM

6. Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.02 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Founders' shares KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 7. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.02 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Classified stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation NOTES: DATE CREATED: DATE MODIFIED:

Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

8. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.04 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 9. According to the basic FCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.04 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value: investment horizon KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 10. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.04 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flows and valuation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 11. The free cash flow valuation model cannot be used unless a company doesn't pay dividends. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.04 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 12. Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of operations. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

ANSWER: e RATIONALE: Statement e is true, because the expected growth rate is also the expected capital gains yield.

All the other statements are false.

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Chapter 07: Corporate Valuation and Stock Valuation POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant free cash flow growth model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 13. If a company’s free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The company’s stock's dividend yield is 5%. b. The value of operations is expected to decline in the future. c. The company's WACC must be equal to or less than 5%. d. The company’s value of operations one year from now is expected to be 5% above the current price. e. The expected return on the company’s stock is 5% a year.

ANSWER: d RATIONALE: Statement d is true, because the value of operations is expected to grow at the free cash flow growth rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant free cash flow growth stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 14. Which of the following statements is NOT CORRECT? a. The free cash flow valuation model discounts free cash flows by the required return on equity. b. The free cash flow valuation model can be used to find the value of a division. c. An important step in applying the free cash flow valuation model is forecasting the firm's pro forma financial Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation statements. d. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. e. The free cash flow valuation model can be used both for companies that pay dividends and those that do not pay dividends.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 15. Which of the following statements is CORRECT? a. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. c. The free cash flow valuation model, Vops =FCF1/(WACC − g), cannot be used for firms that have negative growth rates. d. The free cash flow valuation model, Vops = FCF1/(WACC − g), can be used only for firms whose growth rates exceed their WACC. e. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

ANSWER: b RATIONALE: Statement a is simply false. Statement b is true. Statements c and d are false, because the constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is false⎯a number of companies have different classes of stock with different voting rights.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Common stock concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

16. A company’s free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%, and the constant growth rate is g = 4.0%. What is the current value of operations? a. $23.11 million b. $23.70 million c. $24.31 million d. $24.93 million e. $25.57 million ANSWER: e RATIONALE: $1.50 FCF0 WACC 10.1% g 4.0% $1.56 FCF1 = FCF0(1 + g) = $25.57 Vops = FCF1/(rs − g) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 17. Lance Inc.'s free cash flow was just $1.00 million. If the expected long-run growth rate for this company is 5.4%, if the weighted average cost of capital is 11.4%, Lance has $4 million in short-term investments and $3 million in debt, and 1 million shares outstanding, what is the intrinsic stock price? a. $17.28 b. $17.70 c. $18.13 d. $18.57 e. $19.01 ANSWER: d RATIONALE: $1.00 million Last FCF (FCF0) Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation Long-run growth rate 5.4% Required return 11.4% $1.054 million FCF1 = FCF0(1 + g) = $17.57 million Vops = FCF1/(WACC − g) Short-term investments = $4 million Debt = $3 million Shares outstanding = 1 million Intrinsic value of equity = Value of operations + short-term investments - all debt - preferred stock = 17.57 + 4 - 3 - 0 = $18.57 million. Intrinsic stock price = intrinsic value of equity/number of shares = 18.57/1 = $18.57.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 18. Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions? a. $948 b. $998 c. $1,050 d. $1,103 e. $1,158 ANSWER: c RATIONALE: $100 FCF0: g: 5% WACC: 15% Value Ops = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100(1 + 0.05)/(0.15 − 0.05) = $105/0.1 = $1,050 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Free cash flow valuation model, value of operations Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

19. The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 ANSWER: d RATIONALE: $100,000 FCF1: g: 6% WACC: 11% Value Ops = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100,000/(0.11 − 0.06) = $100,000/0.05 = $2,000,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 20. Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40 ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation RATIONALE:

Value of operations Required return Growth rate Vops = FCF1/(WACC − g), so FCF1 = Vops(WACC − g) = Last FCF = FCF0 = FCF1/(1 + g) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth FCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

$25.00 11.50% 7.00% $1.1250 $1.05

21. Judd Corporation has a weighted average cost of capital of 10.25%, and its value of operations is $57.50 million. Free cash flow is expected to grow at a constant rate of 6.00% per year. What is the expected year-end free cash flow, FCF1 in millions? a. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25 ANSWER: b RATIONALE: Value of operations $57.50 WACC 10.25% Growth rate 6.00% Vops = FCF1/(WACC − g), so FCF1 = Vops(WACC − g) $2.44 Expected FCF = FCF1 = Vops(WACC − g) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth fcf Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

22. A company is expected to have free cash flows of $0.75 million next year. The weighted average cost of capital is WACC = 10.5%, and the expected constant growth rate is g = 6.4%. The company has $2 million in short-term investments, $2 million in debt, and 1 million shares. What is the stock's current intrinsic stock price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22 ANSWER: c RATIONALE: $0.75 million FCF1 WACC 10.5% g 6.4% $18.29 million Vops = FCF1/(WACC − g) Short-term investments $2 million Debt $2 million shares outstanding $1 million Total intrinsic value of equity = Value of operations + short-term investments - all debt preferred stock = $18.29 + 2 - 2 - 0 = $18.29 million. Intrinsic stock price = total intrinsic value of equity / shares outstanding = $18.29 million/1 million = $18.29 per share POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.05 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 23. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth model KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 24. Which of the following statements is CORRECT? a. If a company has a WACC = 12% and its free cash flow is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The value of operations of a stock is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. d. The constant growth model cannot be used for a zero growth stock, where free cash flows are expected to remain constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow model KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 25. Barnette Inc.'s free cash flows are expected to be unstable during the next few years while the company undergoes restructuring. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5? a. $719 b. $757 c. $797 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation d. $839 e. $883 ANSWER: RATIONALE:

e

$50 FCF5: g: 6% WACC: 12% HV5 = FCF6/(WACC − g) = FCF5(1 + g)/(WACC − g) = $50(1 + 0.06)/(0.12 − 0.06) = $53/0.06 = $883 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, horizon value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 26. Gere Furniture forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3? a. $840 b. $882 c. $926 d. $972 e. $1,021 ANSWER: a RATIONALE: $40 FCF3: g: 5% WACC: 10% HV3 = FCF4/(WACC − g) = FCF3(1 + g)/(WACC − g) = $40(1 + 0.05)/(0.10 − 0.05) = $42/0.05 = $840 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Free cash flow valuation model, horizon value Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

27. Decker Tires’ free cash flow was just FCF0 = $1.32. Analysts expect the company's free cash flow to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The WACC for this company 9.00%.

Decker has $4 million in short-term investments and $14 million in debt and 1 million shares outstanding. What is the best estimate of the stock's current intrinsic price? a. $31.59 b. $32.65 c. $33.75 d. $34.87 e. $35.99 ANSWER: d RATIONALE: rs = 9.0% Year 0 1 2 3 Growth rates: 30.0% 10.0% 5.0% FCF $1.32 $1.716 $1.888 $1.982 49.550 Horizon value = FCF3/(WACC − g3) = Total CFs $1.716 $51.437 PV of CFs $1.574 $43.294 Short-term investments = $4 million Debt = $14 million Value of operations = $44.87 Intrinsic value of equity = ($44.87 + 4 - 14)/1 = $34.87 million POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant FCF growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 28. Kinkead Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be −$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions? a. $158 b. $167 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation c. $175 d. $184 e. $193 ANSWER: RATIONALE:

b

−$10 FCF1: $20 FCF2: g: 4% WACC: 14% First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) = $20(1.04)/(0.14 − 0.04) = $20.8/0.10 = $208.00 Then find the PV of the free cash flows and the horizon value: Value of operations = −$10/(1.14)1 + ($20 + $208)/(1.14)2 = −$8.772 + $175.439 = $167 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 29. The free cash flows (in millions) shown below are forecast by Parker & Sons. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions?

Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments).

Year: Free cash flow: a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770 ANSWER: RATIONALE:

1 −$50

2 $100

a −$50 FCF1: $100 FCF2: g: 5% WACC: 11% First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) =

Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation $100(1.05)/(0.11 − 0.05) = $1,750.00 Then find the PV of the free cash flows and the horizon value: Value of operations = −$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 30. Heath and Logan Inc. forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?

Year: Free cash flow: a. $315 b. $331 c. $348 d. $367 e. $386 ANSWER: RATIONALE:

1 −$15

2 $10

3 $40

e Year: 1 2 3 FCF: −$15 $10 $40 g: 5% WACC: 13% First, find the horizon, or terminal, value: HV4 = FCF3(1 + g)/(WACC − g) = $40(1.05)/(0.13 − 0.05) = $525 Then find the PV of the free cash flows and the horizon value: Value of operations = −$15/(1.13) + $10/(1.13)2 + ($40 + $525)/(1.13)3 = $386 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

free cash flow valuation model, value of operations Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

31. Reynolds Construction's value of operations is $750 million based on the free cash flow valuation model. Its balance sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable, $100 million of notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm's value of equity, in millions? a. $429 b. $451 c. $475 d. $500 e. $525 ANSWER: d RATIONALE: Value of operations: $750 Short-term investments: $50 Notes payable: $100 Long-term debt: $200 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $750 + $50 = $800.

Value of Equity = Total MV − Long- and Short-term debt = $500.

The book value of equity figures are irrelevant for this problem. Also, the accounts payable are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model, value of equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 32. Based on the free cash flow valuation model, the value of Weidner Co.'s operations is $1,200 million. The company's balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation $800 million in total common equity. If Weidner has 30 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82 ANSWER: b RATIONALE: Value of operations: $1,200 Short-term investments: $100 Notes payable: $120 Long-term debt: $300 Preferred stock $50 Shares outstanding: 30 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $1,200 + $100 = $1,300.

Value of Equity = Total MV − Long- and Short-term debt and preferred = $830 Stock price = Value of Equity/Shares outstanding = $27.67 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 33. The value of Broadway-Brooks Inc.'s operations is $900 million, based on the free cash flow valuation model. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation e. $34.36 ANSWER: RATIONALE:

c Value of operations: $900 Short-term investments: $30 Notes payable: $110 Long-term debt: $90 Preferred stock $20 Shares outstanding: 25 Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $900 + $30 = $930.

Value of Equity = Total MV − Long- and Short-term debt and preferred = $710 Stock price = Value of Equity/Shares outstanding = $28.40 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 34. Based on the free cash flow valuation model, Bizzaro Co.'s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity.

Bizzaro has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share? a. $13.72 b. $14.44 c. $15.20 d. $16.00 e. $16.80 ANSWER: d RATIONALE: Value of operations: $300 Short-term investments: $20 Notes payable: $90 Long-term debt: $30 Preferred stock $40 Shares outstanding: 10 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $300 + $20 = $320.

Value of Equity = Total MV − Long- and Short-term debt and preferred = $160 Stock price = Value of Equity/Shares outstanding = $16.00 The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 35. Huxley Building Supplies' last free cash flow was $1.75 million. Its free cash flow growth rate is expected to be constant at 25% for 2 years, after which free cash flows are expected to grow at a rate of 6% forever. Its weighted average cost of capital WACC is 12%. Huxley has $5 million in short-term investments and $7 million in debt and has 1 million shares outstanding. What is the best estimate of the current intrinsic stock price? a. $39.58 b. $40.64 c. $41.71 d. $42.80 e. $44.92 ANSWER: b RATIONALE: $1.75 Last FCF (FCF0) Short-run growth rate 25% Long-run growth rate 6% WACC 12% Year 0 1 2 3 25.00% 25.00% 6.00% FCF $1.7500 $2.1875 $2.7344 $2.8984 Horizon value = FCF3/(WACC − g3) 48.3073 = Total CFs $2.1875 $51.0417 PV of CFs $1.9531 $40.6901 Debt = $7 million Short-term investments = $5 million Value of operations = Sum of PVs = $42.64 million. Intrinsic value of equity = Value of operations + short term investments Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation debt = 42.64 + 5 - 7 = $40.64 million.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant free cash flow growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 36. Atchley Corporation’s last free cash flow was $1.55 million. The free cash flow growth rate is expected to be constant at 1.5% for 2 years, after which free cash flows are expected to grow at a rate of 8.0% forever. The firm's weighted average cost of capital (WACC) is 12.0%. Atchley has $2 million in short-term debt and $14 million in debt and 1 million shares outstanding. What is the best estimate of the intrinsic stock price? a. $25.05 b. $26.16 c. $27.30 d. $28.48 e. $29.70 ANSWER: a RATIONALE: $1.55 Last FCF (FCF0) Short-run growth rate 1.50% Long-run growth rate 8.00% Required return 12.00% Year 0 1 2 3 1.50% 1.50% 8.00% FCF $1.5500 $1.5733 $1.5968 $1.7246 Horizon value = FCF3/(WACC − g3) 43.1149 = Total CFs $1.5733 $44.7118 PV of CFs $1.4047 $35.6439 Short-term investments = $2 million Debt = $14 million Value of operations = Sum of PVs = $37.05 Intrinsic value of equity = value of operations + short-term investments - debt = $37.05 + 2 - 14 = $25.05 million. Intrinsic stock price = intrinsic value of equity / shares outstanding = $25.05 / 1 = $25.05 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Nonconstant free cash flow growth valuation Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

37. The free cash flows (in millions) shown below are forecast by Simmons Inc. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: Free cash flow: a. $586 b. $617 c. $648 d. $680 e. $714 ANSWER: RATIONALE:

1 −$20

2 $42

3 $45

b Year: 1 2 3 Free cash flow: −$20 $42 $45 WACC: 13% First, find the growth rate: g = $45/$42 − 1.0 = 7.14% Second, find the horizon, or terminal, value, at Year 2: HV2 = FCF3/(WACC − g) = $45/(0.13 − 0.0714) = $768 Now find the PV of the FCFs and the horizon value: Value of operations = −$20/(1.13) + ($42 + $768)/(1.13)2 = $617 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.06 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 38. Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.07 - LO: 7-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flows and valuation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 39. The expected total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected otal stock returns KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 40. The constant growth dividend model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Constant growth dividend model Bloom’s: Knowledge 8/9/2018 11:02 AM 8/9/2018 11:02 AM

41. Which of the following statements is CORRECT? a. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. d. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth model KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 42. If a firm's expected growth rate increased then its required rate of return would a. decrease. b. fluctuate less than before. c. fluctuate more than before. d. possibly increase, possibly decrease, or possibly remain constant. e. increase.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Required return Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

43. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 44. Which of the following statements is CORRECT? a. Two firms with the same expected dividend and growth rates must also have the same stock price. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

ANSWER: e RATIONALE: Statement e is true, because the expected growth rate is also the expected capital gains yield.

All the other statements are false.

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Chapter 07: Corporate Valuation and Stock Valuation POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 45. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = −5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The company's dividend yield 5 years from now is expected to be 10%. b. The constant growth model cannot be used because the growth rate is negative. c. The company's expected capital gains yield is 5%. d. The company's expected stock price at the beginning of next year is $9.50. e. The company's current stock price is $20.

ANSWER: d RATIONALE: Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Declining constant dividend growth KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 46. If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The stock's dividend yield is 5%.

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Chapter 07: Corporate Valuation and Stock Valuation b. The price of the stock is expected to decline in the future. c. The stock's required return must be equal to or less than 5%. d. The stock's price one year from now is expected to be 5% above the current price. e. The expected return on the stock is 5% a year.

ANSWER: d RATIONALE: Statement d is true, because the stock price is expected to grow at the dividend growth rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 47. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9% a. These two stocks must have the same dividend yield. b. These two stocks should have the same expected return. c. These two stocks must have the same expected capital gains yield. d. These two stocks must have the same expected year-end dividend. e. These two stocks should have the same price.

ANSWER: a RATIONALE: The following calculations show that answer a is correct. The others are all wrong.

A B Expected return 10% 12% Expected growth 7% 9% Dividend yield 3% 3% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Expected and required returns Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

48. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% a. The two stocks could not be in equilibrium with the numbers given in the question. b. A's expected dividend is $0.50. c. B's expected dividend is $0.75. d. A's expected dividend is $0.75 and B's expected dividend is $1.20. e. The two stocks should have the same expected dividend.

ANSWER: d RATIONALE: The following calculations show that answer d is correct. The others are all wrong.

A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 49. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% a. Stock A has a higher dividend yield than Stock B. b. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. c. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's. d. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. e. Stock A's expected dividend at t = 1 is only half that of Stock B. ANSWER: e RATIONALE: Statement e is correct, because if both stocks have the same price and the same required return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example.

A B Price $25 $25 g 10% 5% r 15% 15% Div. Yield = r − g = 5% 10% $1.25 $2.50 D1 = P(Div Yield) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 50. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% a. Stock Y has a higher dividend yield than Stock X. b. One year from now, Stock X's price is expected to be higher than Stock Y's price. c. Stock X has the higher expected year-end dividend. d. Stock Y has a higher capital gains yield.

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Chapter 07: Corporate Valuation and Stock Valuation e. Stock X has a higher dividend yield than Stock Y. ANSWER: b RATIONALE: The correct answer is statement b. Both prices are currently the same, but X's price should grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 51. Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? $3.00 Expected dividend, D1 $50 Current Price, P0 Expected constant growth rate 6.0% a. The stock's expected dividend yield and growth rate are equal. b. The stock's expected dividend yield is 5%. c. The stock's expected capital gains yield is 5%. d. The stock's expected price 10 years from now is $100.00. e. The stock's required return is 10%.

ANSWER: a RATIONALE: The correct answer choice is a. One could quickly calculate the dividend yield and see that it equals the growth rate, but here are some numbers that provide more information. $3.00D1/P0 6.0% D1 $50.00rX 12.0% P0 g 6.0% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Expected and required returns Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

52. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $25 $25 Expected dividend yield 5% 3% Required return 12% 10% a. Stock X pays a higher dividend per share than Stock Y. b. One year from now, Stock X should have the higher price. c. Stock Y has a lower expected growth rate than Stock X. d. Stock Y has the higher expected capital gains yield. e. Stock Y pays a higher dividend per share than Stock X. ANSWER: a RATIONALE: Dividend = Yield × Price: X dividend = $1.25 Y dividend = $0.75 Stock X has a dividend yield of 5% versus a yield of 3% for Y. Since they both have the same stock price, X must pay a higher dividend.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 53. Merrell Enterprises' stock has an expected return of 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock's dividend yield is 8%. b. The current dividend per share is $4.00. c. The stock price is expected to be $54 a share one year from now. d. The stock price is expected to be $57 a share one year from now. e. The stock's dividend yield is 7%.

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Chapter 07: Corporate Valuation and Stock Valuation ANSWER: RATIONALE:

c

P1 = P0(1 + g) = $54. Therefore, c is correct. All the other answers are false. P1 = $54.00.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 54. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. Stock B must have a higher dividend yield than Stock A. b. Stock A must have a higher dividend yield than Stock B. c. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's. d. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. e. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's.

ANSWER: e RATIONALE: Statement e is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation 55. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. b. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. c. The two stocks must have the same dividend growth rate. d. The two stocks must have the same dividend yield. e. The two stocks must have the same dividend per share.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 56. Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. b. A stock's dividend yield can never exceed its expected growth rate. c. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return. d. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return. e. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation OTHER: NOTES: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

8/9/2018 11:02 AM 8/9/2018 11:02 AM

57. Which of the following statements is CORRECT? a. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock. b. Corporations cannot buy the preferred stocks of other corporations. c. Preferred dividends are not generally cumulative. d. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation. e. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 58. Which of the following statements is CORRECT? a. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. b. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. c. One of the disadvantages to a corporation of owning preferred stock instead of owning bonds is that 50% of the preferred dividends received represent taxable income to the corporate recipient, whereas none of the interest received from bonds is taxable income to the corporate recipient. d. One of the advantages for a firm financing with preferred stock is that 50% of the dividends the firm pays may be deducted from its taxable income. e. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 12/5/2018 11:25 AM 59. Which of the following statements is CORRECT? a. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. c. The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative growth rates. d. The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates exceed their required returns. e. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

ANSWER: b RATIONALE: Statement a is simply false. Statement b is true. Statements c and d are false, because the constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is false⎯a number of companies have different classes of stock with different voting rights.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 60. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation CORRECT? a. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. b. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. c. The stocks must sell for the same price. d. Stock Y must have a higher dividend yield than Stock X. e. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

ANSWER: e RATIONALE: Since X has the lower required return, if Y has a lower dividend yield it must have a higher expected growth rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 61. Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% a. Stock A must have a higher dividend yield than Stock B. b. Stock B's dividend yield equals its expected dividend growth rate. c. Stock B must have the higher required return. d. Stock B could have the higher expected return. e. Stock A must have a higher stock price than Stock B. ANSWER: a RATIONALE: Statement a is true, because Stock A has a higher required return but the stocks have the same growth rate, so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point. beta rRF RPM rStock A 6.40% + 1.10 × 6.00% = 13.00% B 6.40% + 0.90 × 6.00% = 11.80% Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation Div. Yld. A B

D1/P0 D1/P0

g + +

7.00% 7.00%

= =

rStock 13.00% 11.80%

D1/P0 = r − g = 6.00% D1/P0 = r − g = 4.80%

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth model: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer.

DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 62. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22 ANSWER: c RATIONALE: $0.75 D1 10.5% rs g 6.4% $18.29 P0 = D1/(rs − g) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation 63. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57 ANSWER: e RATIONALE: $1.50 D0 10.1% rs g 4.0% $1.56 D1 = D0(1 + g) = $25.57 P0 = D1/(rs − g) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 64. A share of Lash Inc.'s common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investors' required rate of return is 11.4%, what is the stock price? a. $16.28 b. $16.70 c. $17.13 d. $17.57 e. $18.01 ANSWER: d RATIONALE: $1.00 Last dividend (D0) Long-run growth rate 5.4% Required return 11.4% $1.054 D1 = D0(1 + g) = $17.57 P0 = D1/(rs − g) POINTS: DIFFICULTY: QUESTION TYPE:

1 Difficulty: Easy Multiple Choice

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Chapter 07: Corporate Valuation and Stock Valuation HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 65. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65% ANSWER: e RATIONALE: $1.25 Expected dividend (D1) Stock price $32.50 Required return 10.5% Dividend yield 3.85% 6.65% Growth rate = rs − D1/P0 = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 66. $35.50 per share is the current price for Foster Farms' stock. The dividend is projected to increase at a constant rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? a. $37.86 b. $38.83 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation c. $39.83 d. $40.85 e. $41.69 ANSWER: RATIONALE:

e Stock price $35.50 Growth rate 5.50% Years in the future 3 3 $41.69 P3 = P0(1 + g) = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth: future price KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 67. Kelly Enterprises' stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate of 4.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the stock's expected price 5 years from now? a. $40.17 b. $41.20 c. $42.26 d. $43.34 e. $44.46 ANSWER: e RATIONALE: Growth rate 4.75% Years in the future 5 Stock price $35.25 5 $44.46 P5 = P0(1 + g) = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth: future price Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

68. If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock's expected dividend yield for the coming year? a. 4.12% b. 4.34% c. 4.57% d. 4.81% e. 5.05% ANSWER: d RATIONALE: $1.25 D1 g 4.7% $26.00 P0 4.81% Dividend yield = D1/P0 = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected dividend yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 69. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock's expected dividend yield for the coming year? a. 4.42% b. 4.66% c. 4.89% d. 5.13% e. 5.39% ANSWER: b RATIONALE: $2.25 D0 g 3.5% $50.00 P0 $2.329 D1 = D0(1 + g) = Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation 4.66% Dividend yield = D1/P0 = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected dividend yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 70. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the coming year? a. 6.50% b. 6.83% c. 7.17% d. 7.52% e. 7.90% ANSWER: a RATIONALE: $1.50 D1 g 6.5% $56.00 P0 Capital gains yield = g = 6.50% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected cap. gains yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 71. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock's expected total return for the coming year?

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Chapter 07: Corporate Valuation and Stock Valuation a. 7.54% b. 7.73% c. 7.93% d. 8.13% e. 8.34% ANSWER: RATIONALE:

e

$1.25 D1 g 5.5% $44.00 P0 8.34% Total return = rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected total return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 72. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year? a. 8.37% b. 8.59% c. 8.81% d. 9.03% e. 9.27% ANSWER: e RATIONALE: $1.75 D0 g 3.6% $32.00 P0 $1.81 D1 = D0(1 + g) = 9.27% Total return = rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Expected total return Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

73. Dyer Furniture is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is Dyer's current stock price? a. $28.90 b. $29.62 c. $30.36 d. $31.12 e. $31.90 ANSWER: a RATIONALE: $1.25 D1 b 1.15 4.00% rRF 5.50% RPM g 6.00% 10.33% rs = rRF + b(RPM) = $28.90 P0 = D1/(rs − g) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth value: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 74. The Jameson Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.15, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is Jameson's current stock price, P0? a. $18.62 b. $19.08 c. $19.56 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation d. $20.05 e. $20.55 ANSWER: RATIONALE:

a

$0.75 D0 b 1.15 4.0% rRF 5.0% RPM g 5.5% $0.7913 D1 = D0(1 + g) = 9.75% rs = rRF + b(RPM) = $18.62 P0 = D1/(rs − g) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend g value: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 75. National Advertising just paid a dividend of D0 = $0.75 per share, and that dividend is expected to grow at a constant rate of 6.50% per year in the future. The company's beta is 1.25, the required return on the market is 10.50%, and the riskfree rate is 4.50%. What is the company's current stock price? a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03 ANSWER: a RATIONALE: $0.75 D0 b 1.25 4.5% rRF 10.5% rM g 6.5% $0.7988 D1 = D0(1 + g) = 12.0% rs = rRF + b(rM − RRF) = $14.52 P0 = D1/(rs − g) POINTS:

1

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Chapter 07: Corporate Valuation and Stock Valuation DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend g value: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 76. Kellner Motor Co.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share. Kellner's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40 ANSWER: b RATIONALE: Stock price $25.00 Required return 11.50% Growth rate 7.00% $1.1250 P0 = D1/(rs − g), so D1 = P0(rs − g) = $1.05 Last dividend = D0 = D1/(1 + g) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 77. Hirshfeld Corporation's stock has a required rate of return of 10.25%, and it sells for $57.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1? a. $2.20 b. $2.44 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation c. $2.69 d. $2.96 e. $3.25 ANSWER: RATIONALE:

b Stock price Required return Growth rate P0 = D1/(rs − g), so D1 = P0(rs − g) Expected dividend = D1 = P0(rs − g) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

$57.50 10.25% 6.00% $2.44

78. Connolly Co.'s expected year-end dividend is D1 = $1.60, its required return is rs = 11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the future. What is Connolly's expected stock price in 7 years, i.e., what is ? a. $37.52 b. $39.40 c. $41.37 d. $43.44 e. $45.61 ANSWER: a RATIONALE: $1.60 Next expected dividend = D1 = Required return 11.0% 6.0% Dividend yield = D1/P0 = 5.0% Find the growth rate: g = rs − yield = $26.67 Find P0 = D1/(rs − g) = Years in the future 7 7 $37.52 = P0(1 + g) POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES:

1 Difficulty: Moderate Multiple Choice False

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Chapter 07: Corporate Valuation and Stock Valuation LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth: future price KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 79. Burke Tires just paid a dividend of D0 = $1.32. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%.

What is the best estimate of the stock's current market value? a. $41.59 b. $42.65 c. $43.75 d. $44.87 e. $45.99 ANSWER: d RATIONALE: rs = 9.0% Year 0 1 2 3 Growth rates: 30.0% 10.0% 5.0% Dividend $1.32 $1.716 $1.888 $1.982 49.550 Horizon value = D3/(rs − g3) = Total CFs $1.716 $51.437 PV of CFs $1.574 $43.294 Stock price = $44.87 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 80. McGaha Enterprises expects earnings and dividends to grow at a rate of 25% for the next 4 years, after the growth rate in earnings and dividends will fall to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? a. $26.77 Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation b. $27.89 c. $29.05 d. $30.21 e. $31.42 ANSWER: RATIONALE:

c Last dividend (D0) Short-run growth rate Long-run growth rate Beta Market risk premium Risk-free rate Required return = rs = rRF + b(RPM) = Year 0

$1.25 25% 0% 1.20 5.50% 3.00% 9.60% 1 25% $1.5625

Dividend $1.2500 Horizon value = D5/(rs − g5) = Total CFs $1.5625 PV of the CFs $1.4256 Price = Sum of PVs = $29.05 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

2 25% $1.9531

3 25% $2.4414

4 25% $3.0518

5 0% $3.0518

31.7891 $1.9531 $1.6260

$2.4414 $34.8409 $1.8544 $24.1461

81. Orwell Building Supplies' last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price? a. $41.58 b. $42.64 c. $43.71 d. $44.80 e. $45.92 ANSWER: b RATIONALE: $1.75 Last dividend (D0) Short-run growth rate 25% Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation Long-run growth rate Required return Year

6% 12% 0

Dividend $1.7500 Horizon value = D3/(rs − g3) = Total CFs PV of CFs Price = Sum of PVs = $42.64 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

1 25.00% $2.1875 48.3073 $2.1875 $1.9531

2 25.00% $2.7344

3 6.00% $2.8984

$51.0417 $40.6901

82. The last dividend paid by Wilden Corporation was $1.55. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%.

What is the best estimate of the current stock price? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70 ANSWER: a RATIONALE: $1.55 Last dividend (D0) Short-run growth rate 1.50% Long-run growth rate 8.00% Required return 12.00% Year 0 1 2 3 1.50% 1.50% 8.00% Dividend $1.5500 $1.5733 $1.5968 $1.7246 43.1149 Horizon value = D3/(rs − g3) = Total CFs $1.5733 $44.7118 PV of CFs $1.4047 $35.6439 Price = Sum of PVs = $37.05 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 83. The last dividend paid by Coppard Inc. was $1.25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 ANSWER: d RATIONALE: Required return 11.0% Short-run growth rate 15.0% Long-run growth rate 6.0% $1.25 Last dividend (D0) Year 0 1 2 3 4 Dividend $1.2500 $1.4375 $1.6531 $1.9011 $2.0152 Horizon value = P3 = D4/(rs − g4) 40.3032 = Total CFs $1.4375 $1.6531 $42.2043 PV of CFs $1.2950 $1.3417 $30.8594 Price = Sum of PVs = $33.50 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation 84. Sawchuck Consulting has been profitable for the last 5 years, but it has never paid a dividend. Management has indicated that it plans to pay a $0.25 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years, and then to increase it at a constant rate of 8.00% thereafter. Management's forecast of the future dividend stream, along with the forecasted growth rates, is shown below. Assuming a required return of 11.00%, what is your estimate of the stock's current value?

Year Growth rate Dividends a. $9.94 b. $10.19 c. $10.45 d. $10.72 e. $10.99 ANSWER: RATIONALE:

0 NA $0.000

1 NA $0.000

2 NA $0.000

3 NA $0.250

4 50.00% $0.375

d Required return = 11% Year

0

1

5 25.00% $0.469

2

Dividend $0.000 $0.000 $0.000 Horizon value = P5 = D6/(rs − g6) = Total CFs $0.000 $0.000 PV of CFs $0.000 $0.000 Price = $10.72 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

6 8.00% $0.506

3

4 5 6 50.00% 25.00% 8.00% $0.250 $0.375 $0.469 $0.506 16.875 $0.250 $0.183

$0.375 $17.344 $0.247 $10.293

85. The required return for Williamson Heating's stock is 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock's expected constant growth rate after t = 4, i.e., what is X? a. 5.17% b. 5.44% c. 5.72% d. 6.02% Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation e. 6.34% ANSWER: RATIONALE:

e Stock price Paid dividend (D0) Short-run growth rate Required return Forecasted LR growth rate, X Year

0

$40.00 $1.00 30.0% 12.0% 6.34%Arbitrarily set at 5% initially.

1 2 3 4 5 30.0% 30.0% 30.0% 30.0% 6.34% $1.3000 $1.6900 $2.1970 $2.8561 $3.0372

Dividend $1.0000 Horizon value = P4 = D5/(rs 53.6777 − g5): Total CFs $1.3000 $1.6900 $2.1970 $56.5338 PV of CFs $1.1607 $1.3473 $1.5638 $35.9282 Stock price = $40.00. Must equal $40. Change the forecasted growth rate till reach $40. We must solve for the long-run growth rate. We can forecast the dividends in Years 1-4, so they are inserted in the time line. We need a growth rate to find D5 and the TV. We begin with a guess of say 5.0%, which we insert in the forecast cell. We then find the PV of the forecasted CFs and sum them. If the sum equals the given price, then our growth rate would be correct.

If not, we need to substitute in different g's until we find the one that works. We used Excel's Goal Seek function to simplify the process, but one could use trial and error.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth rate–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 86. Julia Saunders is your boss and the treasurer of Foster Carter Enterprises (FCE). She asked you to help her estimate the intrinsic value of the company's stock. FCE just paid a dividend of $1.00, and the stock now sells for $15.00 per share.

Julia asked a number of security analysts what they believe FCE's future dividends will be, based on their analysis of the company. The consensus is that the dividend will be increased by 10% during Years 1 to 3, and it will be increased at a rate of 5% per year in Year 4 and thereafter. Julia asked you to use that information to estimate the required rate of return on the stock, rs, and she provided you with the following template for use in the analysis:

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Chapter 07: Corporate Valuation and Stock Valuation

Julia told you that the growth rates in the template were just put in as a trial, and that you must replace them with the analysts' forecasted rates to get the correct forecasted dividends and then the estimated TV. She also notes that the estimated value for rs, at the top of the template, is also just a guess, and you must replace it with a value that will cause the Calculated Price shown at the bottom to equal the Actual Market Price. She suggests that, after you have put in the correct dividends, you can manually calculate the price, using a series of guesses as to the Estimated rs. The value of rs that causes the calculated price to equal the actual price is the correct one. She notes, though, that this trial-and-error process would be quite tedious, and that the correct rs could be found much faster with a simple Excel model, especially if you use Goal Seek. What is the value of rs? a. 11.84% b. 12.21% c. 12.58% d. 12.97% e. 13.36% ANSWER: d RATIONALE: Finding the discount rate when we know the dividends and the actual stock price is complicated if the growth rate is not constant, and an iterative solution is required.

12.97% Estimated rs = $15.00 Actual Market Price, P0: Rapid Growth Normal Growth Year 0 1 2 3 4 5 Dividend growth rate 10% 10% 10% 5% 5% $1.00 $1.100 $1.210 $1.331 $1.398 Dividends (D0 has been paid) TV3 = P3 = D4/(rs − g4). Use $17.527 Estimated rs.

Total CFs $1.100 $1.210 $18.858 PVs of CFs discounted at $0.974 $0.948 $13.078 Estimated rs Calculated Price = P0 = Sum of PVs = $15.00

POINTS: DIFFICULTY:

1 Difficulty: Challenging

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Chapter 07: Corporate Valuation and Stock Valuation QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.11 - LO: 7-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant value: Excel–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 87. Preferred stock is a hybrid⎯a sort of cross between a common stock and a bond⎯in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond. a. True b. False ANSWER: False RATIONALE: Preferred dividends don't normally grow, and they are not guaranteed.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.14 - LO: 7-14 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 88. From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: Bonds are the most risky for the firm, preferred is next, and common is least risky. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.14 - LO: 7-14 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Preferred stock Bloom’s: Knowledge 8/9/2018 11:02 AM 8/9/2018 11:02 AM

89. Carby Hardware has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, at what price should the preferred stock sell? a. $104.27 b. $106.95 c. $109.69 d. $112.50 e. $115.38 ANSWER: e RATIONALE: Preferred dividend $7.50 Required return 6.5% $115.38 Preferred price = DP/rP = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.14 - LO: 7-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 90. Alcott's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return? a. 8.03% b. 8.24% c. 8.45% d. 8.67% e. 8.89% ANSWER: e RATIONALE: Pref. quarterly dividend $1.00 Annual dividend = Qtrly dividend × 4 = $4.00 Preferred stock price $45.00 Nom. required return = Annual dividend/Price = 8.89% POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 07: Corporate Valuation and Stock Valuation QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.14 - LO: 7-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 91. Connor Publishing's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return? a. 6.62% b. 6.82% c. 7.03% d. 7.25% e. 7.47% ANSWER: e RATIONALE: Periods per year = 4 Pref. quarterly dividend $1.00 Preferred stock price $55.00 N− 7.47% Eff % required return = (1+ (Qt Div/P)) 1= POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.07.14 - LO: 7-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

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Chapter 08: Financial Options and Applications in Corporate Finance 1. An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 2. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Strike price KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 3. If a stock's price is above the strike price of a call option written on the stock, then the exercise value is equal to the stock price minus the strike price. If the stock price is below the strike price, the exercise value of the call option is zero. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exercise value KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exercise value KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 5. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option time value KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance DATE MODIFIED:

11/16/2018 9:18 AM

6. If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 7. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the stock's current price and the option's strike price. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 8. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 9. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 10. If we define the "premium" on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stock's current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant. a. True b. False ANSWER: False RATIONALE: For a stock price that is above the strike price, increasing the stock price causes the option price to get closer to the exercise value (i.e., the stock price minus the strike price) because the probability that the stock price will be out of the money expiration gets smaller. In other words, a high stock price relative to the strike price means that at expiration the option value is likely to equal the stock price minus the strike price. Therefore, the premium (which is the amount by which the option price exceeds the exercise value) gets smaller.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 11. An option that gives the holder the right to sell a stock at a specified price at some future time is a. a put option. b. an out-of-the-money option. c. a naked option. d. a covered option. e. a call option.

ANSWER: a POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option terms KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 12. Other things held constant, the value of an option depends on the stock's price, the risk-free rate, and the a. Variability of the stock price. b. Option's time to maturity. c. Strike price. d. All of the above. e. None of the above.

ANSWER: d POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Derivatives United States - OH - Default City - TBA Option value Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:01 AM 11/16/2018 9:18 AM

13. Which of the following statements is most correct, holding other things constant, for XYZ Corporation's traded call options? a. The higher the strike price on XYZ's options, the higher the option's price will be. b. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months. c. If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase. d. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend. e. The price of these call options is likely to rise if XYZ's stock price rises.

ANSWER: e POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 14. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant? a. The exercise price of the option is increased. b. The life of the option is increased, i.e., the time until it expires is lengthened. c. The Federal Reserve takes actions that increase the risk-free rate. d. BLW's stock price becomes more risky (higher variance). e. BLW's stock price suddenly increases.

ANSWER: a POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 15. Which of the following statements is CORRECT? a. Call options give investors the right to sell a stock at a certain strike price before a specified date. b. Options typically sell for less than their exercise value. c. LEAPS are very short-term options that were created relatively recently and now trade in the market. d. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. e. Put options give investors the right to buy a stock at a certain strike price before a specified date.

ANSWER: d POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 16. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options? a. Put b. Naked c. Covered d. Out-of-the-money e. In-the-money ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 17. Cazden Motors' stock is trading at $30 a share. Call options on the company's stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options? a. The options with the $25 strike price will sell for less than the options with the $35 strike price. b. The options with the $25 strike price have an exercise value greater than $5. c. The options with the $35 strike price have an exercise value greater than $0. d. If Cazden's stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5. e. The options with the $25 strike price will sell for $5.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 18. Braddock Construction Co.'s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share? a. The price of the call option will increase by more than $2. b. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%. c. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%. d. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%. e. The price of the call option will increase by $2.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 19. Which of the following statements is CORRECT? a. As the stock's price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases. b. Issuing options provides companies with a low cost method of raising capital. c. The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price. d. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger. e. An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value.

ANSWER: c POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 20. Suppose you believe that Basso Inc.'s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Basso's stock price actually rises to $45, what would your pre-tax net profit be? a. −$3.10 b. $16.90 c. $17.75 Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance d. $22.50 e. $25.60 ANSWER: RATIONALE:

b The call option will be exercised only if the final price is above the strike price. If the final price is below the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $25.00 No. of options: 1 Final price: $45.00 Option cost: $3.10 Profit per share = Final price − Strike price = $45 − $25 or zero: $20.00 Total profit = Profit/option × No. of options − Cost of options = $16.90 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call options KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 21. Suppose you believe that Florio Company's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florio's stock price actually dropped to $60, what would your pretax net profit be? a. −$5.10 b. $19.90 c. $20.90 d. $22.50 e. $27.60 ANSWER: b RATIONALE: The put option will be exercised only if the final price is below the strike price. If the final price exceeds the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $85.00 No. of options: 1 Final price: $60.00 Option cost: $5.10 Profit per share = Strike price − Final price = $85 − $60 or zero: $25.00 Total profit = Profit/option × No. of options − Cost of options = $19.90 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.01 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Put options Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:01 AM 11/16/2018 9:18 AM

22. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock, provided the strike prices for the put and call are the same. a. True b. False ANSWER: False RATIONALE: Recognize that if a stock is selling far above the strike price, the call option will be quite valuable, but the put option will be worth very little because the probability is low that the stock's market price will fall below the put's strike price.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.06 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put-call parity KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 23. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firm's stock. a. True b. False ANSWER: False RATIONALE: Dividends do not enter into the OPM pricing formula. We would expect the stock of a firm that retains all of its earnings to grow over time due to the reinvestment of its earnings, whereas a firm that retains zero earnings should not grow much if any. Therefore, the value of the firm's long-term options should decline if it announces a change from a zero to a 100% payout policy.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.06 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Put-call parity Bloom’s: Comprehension 8/9/2018 11:01 AM 11/16/2018 9:18 AM

24. Which of the following statements is CORRECT? a. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. b. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be. c. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be. d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. e. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.06 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous option concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 25. The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option? a. $7.33 b. $7.71 c. $8.12 d. $8.55 e. $9.00 ANSWER: e RATIONALE: Stock price: $50.00 Strike price: $55.00 Call option price: $7.20 Risk-free rate: 6.0% Value of put = Value of call − Stock price + (Exercise price × e−rt) Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance = $7.20 − $50.00 + $55 × e−rt = $7.20 − $50.00 + $51.80 = $9.00 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.06 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put-call parity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 26. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available.

Based on the binomial model, what is the option's value? (Hint: Use daily compounding.) a. $2.43 b. $2.70 c. $2.99 d. $3.29 e. $3.62 ANSWER: c RATIONALE: Current price $22.00 Price at end of year: Exercise price $22.00 High $27.00 6.00% Low $17.00 rRF Step 1. Payoff range, stock: $27.00 − $17.00 = $10.00 Step 2.

If stock is high: If stock is low: Option range:

$5.00 0.00 $5.00

Equalize the ranges to find the number of shares of stock:

Step 3.

Option range/Stock range = $5/$10 = shares of stock = Step 4.

Payoff range, option: Price − Exercise = 27 − 22 = (Price − Exercise) or $0 = $5 − $0 =

The payoff from 0.5 shares of stock will be either: The payoff from the option will be either: The portfolio's payoff will be either:

Copyright Cengage Learning. Powered by Cognero.

0.5

$13.50 or

$8.50

5.00 or

0.00

$ 8.50 or

$8.50 Page 13

Chapter 08: Financial Options and Applications in Corporate Finance So the portfolio's payoff is riskless, $8.50 regardless of which choice materializes.

Step 5.

Step 6.

The present value of $8.50 at the daily compounded risk-free rate is: PV = $8.50/(1 + (0.06/365))365 = $8.005.

The option price is the cost of the stock purchased for the portfolio minus the PV of the payoff: V = 0.5($22) −$8.01 = $2.99

Note: Using the formula for the binomial model yields a call value of $2.9950.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.02 - LO: 8-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option price based on binomial model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM 27. An analyst wants to use the Black-Scholes model to value call options on the stock of Heath Corporation based on the following data: ∙ ∙ ∙ ∙ ∙

The price of the stock is $40.

The strike price of the option is $40.

The option matures in 3 months (t = 0.25).

The standard deviation of the stock's returns is 0.40, and the variance is 0.16.

The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: ∙ ∙ ∙ ∙

d1 = 0.175 d2 = −0.025 N(d1) = 0.56946 N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is the value of the call option? a. $2.81 b. $3.12 c. $3.47 Copyright Cengage Learning. Powered by Cognero.

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Chapter 08: Financial Options and Applications in Corporate Finance d. $3.82 e. $4.20 ANSWER: RATIONALE:

c

Stock price: $40.00N(d1) = 0.56946 Strike price: $40.00N(d2) = 0.49003 Option maturity: 0.25 Variance of stock returns: 0.16 Risk-free rate: 6.0% The Black-Scholes model calculates the value of the call option as: V= P[N(d1)] − Xe−rt[N(d2)] = $40(0.56946) − $40e−rt(0.49003) = $22.78 − $19.31 = $3.47 POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.08.05 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Black-Scholes model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:01 AM DATE MODIFIED: 11/16/2018 9:18 AM

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Chapter 09: The Cost of Capital 1. "Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.01 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/13/2018 11:29 AM 2. The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.01 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/13/2018 11:31 AM 3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.01 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Component capital costs KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 4. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock “raised” by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.01 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital components KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of debt KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 6. Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

ANSWER: d RATIONALE: Statement d is true, because the after-tax cost of debt is rd(1 − T). So, if rd remains constant but T increases, rd(1 − T) will decline. The other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital components KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 7. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of debt KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 8. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of debt KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 9. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA After-tax cost of debt Bloom’s: Comprehension 8/9/2018 11:03 AM 8/9/2018 11:03 AM

10. Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation? a. 5.44% b. 5.73% c. 6.03% d. 6.35% e. 6.67% ANSWER: d RATIONALE: Coupon rate 9.25% Periods/year 2 Maturity (yr) 20 Bond price $1,075.00 Par value $1,000 Tax rate 25% Calculator inputs: N = Periods/year × Maturity 40 PV = Bond's price −$1,075.00 PMT = Coupon rate × Par/2 $46.25 FV = Par = Maturity value $1,000 Calculator output: I/YR, semiannual rate 4.23% Annual rate = 2 × (I/YR) = Before-tax cost of debt 8.47% 6.35% After-tax cost of debt = rd(1 −T) for use in WACC POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of debt KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:16 PM 11. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 25%. What is the component cost of debt for use in the WACC calculation?

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Chapter 09: The Cost of Capital a. 5.35% b. 5.58% c. 5.81% d. 6.04% e. 6.28% ANSWER: RATIONALE:

c Coupon rate 7.00% Periods/year 2 Maturity (yr) 20 Bond price $925.00 Par value $1,000 Tax rate 25% Calculator inputs: N = Periods/year × Maturity 40 PV = Bond's price −$925.00 PMT = Coupon rate × Par/2 $35 FV = Par = Maturity value $1,000 I/YR 3.87% Times periods/yr = before-tax cost of debt 7.74% 5.81% After-tax cost of debt = rd(1 −T) for use in WACC POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:18 PM 12. Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 25%, but Congress is considering a change in the corporate tax rate to 15%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? a. 0.57% b. 0.63% c. 0.70% d. 0.77% e. 0.85% ANSWER: c RATIONALE: Tax Rate Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital Old rate 7.00% 2 20 $1,000 25%

Coupon rate Periods/year Maturity (yr) Bond price = Par value Old and New tax rates

New rate 7.00% 2 20 $1,000 15%

Calculator inputs: N = Periods/year × Maturity 40 40 PV = Bond's price −$1,000 −$1,000 PMT = Coupon rate × Par/2 $35.00 $35.00 FV = Par = Maturity value −$1,000 −$1,000 I/YR 3.50% 3.50% Times periods/yr = before-tax cost of debt 7.00% 7.00% 5.25% 5.95% After-tax cost of debt = rd(1 −T) for use in WACC Difference = Cost at new rate −Cost at old rate = 0.70% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taxes and cost of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:21 PM Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets Current assets Net plant, property, and equipment Total assets

$ 38,000,000 101,000,000 $139,000,000

Liabilities and Equity Accounts payable Accruals Current liabilities Long-term debt (40,000 bonds, $1,000 par value) Total liabilities Common stock (10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity

$ 10,000,000 9,000,000 $ 19,000,000 40,000,000 $ 59,000,000 30,000,000 50,000,000 80,000,000 $139,000,000

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Chapter 09: The Cost of Capital The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

13. Refer to the data for the Collins Group. What is the best estimate of the after-tax cost of debt? a. 5.80% b. 6.10% c. 6.43% d. 6.75% e. 7.08% ANSWER: c RATIONALE: Coupon rate 7.25% Periods/year 2 Maturity (yr) 20 Bond price $875 Par value $1,000 Tax rate 25% Calculator inputs: N = 2 × Years = 40 PV = −Bond Price = −$875.00 PMT = (Coupon rate × Par)/2 = $36.25 FV = Par value = $1,000 Yield = I/YR, which we solve for = 4.28% 8.57% Before-tax cost of debt = rd = yield × 2 = 6.43% After-tax cost of debt for use in WACC = rd(1 −T) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Collins Group LEARNING OBJECTIVES: FMTP.EHRH.20.09.03 - LO: 9-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: After-tax cost of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Keep problems referring to the Preface for the data for the Collins Group together.

DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:24 PM 14. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/13/2018 11:51 AM 15. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 16. Because 50% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.50)(0.50). a. True b. False ANSWER: False RATIONALE: The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!

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Chapter 09: The Cost of Capital POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/13/2018 11:52 AM 17. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22% ANSWER: b RATIONALE: Preferred stock price $97.50 Preferred dividend $8.50 Flotation cost 4.00% 9.08% rp = Dp/(Pp(1 − F)) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 18. A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

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Chapter 09: The Cost of Capital a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56% ANSWER: RATIONALE:

d Preferred stock price $92.50 Preferred dividend $8.00 Flotation cost 5.00% 9.10% rp = Dp/(Pp(1 − F)) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 19. Which of the following statements is CORRECT? a. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. b. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. c. When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. d. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the aftertax cost of debt. e. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings.

ANSWER: d RATIONALE: Statement d is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 50% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 50% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt.

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Chapter 09: The Cost of Capital POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 12/4/2018 7:33 PM 20. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.04 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 21. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 22. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 23. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common stock Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Knowledge 8/9/2018 11:03 AM 8/9/2018 11:03 AM

24. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of new common stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 25. The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvested earnings KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 26. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. a. True b. False ANSWER: True RATIONALE: Unfortunately, this is true.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity: CAPM KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 27. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity estimates KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 28. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.

Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital b. False ANSWER: RATIONALE:

False Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inflation and cap. costs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 29. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inflation and cap. costs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 30. When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM).

ANSWER: RATIONALE:

d By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 31. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72% ANSWER: a RATIONALE: 5.00% rRF 6.00% RPM b 1.05 11.30% rs = rRF + (RPM × b) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: CAPM KEYWORDS: Bloom’s: Application Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

32. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93% ANSWER: e RATIONALE: 4.10% rRF 5.25% RPM b 1.30 10.925% rs = rRF + (RPM × b) POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: CAPM KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets Current assets Net plant, property, and equipment Total assets

$ 38,000,000 101,000,000 $139,000,000

Liabilities and Equity Accounts payable Accruals Current liabilities Long-term debt (40,000 bonds, $1,000 par value) Total liabilities

$ 10,000,000 9,000,000 $ 19,000,000 40,000,000 $ 59,000,000

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Chapter 09: The Cost of Capital Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

33. Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock? a. 11.15% b. 11.73% c. 12.35% d. 13.00% e. 13.65% ANSWER: d RATIONALE: 5.50% rRF 11.50% Expected rM 6.00% RPM = Expected return on Market − rRF = b 1.25 13.00% rs = rRF + rRF(RPM × b) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Collins Group LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Keep problems referring to the Preface for the data for the Collins Grou together.

DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 34. Which of the following statements is CORRECT? a. If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. b. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. c. An advantage shared by both the dividend growth model and CAPM methods when they are used to estimate Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. d. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-riskpremium approach. e. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.06 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and dividend growth model (discounted cash flow, DCF) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 35. When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs. a. True b. False ANSWER: True RATIONALE: Unfortunately, this is true.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity: Dividend growth or discounted cash flow, DCF KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 36. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach?

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Chapter 09: The Cost of Capital a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51% ANSWER: RATIONALE:

c

$0.67 D1 $27.50 P0 g 8.00% 10.44% rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: dividend growth model or discounted cash flow, DCF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 37. To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59% ANSWER: d RATIONALE: $1.45 D1 P0 g rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 Copyright Cengage Learning. Powered by Cognero.

$22.50 6.50% 12.94%

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Chapter 09: The Cost of Capital NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: Dividend growth model, or discounted cash flow, DCF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 38. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings? a. 9.29% b. 9.68% c. 10.08% d. 10.50% e. 10.92% ANSWER: d RATIONALE: $0.90 D0 $27.50 P0 g 7.00% $0.963 D1 = D0 × (1 + g) 10.50% rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: Dividend growth model, or discounted cash flow, DCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 39. As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and gL = 8.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings? a. 10.69% b. 11.25% Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital c. 11.84% d. 12.43% e. 13.05% ANSWER: RATIONALE:

c

$0.80 D0 $22.50 P0 g 8.00% $0.864 D1 = D0 × (1 + g) 11.84% rs = D1/P0 + g POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: Dividend growth model, discounted cash flow, DCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 40. The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects? a. −1.49% b. −1.66% c. −1.84% d. −2.03% e. −2.23% ANSWER: c RATIONALE: Old Price New Price $0.85 $0.85 D0 $22.00 $40.00 P0 g 6.00% 6.00% $0.901 $0.901 D1 = D0 × (1 + g) 10.10% 8.25% rs = D1/P0 + g −1.84% Difference, rs0 − rs1 POINTS: DIFFICULTY: QUESTION TYPE:

1 Difficulty: Challenging Multiple Choice

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Chapter 09: The Cost of Capital HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.07 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: Dividend growth model, discounted cash flow, DCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 41. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Specific capital cost KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 42. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

capital United States - OH - Default City - TBA WACC Bloom’s: Knowledge 8/9/2018 11:03 AM 8/9/2018 11:03 AM

43. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. False ANSWER: False RATIONALE: In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered.

This is a specific situation, however, and not the "in general" case.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Specific capital cost KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 44. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T). a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 45. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taxes, cost of debt, and WACC KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 46. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

ANSWER: e RATIONALE: Statement e is true; interest payments on debt are tax deductible. The other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital components KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 47. Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A company must try to adjust its current actual market value weights toward its target weights. d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 50% of the dividends received by corporate investors are excluded from their taxable income.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital components KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 12/4/2018 6:51 PM 48. Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

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Chapter 09: The Cost of Capital e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 49. Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC. ANSWER: c RATIONALE: Statement c is true, because the cost of debt for WACC purposes = rd(1 − T), so if T increases, then rd(1 − T) declines.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 50. Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The required return on debt used in calculating a firm's WACC should be based on the debt's current required return even if it is higher than the debt's coupon rate. e. The WACC is calculated using before-tax costs for all components.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and cap. components KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 12/4/2018 6:59 PM 51. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

ANSWER: c RATIONALE: Statement c is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and cap. components KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 8/9/2018 11:03 AM

52. Which of the following statements is CORRECT? a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital components KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 53. Which of the following statements is CORRECT? a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. b. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock.

In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. c. Whether shareholders are already equity holders or are brand-new equity holders, they all have the

same required rate of return on stock. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital the project will be financed with equity.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 12/4/2018 6:42 PM 54. Which of the following statements is CORRECT? a. The dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the dividend growth model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The dividend growth model model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 8/9/2018 11:03 AM

55. Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12% ANSWER: b RATIONALE: Weights Costs Debt 40% 6.00% Preferred 15% 7.50% Common 45% 12.75% 9.26% WACC = wd × rd × (1 − T) + wp × rp + ws × rs POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 56. Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax rate is 25%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from reinvested earnings? a. 7.53% b. 7.85% c. 8.18% d. 8.50% e. 8.84% ANSWER: c RATIONALE: $2.50 D1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital g 5.50% $52.50 P0 7.50% rd Tax rate 25% 45% wd 55% ws 5.63% rd(1 − T) 10.26% rs = D1/P0 + g 8.18% WACC = wd(rd)(1 − T) + ws(rs) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:27 PM 57. Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 25%. The firm will not be issuing any new common stock. What is Avery's WACC? a. 8.49% b. 8.83% c. 9.19% d. 9.55% e. 9.94% ANSWER: a RATIONALE: Tax rate = 25% Weights AT Costs rd Debt 35% 6.50% 4.88% Preferred 10% 6.00% Common 55% 11.25% WACC 100% 8.49% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and target cap. struc.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:28 PM 58. The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman's balance sheet shows a total of noncallable $45 million longterm debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 25%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 1.42% b. 1.57% c. 1.75% d. 1.94% e. 2.16% ANSWER: e RATIONALE: $22.50 P0 Shares outstanding (millions) 10 bond coupon rate (not used) 7.00% 6.00% YTM = rd 14.00% rs Tax rate 25% BV debt (millions) $45.00 BV equity (millions) $65.00 MV debt (millions) $50.00 $225.00 MV equity (millions) = # sh × P0 = 4.50% AT cost of debt = rd(1 − T) Book value weights⎯WRONG!!!

Capital Weights Cost rates Product Debt $45.00 40.91% 4.50% 1.84% Equity $65.00 59.09% 14.00% 8.27% Total $110.00 100.00% WACC = 10.11%

Debt Equity Total POINTS:

Capital $50.00 $225.00 $275.00

Market value weights⎯RIGHT!!!

Weights Cost rates 18.18% 4.50% 81.82% 14.00% 100.00% WACC = Difference =

Product 0.82% 11.45% 12.27% 2.16%

1

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Chapter 09: The Cost of Capital DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and market cap. struc.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:31 PM 59. To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company's tax rate is 25%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC? a. 7.48% b. 7.88% c. 8.29% d. 8.73% e. 9.19% ANSWER: e RATIONALE: Coupon rate 8.00% Maturity 20 Bond price $1,050.00 Par value $1,000 Tax rate 25% 4.50% rRF 5.50% RPM b 1.20 35% wd 65% ws Bond yield 7.51% 5.63% rd(1 − T) 11.10% Cost of equity, rs = rRF + b(RPM) 9.19% WACC = wd(rd)(1 − T) + ws(rs) = POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and common from RE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:33 PM Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets Current assets Net plant, property, and equipment Total assets

$ 38,000,000 101,000,000 $139,000,000

Liabilities and Equity Accounts payable $ 10,000,000 Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

60. Refer to the data for the Collins Group. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC? a. 18.67% b. 19.60% c. 20.58% d. 21.61% e. 22.69% ANSWER: a RATIONALE: Bond price $875.00 Number of bonds 40,000 MV of debt = D $35,000,000 $15.25 Stock price = P0 Shares outstanding 10,000,000 MV of equity = E $152,500,000 Total MV = D + E $187,500,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital 18.67% Weight debt = wd = D/Total MV POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Collins Group LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Weights for WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Keep problems referring to the Preface for the data for the Collins Group together.

DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 61. Refer to the data for the Collins Group. What is the best estimate of the firm's WACC? a. 11.08% b. 11.42% c. 11.77% d. 12.13% e. 12.49% ANSWER: c RATIONALE: 18.67% wd 6.43% rd(1 − T) 81.33% wc = 100.00% − wd = 13.00% rs 11.77% WACC = wd(rd)(1 − T) + ws(rs) = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Collins Group LEARNING OBJECTIVES: FMTP.EHRH.20.09.08 - LO: 9-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital NOTES: DATE CREATED: DATE MODIFIED:

Keep problems referring to the Preface for the data for the Collins Group together.

8/9/2018 11:03 AM 1/27/2019 5:34 PM

62. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Flotation and capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 63. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)." a. True b. False ANSWER: False RATIONALE: This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.

Positive g Zero g Price $10.00 $10.00 Dividend $0.50 $0.50 Growth 6.00% 0.00% Flotation 5.00% 5.00% 11.00% 5.00% rs = D1/P0 + g 11.263% 5.263%Equal only if g = zero. re = D1/P0(1 − F) + g 11.579% 5.263% rs/(1 − F) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Cost of new common equity Bloom’s: Comprehension 8/9/2018 11:03 AM 8/9/2018 11:03 AM

64. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. a. True b. False ANSWER: True RATIONALE: This statement is true. Here are some illustrative numbers to demonstrate this point.

Positive g Zero g Price $10.00 $10.00 Dividend $0.50 $0.50 Growth 6.00% 0.00% Flotation 5.00% 5.00% 11.00% 5.00% rs = D1/P0 + g 11.263% 5.263%Equal only if g = zero. re = D1/P0(1 − F) + g 11.579% 5.263% rs/(1 − F) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of new common equity KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 65. Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? a. 12.70% b. 13.37% c. 14.04% d. 14.74% Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital e. 15.48% ANSWER: RATIONALE:

b

$3.50 Expected EPS1 Payout ratio 65% $2.275 Expected dividend, D1 = EPS × Payout Current stock price $32.50 g 6.00% F 5.00% 13.37% re = D1/(P0 × (1 − F)) + g POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of new common stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 66. You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; gL = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 9.06% b. 9.44% c. 9.84% d. 10.23% e. 10.64% ANSWER: c RATIONALE: $1.25 D1 P0 g F re = D1/(P0 × (1 − F)) + g = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

$27.50 5.00% 6.00% 9.84%

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Chapter 09: The Cost of Capital STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Cost of new common stock Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

67. You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; gL = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a. 10.77% b. 11.33% c. 11.90% d. 12.50% e. 13.12% ANSWER: b RATIONALE: $1.75 D1 $42.50 P0 g 7.00% F 5.00% 11.33% re = D1/(P0 × (1 − F)) + g POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of new common stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 68. As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from reinvested earnings? a. 0.09% b. 0.19% Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital c. 0.37% d. 0.56% e. 0.84% ANSWER: RATIONALE:

c

$2.75 Expected EPS1 Payout ratio 70% Current stk price $45.00 g 6.00% F 8.00% $1.925 D1 10.28% rs = D1/P0 + g 10.65% re = D1/(P0 × (1 − F)) + g 0.37% Difference = re − rs POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common stock vs. cost of new common equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 69. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

capital United States - OH - Default City - TBA Capital components Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 8/9/2018 11:03 AM

70. Which of the following statements is CORRECT? a. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. The WACC for a firm that pays dividends and regularly issues new equity will be greater than the WACC for an otherwise identical company that pays lower dividends and that rarely issues new equity. d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

ANSWER: c RATIONALE: Statement c is true⎯the WACC will increase if the firm raises more funds than can be supported by reinvested earnings.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 12/4/2018 7:29 PM 71. Assume that you are an intern with the Brayton Company, and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 25%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget? a. 7.34% b. 7.73% c. 8.14% Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital d. 8.56% e. 8.99% ANSWER: RATIONALE:

d YTM Tax rate D1 g P0 F wd ws

7.75% 40% $0.65 6.00% $15.00 10.0% 45% 55%

5.81% rd(1 − T) 10.81% re = D1/(P0 × (1 − F)) + g 8.56% WACC = wd(rd)(1 − T) + ws(rs) = POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.09 - LO: 9-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and new equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:35 PM 72. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False ANSWER: True RATIONALE: True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.10 - LO: 9-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Cost of equity: private cos.

Bloom’s: Comprehension 8/9/2018 11:03 AM 8/9/2018 11:03 AM

73. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. a. True b. False ANSWER: True RATIONALE: Unfortunately, this is true.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.10 - LO: 9-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity: BY + RP KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 74. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74% ANSWER: a RATIONALE: Bond yield 8.75% Risk premium 3.85% 12.60% rs = rd + Risk premium POINTS: DIFFICULTY: QUESTION TYPE:

1 Difficulty: Easy Multiple Choice

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Chapter 09: The Cost of Capital HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.10 - LO: 9-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of common: BY + RP KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 75. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.

They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Adjusting cap. costs for risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 76. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions.

Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return.

ANSWER: b RATIONALE: The correct answer is statement b. Division X should accept only projects with returns greater than 10%, while Division Y should accept only projects with returns greater than Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital 14%. Only statement b meets this criterion.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Divisional risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 77. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. c. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. e. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.

ANSWER: b RATIONALE: By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm's value will fall. Therefore, statement b is true and the other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted capital cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 78. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project.

Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Div. risk and projects KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 79. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. c. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

ANSWER: d RATIONALE: The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital.

This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta and project risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 80. Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

ANSWER: b POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.11 - LO: 9-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of capital concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 81. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. None of the projects should be accepted. d. All of the projects should be accepted. e. Project B, which is of below-average risk and has a return of 8.5%.

ANSWER: e RATIONALE: Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.12 - LO: 9-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and projects KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 82. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

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Chapter 09: The Cost of Capital b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

ANSWER: c RATIONALE: Statement c is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.12 - LO: 9-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and projects KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 83. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.

ANSWER: e RATIONALE: Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their riskadjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.

POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.12 - LO: 9-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted capital cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 84. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized.

ANSWER: c RATIONALE: Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their riskadjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement c is correct.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.12 - LO: 9-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted capital cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM

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Chapter 09: The Cost of Capital 85. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 25%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC). a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.13 - LO: 9-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Factors affecting WACC KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 1/27/2019 5:36 PM 86. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year.

ANSWER: a RATIONALE: Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.13 - LO: 9-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Factors affecting WACC KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 09: The Cost of Capital 87. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.09.13 - LO: 9-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Factors affecting WACC KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows 1. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC). a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.01 - LO: 10-01 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 2. Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 3. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 4. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 5. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive NPV. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Mutually exclusive projects Bloom’s: Knowledge 8/9/2018 11:03 AM 8/9/2018 11:03 AM

6. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive IRR. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mutually exclusive projects KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 7. When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not. a. True b. False ANSWER: False RATIONALE: Think about the following equally risky projects. The cost of capital is WACC = 10% 0 1 2 3 4 5 6 S −1,000 1,400 L −1,000 378.34 378.34 378.34 378.34 378.34 378.34 IRRS = 40.0% NPVS = $272.73 IRRL = 30.0% NPVL = $647.77 S has the higher IRR, but L has a much higher NPV and is therefore preferable. If the project could be repeated, though, S would turn out to be better⎯it would have both a higher NPV and IRR. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Mutually exclusive projects Bloom’s: Comprehension 8/9/2018 11:03 AM 8/9/2018 11:03 AM

8. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The lower the cost of capital used to calculate a project's NPV, the lower the calculated NPV will be. b. If a project's NPV is less than zero, then its IRR must be less than the cost of capital. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPV of a relatively low-risk project should be found using a relatively high cost of capital. e. A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the cost of capital.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 9. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The higher the cost of capital used to calculate the NPV, the lower the calculated NPV will be. b. If a project's NPV is greater than zero, then its IRR must be less than the cost of capital. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPVs of relatively risky projects should be found using relatively low costs of capital. e. A project's NPV is generally found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting the TV at the IRR to find its PV. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 10. Ellmann Systems is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: 9.00% Year 0 1 2 3 Cash flows −$1,000 $500 $500 $500 a. $265.65 b. $278.93 c. $292.88 d. $307.52 e. $322.90 ANSWER: a RATIONALE: WACC: 9.00% Year 0 1 2 3 Cash flows −$1,000 $500 $500 $500 NPV = $265.65 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 11. Scott Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: Year

11.00% 0

1

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2

3

4 Page 5

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Cash flows a. $77.49 b. $81.56 c. $85.86 d. $90.15 e. $94.66 ANSWER: RATIONALE:

−$1,000

$350

$350

$350

$350

c WACC: 11.00% Year 0 1 2 3 4 Cash flows −$1,000 $350 $350 $350 $350 NPV = $85.86 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 12. Robbins Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: 10.25% Year 0 1 2 Cash flows −$1,000 $300 $300 a. $105.89 b. $111.47 c. $117.33 d. $123.51 e. $130.01 ANSWER: e RATIONALE: WACC: 10.25% Year 0 Cash flows −$1,000 NPV = $130.01 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

3 $300

1 $300

4 $300

2 $300

5 $300

3 $300

4 $300

5 $300

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 13. Reed Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 10.00% Year 0 1 2 3 Cash flows −$1,050 $450 $460 $470 a. $92.37 b. $96.99 c. $101.84 d. $106.93 e. $112.28 ANSWER: a RATIONALE: WACC: 10.00% Year 0 1 2 3 Cash flows −$1,050 $450 $460 $470 NPV = $92.37 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 14. Patterson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: Year

10.00% 0

1

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2

3 Page 7

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Cash flows a. $54.62 b. $57.49 c. $60.52 d. $63.54 e. $66.72 ANSWER: RATIONALE:

−$950

$500

$400

$300

c WACC: 10.00% Year 0 1 2 3 Cash flows −$950 $500 $400 $300 NPV = $60.52 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 15. Yoga Center Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 14.00% Year 0 1 2 Cash flows −$1,200 $400 $425 a. $41.25 b. $45.84 c. $50.93 d. $56.59 e. $62.88 ANSWER: e RATIONALE: WACC: 14.00% Year 0 Cash flows −$1,200 NPV = $62.88 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

3 $450

1 $400

4 $475

2 $425

3 $450

4 $475

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 16. Dickson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 12.00% Year 0 1 2 3 4 5 Cash flows −$1,100 $400 $390 $380 $370 $360 a. $250.15 b. $277.94 c. $305.73 d. $336.31 e. $369.94 ANSWER: b RATIONALE: WACC: 12.00% Year 0 1 2 3 4 5 Cash flows −$1,100 $400 $390 $380 $370 $360 NPV = $277.94 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 17. Last month, Standard Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project took place, the Federal Reserve changed interest rates and therefore the firm's cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Old r: 10.00% New r: 11.25% Year 0 1 2 3 Cash flows −$1,000 $410 $410 $410 a. −$18.89 b. −$19.88 c. −$20.93 d. −$22.03 e. −$23.13 ANSWER: d RATIONALE: Old r: 10.00% New r: 11.25% Year 0 1 2 3 Cash flows −$1,000 $410 $410 $410 Old NPV = $19.61 New NPV = −$2.42 Change = −$22.03 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV sensitivity to WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 18. Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However, before the company decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm's cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.

Old r: 8.00% New r: 11.25% Year 0 1 2 3 Cash flows −$1,000 $410 $410 $410 a. −$59.03 b. −$56.08 c. −$53.27 d. −$50.61 e. −$48.08 ANSWER: a RATIONALE: Old r: 8.00% New r: 11.25% Year 0 1 2 Cash flows −$1,000 $410 $410 Old NPV = $56.61 New NPV = −$2.42 Change = −$59.03 Copyright Cengage Learning. Powered by Cognero.

3 $410

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.03 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV sensitivity to WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 19. The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 20. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA IRR Bloom’s: Knowledge 8/9/2018 11:03 AM 8/9/2018 11:03 AM

21. A project's IRR is independent of the firm's cost of capital. In other words, a project's IRR doesn't change with a change in the firm's cost of capital. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 22. Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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23. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 24. The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvestment rate assumption KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 25. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvestment rate assumption KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 26. The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvestment rate assumption KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 27. Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 28. An increase in the firm's cost of capital will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV and IRR KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 29. The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X. a. True b. False ANSWER: False RATIONALE: Project X may have a negative NPV if r > IRR. The NPV profile line crosses the horizontal axis, and the NPV at the cost of capital is in the lower right quadrant.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 30. Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV. a. True b. False ANSWER: False RATIONALE: We can see from the graph that S has the higher NPV if r > 0.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA NPV profiles Bloom’s: Comprehension 8/9/2018 11:03 AM 8/9/2018 11:03 AM

31. If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0. a. True b. False ANSWER: False RATIONALE: We do not know if the cost of capital is to the right or left of the crossover point. Therefore, NPVX may be either higher or lower than NPVY. POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 32. Which of the following statements is CORRECT? a. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. c. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. d. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects. e. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life.

ANSWER: d RATIONALE: The IRR would rank a project that cost $100 and had a 100% IRR ahead of a project that cost $1,000,000 and had an IRR of 90%. The larger project would increase the firm's value more, as the NPV would demonstrate.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 33. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by discounting the cash inflows at the cost of capital to find the present value (PV), then compounding this PV to find the IRR. b. If a project's IRR is greater than the WACC, then its NPV must be negative. c. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. d. To find a project's IRR, we must find a discount rate that is equal to the cost of capital. e. A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting this TV at the cost of capital.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 34. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the present value (PV), then discounting the TV to find the IRR. b. If a project's IRR is smaller than the cost of capital, then its NPV will be positive. c. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. d. If a project's IRR is positive, then its NPV must also be positive. e. A project's regular IRR is found by compounding the initial cost at the cost of capital to find the terminal value Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows (TV), then discounting the TV at the cost of capital.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 35. Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its MIRR must be positive. b. If a project has "normal" cash flows, then it will have exactly two real IRRs. c. The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life. d. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR. e. If a project has "normal" cash flows, then its IRR must be positive.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Normal vs. nonnormal CFs KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 36. Which of the following statements is CORRECT? a. Projects with "normal" cash flows can have two or more real IRRs. b. Projects with "normal" cash flows must have two changes in the sign of the cash flows, e.g., from negative to Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows positive to negative. If there are more than two sign changes, then the cash flow stream is "nonnormal." c. The "multiple IRR problem" can arise if a project's cash flows are "normal." d. Projects with "nonnormal" cash flows are almost never encountered in the real world. e. Projects with "normal" cash flows can have only one real IRR. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Normal vs. nonnormal CFs KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 37. Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of the time value of money. b. One defect of the IRR method is that it does not take account of the cost of capital. c. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. d. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid. e. One defect of the IRR method is that it does not take account of cash flows over a project's full life.

ANSWER: d RATIONALE: The IRR assumes reinvestment at the IRR, and that is generally not as valid as assuming reinvestment at the WACC, as with the NPV. POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvestment rate KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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38. Which of the following statements is CORRECT? a. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. b. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. c. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital. d. We cannot draw a project's NPV profile unless we know the appropriate cost of capital for use in evaluating the project's NPV. e. An NPV profile graph shows how a project's payback varies as the cost of capital changes.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 39. Which of the following statements is CORRECT? a. If the cost of capital declines, this lowers a project's NPV. b. The NPV method is regarded by most academics as being the best indicator of a project's profitability; hence, most academics recommend that firms use only this one method. c. A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the cost of capital, it does not matter if the cash flows occur early or late in the project's life. d. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project. e. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability.

ANSWER: d RATIONALE: Statement e is correct. The others are false. If you draw an NPV profile for one project, you will see that if the WACC is less than the IRR, the NPV will be positive.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV and IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 40. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. b. The IRR calculation implicitly assumes that all cash flows are reinvested at the cost of capital. c. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. d. If a project has normal cash flows and its IRR exceeds its cost of capital, then the project's NPV must be positive. e. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV and IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 41. Which of the following statements is CORRECT? a. If two projects are mutually exclusive, then they are likely to have multiple IRRs. b. If a project is independent, then it cannot have multiple IRRs. c. Multiple IRRs can occur only if the signs of the cash flows change more than once. d. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon. e. For a project to have more than one IRR, then both IRRs must be greater than the cost of capital.

ANSWER: c POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 42. Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the risk-free rate. c. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. d. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the IRR. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Reinvestment rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 43. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years. The two NPV profiles are given below:

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows

Which of the following statements is CORRECT? a. More of Project B's cash flows occur in the later years. b. We must have information on the cost of capital in order to determine which project has the larger early cash flows. c. The NPV profile graph is inconsistent with the statement made in the problem. d. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project's IRR. e. More of Project A's cash flows occur in the later years.

ANSWER: e RATIONALE: Statement e is true and the other statements are false. Distant cash flows are more severely penalized by high discount rates, so if the NPV profile line has a steep slope, this indicates that cash flows occur relatively late.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 44. Projects S and L are both normal projects with an initial cost of $10,000, followed by a series of positive cash inflows.

Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a cost of capital of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the cost of capital? a. Project L. b. Both projects are equally sensitive to changes in the cost of capital since their NPVs are equal at all costs of capital. c. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. d. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs. Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows e. Project S. ANSWER: RATIONALE:

a Statement a is true, while the other statements are false. Since Project L's undiscounted CFs are larger, they must occur in the more distant future, and since distant cash flows are impacted more by changes in the discount rate, L's NPV profile must be steeper. One can also see this in an NPV profile graph like the one in Question 50. The higher Y-axis intercept indicates more undiscounted CFs, and for the profiles to cross, the one with the higher intercept must be steeper.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 45. Projects C and D both have normal cash flows and are mutually exclusive. Project C has a higher NPV if the cost of capital is less than 12%, whereas Project D has a higher NPV if the cost of capital exceeds 12%. Which of the following statements is CORRECT? a. Project D is probably larger in scale than Project C. b. Project C probably has a faster payback. c. Project C probably has a higher IRR. d. The crossover rate between the two projects is below 12%. e. Project D probably has a higher IRR. ANSWER: e RATIONALE: The NPV profiles cross at 12%. To the left, or at lower discount rates, C has the higher NPV, so its slope is steeper, causing its profile to hit the X-axis sooner. This means that C has the lower IRR; hence, D has the higher IRR. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles Copyright Cengage Learning. Powered by Cognero.

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46. The cost of capital for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current cost of capital. However, you believe that money costs and thus your cost of capital will also increase. You also think that the projects will not be funded until the cost of capital has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. b. You should recommend Project R, because at the new cost of capital it will have the higher NPV. c. You should recommend Project K, because at the new cost of capital it will have the higher NPV. d. You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new cost of capital. e. You should reject both projects because they will both have negative NPVs under the new conditions.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 47. The cost of capital for two mutually exclusive projects that are being considered is 12%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 12% current cost of capital. Interest rates are currently high. However, you believe that money costs and thus your cost of capital will soon decline. You also think that the projects will not be funded until the cost of capital has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. b. You should recommend Project R, because at the new cost of capital it will have the higher NPV. c. You should recommend Project K, because at the new cost of capital it will have the higher NPV. d. You should recommend Project R because it will have both a higher IRR and a higher NPV under the new conditions. e. You should reject both projects because they will both have negative NPVs under the new conditions.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 48. Which of the following statements is CORRECT? a. If Project A's IRR exceeds Project B's, then A must have the higher NPV. b. A project's MIRR can never exceed its IRR. c. If a project with normal cash flows has an IRR less than the cost of capital, the project must have a positive NPV. d. If the NPV is negative, the IRR must also be negative. e. If a project with normal cash flows has an IRR greater than the cost of capital, the project must also have a positive NPV. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV, IRR, and MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 49. Which of the following statements is CORRECT? a. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. b. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. c. The higher the cost of capital, the shorter the discounted payback period.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows d. The MIRR method assumes that cash flows are reinvested at the crossover rate. e. The MIRR and NPV decision criteria can never conflict.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV, IRR, and MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 50. Which of the following statements is CORRECT? a. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the cost of capital to find the PV. b. The NPV and IRR methods both assume that cash flows can be reinvested at the cost of capital. However, the MIRR method assumes reinvestment at the MIRR itself. c. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years. e. For a project with normal cash flows, any change in the cost of capital will change both the NPV and the IRR. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV, IRR, and MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 51. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows a. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the cost of capital, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. b. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. c. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. d. Since cash flows under the IRR and MIRR are both discounted at the same rate (the cost of capital), these two methods always rank mutually exclusive projects in the same order. e. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not.

ANSWER: a RATIONALE: Statement a is correct, and the others are false. Cash flows from a project can be used to replace funds that would be raised in the market at the WACC, so the WACC is the opportunity cost for reinvested cash flows. Since the NPV assumes reinvestment at the WACC while the IRR assumes reinvestment at the IRR, NPV is generally the better method.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital budgeting: NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 52. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the cost of capital is 7%. Which of the following statements is CORRECT? a. If the cost of capital is 6%, Project S will have the higher NPV. b. If the cost of capital is 13%, Project S will have the lower NPV. c. If the cost of capital is 10%, both projects will have a negative NPV. d. Project S's NPV is more sensitive to changes in cost of capital than Project L's. e. If the cost of capital is 10%, both projects will have positive NPVs. ANSWER: e RATIONALE: The easiest way to think about this question is to begin by drawing an NPV profile as shown below, then using it to decide which statement is correct.

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Statement e is true, because both projects have an IRR greater than the WACC and thus will have a positive NPV. Statement a is false, because at 6%, the WACC is less than the crossover rate and Project L has a higher NPV than S. Statement b is false, because at 13% the WACC is greater than the crossover rate and S would have a higher NPV than L. Statement c is false, because of reasons mentioned in statement a. Statement d is false, because Project L's NPV profile is steeper, which means Project L's NPV is more sensitive to changes in WACC than Project S's NPV. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 53. Lancaster Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows.

Project A has an IRR of 11%, while Project B's IRR is 14%. When the cost of capital is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? a. If the cost of capital is 9%, Project A's NPV will be higher than Project B's. b. If the cost of capital is 6%, Project B's NPV will be higher than Project A's. c. If the cost of capital is greater than 14%, Project A's IRR will exceed Project B's. d. If the cost of capital is 9%, Project B's NPV will be higher than Project A's. e. If the cost of capital is 13%, Project A's NPV will be higher than Project B's.

ANSWER: d

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows RATIONALE:

Statement d is true, while the

others are false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 54. You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the cost of capital.

Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows. a. If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. The same project will rank higher by both criteria. b. If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. The same project will rank higher by both criteria. c. For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other. d. For a conflict to exist between NPV and IRR, one project must have an increasing stream of cash flows over time while the other has a decreasing stream. If both sets of cash flows are increasing or decreasing, then it would be impossible for a conflict to exist, even if one project is larger than the other. e. If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected.

ANSWER: a RATIONALE: Again, it is useful to draw NPV profiles that fit the description given in the question. Any numbers that meet the criteria will do.

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Statement a is true. Statement b is

false. Statement c is false because a conflict can result from differences in the timing of the cash flows. Statement d is false because scale differences can result in profile crossovers and thus conflicts. Statement e is false, because if the profiles do not cross, then one will dominate the other, with both a higher IRR and a higher NPV at every discount rate.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 55. Consider two projects, X and Y. Project X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the cost of capital is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is CORRECT? a. The crossover rate must be greater than 10%. b. If the cost of capital is 8%, Project X will have the higher NPV. c. If the cost of capital is 18%, Project Y will have the higher NPV. d. Project X is larger in the sense that it has the higher initial cost. e. The crossover rate must be less than 10%.

ANSWER: a RATIONALE: Again, it is useful to draw NPV profiles that fit the description given in the question. Any number that meets the criteria will do.

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As we can see from the graph,

statement a is true; the other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 56. You are on the staff of O'Hara Inc. The CFO believes project acceptance should be based on the NPV, but Andrew O'Hara, the president, insists that no project should be accepted unless its IRR exceeds the project's risk-adjusted cost of capital. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and −$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate cost of capital for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president? a. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the cost of capital. b. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the cost of capital. You should explain this to the president and tell him that the firm's value will increase if the project is accepted. c. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the cost of capital, which indicates that the firm's value will decline if the project is accepted. d. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the cost of capital, and that indicates that the firm's value will decline if it is accepted. e. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the cost of capital.

ANSWER: b RATIONALE: Statement b is true, while the other statements are false. It is not necessary to calculate the Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows two IRRs and the MIRR as the data in the problem are correct, but we show the Excel calculations below.

WACC 10% Years 0 1 2 CF −$15,000 $110,000 −$100,000 NPV $2,355.37 IRR1 6.33% IRR2 527.01% MIRR 11.32% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multiple IRRs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 57. Consider projects S and L. Both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same cost of capital, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT? a. If Project S has a positive NPV, Project L must also have a positive NPV. b. If the cost of capital falls, each project's IRR will increase. c. If the cost of capital increases, each project's IRR will decrease. d. If Projects S and L have the same NPV at the current cost of capital, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the cost of capital used to evaluate the projects declined. e. Project S must have a higher NPV than Project L. ANSWER: d RATIONALE: Refer to the NPV profile below. Statement a is false, because if the WACC is greater than IRRL but less than IRRS then Project S will have a positive NPV and Project L's NPV will be negative. Statements b and c are false, because IRR is independent of WACC. Statement d is true, because Project S has the higher IRR, so Project L's NPV profile is above Project S's when the WACC is less than the crossover rate. Statement e is false, because you do not know which project has the higher NPV unless you know the WACC.

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POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 58. Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky. a. If a project's IRR is equal to its cost of capital, then under all reasonable conditions, the project's IRR must be negative. b. If a project's IRR is equal to its cost of capital, then under all reasonable conditions the project's NPV must be zero. c. There is no necessary relationship between a project's IRR, its cost of capital, and its NPV. d. When evaluating mutually exclusive projects, those projects with relatively long lives will tend to have relatively high NPVs when the cost of capital is relatively high. e. If a project's IRR is equal to its cost of capital, then, under all reasonable conditions, the project's NPV must be negative.

ANSWER: b RATIONALE: Recall that the very definition of the IRR is the discount rate at which the NPV is zero.

Therefore, statement b is true. The other statements are false.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 59. Clifford Company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. The projects are equally risky. Which of the following statements is CORRECT? a. Since the smaller project has the higher IRR, the two projects' NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of the cost of capital. b. If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longerterm projects, regardless of how high or low the cost of capital is. c. Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the cost of capital is less than the crossover rate. d. Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects' NPV profiles will cross, and the smaller project will look better if the cost of capital is less than the crossover rate. e. Since the smaller project has the higher IRR, the two projects' NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of the cost of capital.

ANSWER: c

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows RATIONALE:

Statement c is true; the other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 60. Martin Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects.

Martin's cost of capital is 10%. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT? a. Since the projects are mutually exclusive, the firm should always select Project B. b. If the crossover rate is 8%, Project B will have the higher NPV. c. Only one project has a positive NPV. d. If the crossover rate is 8%, Project A will have the higher NPV. e. Each project must have a negative NPV. ANSWER: b RATIONALE: Statement b is true, while the other statements are false. If we draw an NPV profile graph, we would see that A must have the steeper slope. If the crossover is 8% and the WACC is 10%, then B will have the higher NPV. POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles Copyright Cengage Learning. Powered by Cognero.

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61. Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and B's IRR is 20%. The company's cost of capital is 12%, and at that rate Project A has the higher NPV. Which of the following statements is CORRECT? a. Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale). b. Assuming the two projects have the same scale, Project B probably has a faster payback than Project A. c. The crossover rate for the two projects must be 12%. d. Since B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the cost of capital of 12%. e. The crossover rate for the two projects must be less than 12%.

ANSWER: b RATIONALE: Consider the following NPV profile graph:

We can see that statements c, d, and e are incorrect. Statement a is also incorrect, because if the projects have the same timing pattern, then A must have the higher cost. That leaves statement b as being correct, and that conclusion is confirmed by noting that since A have the steeper slope, its cash flows must come in slower; hence, B's cash flows come in more quickly and thus has the faster payback.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV profiles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 62. Hart Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital or negative, in both cases it will be rejected.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Year Cash flows a. 12.55% b. 13.21% c. 13.87% d. 14.56% e. 15.29% ANSWER: RATIONALE:

0 −$1,000

1 $425

2 $425

3 $425

b Year 0 1 2 3 Cash flows −$1,000 $425 $425 $425 IRR = 13.21% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 63. Spence Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital or negative, in both cases it will be rejected.

Year Cash flows a. 14.05% b. 15.61% c. 17.34% d. 19.27% e. 21.20% ANSWER: RATIONALE:

0 −$1,050

1 $400

2 $400

d Year 0 1 Cash flows −$1,050 $400 IRR = 19.27% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 Copyright Cengage Learning. Powered by Cognero.

3 $400

4 $400

2 $400

3 $400

4 $400

Page 39

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 64. Nichols Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital or negative, in both cases it will be rejected.

Year Cash flows a. 9.43% b. 9.91% c. 10.40% d. 10.92% e. 11.47% ANSWER: RATIONALE:

0 −$1,250

1 $325

2 $325

3 $325

4 $325

5 $325

a Year 0 1 2 3 4 5 Cash flows −$1,250 $325 $325 $325 $325 $325 IRR = 9.43% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 65. Kiley Electronics is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 9.70% b. 10.78%

0 −$1,100

1 $450

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2 $470

3 $490

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows c. 11.98% d. 13.31% e. 14.64% ANSWER: RATIONALE:

d Year 0 1 2 3 Cash flows −$1,100 $450 $470 $490 IRR = 13.31% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 66. Modern Refurbishing Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 13.13% b. 14.44% c. 15.89% d. 17.48% e. 19.22% ANSWER: RATIONALE:

0 −$850

1 $300

2 $290

3 $280

4 $270

a Year 0 1 2 3 4 Cash flows −$850 $300 $290 $280 $270 IRR = 13.13% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

IRR Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

67. Pet World is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 2.08% b. 2.31% c. 2.57% d. 2.82% e. 3.10% ANSWER: RATIONALE:

0 −$9,500

1 $2,000

2 $2,025

3 $2,050

4 $2,075

5 $2,100

c Year 0 1 2 3 4 5 Cash flows −$9,500 $2,000 $2,025 $2,050 $2,075 $2,100 IRR = 2.57% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 68. Current Design Co. is considering two mutually exclusive, equally risky, and not repeatable projects, S and L. Their cash flows are shown below. The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost. r: 7.50% Year 0 −$1,100 CFS −$2,700 CFL a. $138.10

1 $550 $650

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2 $600 $725

3 $100 $800

4 $100 $1,400 Page 42

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows b. $149.21 c. $160.31 d. $171.42 e. $182.52 ANSWER: RATIONALE:

a First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR information is not needed for this problem. We then see what NPV would result if the decision were based on the IRR (and the MIRR). The difference between the NPVs is the loss incurred if the IRR criterion is used. Of course, it's possible that IRR could choose the correct project.

WACC: 7.5000% Year 0 1 2 3 4 TV MIRR −$1,100 $550 $600 $100 $100 CFS Compounded CFs: 683.26 693.38 107.50 100.00 $1,584.14 9.5469% −$2,700 $650 $725 $800 $1,400 CFL Compounded CFs: 807.49 837.83 860.00 1,400.00 $3,905.32 9.6663% Δ −$1,600 $100 $125 $700 $1,300 Crossover rate = 10.16% At interest rates < crossover rate, conflict exists.

9.67%IRRL = 10.71181%NPVL = $224.3065 MIRRL = 9.55%IRRS = 12.24157%NPVS = $86.2036 MIRRS = MIRR Choice: LIRR Choice: SNPV Choice: L NPV using MIRR: $224.31NPV using IRR: $86.20NPV using NPV: $224.31 Lost value using IRR versus MIRR: $138.10 Lost value using MIRR versus NPV: $0.00 Lost value using IRR versus NPV: $138.10 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 69. Murray Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise Murray on the best procedure. If the wrong decision criterion is used, how much potential value would Murray lose? r: 6.00% Year 0

1

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2

3

4 Page 43

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows CFS CFL a. $188.68 b. $198.61 c. $209.07 d. $219.52 e. $230.49 ANSWER: RATIONALE:

−$1,025 −$2,150

$380 $765

$380 $765

c WACC: 6.000% Year 0 −$1,025 CFS −$2,150 CFL Δ −$1,125 Crossover rate = 13.86% 15.781% IRRL 17.861% IRRS NPVL NPVS

0% 2% 4% 6% 8% 10% 12% Copyright Cengage Learning. Powered by Cognero.

$380 $765

1 $380 $765 $385

$380 $765

2 3 4 $380 $380 $380 $765 $765 $765 $385 $385 $385 At interest rates < crossover rate, conflict exists.

$500.81 $291.74 $209.07= Value lost if use the IRR criterion

S 291.7 495.0 421.9 354.4 291.7 233.6 179.5 129.2

L 500.8 910.0 762.9 626.9 500.8 383.8 274.9 173.6 Page 44

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows 13.860% 85.4 85.4 14% 82.2 79.0 16% 38.3 −9.4 18% −2.8 −92.1 20% −41.3 −169.6 22% −77.4 −242.4 24% −111.4 −310.7 Note that the WACC is constrained to be less than the crossover rate. So, there is a conflict between NPV and IRR; hence, following the IRR rule results in a loss of value. In the next problem the constraint is relaxed.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 70. Projects S and L, whose cash flows are shown below, are mutually exclusive, equally risky, and not repeatable.

Hooper Inc. is considering which of these two projects to undertake. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used. r: 10.25% Year 0 1 2 −$2,050 $750 $760 CFS −$4,300 $1,500 $1,518 CFL a. $134.79 b. $141.89 c. $149.36 d. $164.29 e. $205.36 ANSWER: c RATIONALE: WACC: 10.25% Year 0 −$2,050 CFS −$4,300 CFL Δ −$2,250 Copyright Cengage Learning. Powered by Cognero.

3 $770 $1,536

1 $750 $1,500 $750

4 $780 $1,554

2 $760 $1,518 $758

3 $770 $1,536 $766

4 $780 $1,554 $774 Page 45

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Crossover rate = 13.275% At interest rates < crossover rate, conflict exists.

15.58% IRRL 18.06% IRRS $507.40 $358.05 $149.36= Value lost if use the IRR criterion Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM NPVL NPVS

71. Markman & Sons is considering Projects S and L. These projects are mutually exclusive, equally risky, and not repeatable and their cash flows are shown below. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, i.e., no conflict will exist. r: 10.00% Year 0 1 2 3 4 −$1,025 $650 $450 $250 $50 CFS −$1,025 $100 $300 $500 $700 CFL a. $5.47 b. $6.02 c. $6.62 d. $7.29 e. $7.82 ANSWER: e RATIONALE: WACC: 10.000% Year 0 1 2 3 −$1,025 $650 $450 $250 CFS −$1,025 $100 $300 $500 CFL Δ $0 −$550 −$150 $250 Crossover rate = 10.549% At interest rates < crossover rate, conflict exists.

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4 $50 $700 $650 Page 46

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows IRRL IRRS

15.66% 19.86%

$167.61 $159.79 $7.82= Value lost if use the IRR criterion Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM NPVL NPVS

72. Carolina Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost. r: 7.75% Year 0 1 2 3 4 −$1,050 $675 $650 CFS −$1,050 $360 $360 $360 $360 CFL a. $11.45 b. $12.72 c. $14.63 d. $16.82 e. $19.35 ANSWER: b RATIONALE: WACC: 7.75% Year 0 1 2 3 −$1,050 $675 $650 CFS −$1,050 $360 $360 $360 CFL Δ $0 −$315 −$290 $360 Crossover rate = 8.994% At interest rates < crossover rate, conflict exists.

13.95% IRRL Copyright Cengage Learning. Powered by Cognero.

4 $360 $360

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows 17.13%

IRRS

$149.03 $136.31 $12.72= Value lost if use the IRR criterion Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM NPVL NPVS

73. Silverman Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost. r: 8.75% Year 0 1 −$1,100 $375 CFS −$2,200 $725 CFL a. $32.12 b. $35.33 c. $38.87 d. $40.15 e. $42.16 ANSWER: d WACC: 8.750% RATIONALE: Year CFS

0 −$1,100

CFL

−$2,200

Δ

−$1,100

2 $375 $725

1 $375 482.30 $725 932.45 $350

3 $375 $725

2 $375 443.50 $725 857.43 $350

4 $375 $725

3 $375 407.81 $725 788.44 $350

4 $375 375.00 $725 725.00 $350

TV

MIRR

$1,708.61

11.64%

$3,303.31

10.70%

Crossover rate = 10.396% Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows MIRRL MIRRS

10.70% 11.64%

$161.74 $121.59 $ 40.15= Value lost if use the MIRR criterion Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the MIRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM NPVL NPVS

74. Farmer Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. r =10.25% Year 0 1 −$950 $500 CFS −$2,100 $400 CFL a. $24.14 b. $26.82 c. $29.80 d. $33.11 e. $36.42 ANSWER: d RATIONALE: WACC: Year CFS CFL Cumulative CFS Cumulative CFL Copyright Cengage Learning. Powered by Cognero.

2 $800 $800

3 $0 $800

10.250% 0 −$950 −$2,100 −$950 −$2,100

1 $500 $400 −$450 −$1,700

4 $0 $1,000

2 $800 $800 $350 −$900

3 $0 $800 $350 −$100

4 $0 $1,000 $350 $900 Page 49

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Δ −$1,150 −$100 $0 $800 $1,000 Crossover rate = 11.093% At interest rates < crossover rate, conflict exists. − − 1.56 − − PaybackS = 1.56 − − − − 3.10 PaybackL = 3.10 $194.79 NPVL = $161.68 NPVS = Value lost $ 33.11 Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and payback; hence following the IRR rule may not result in a loss of value, so the correct answer may be $0.00.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. payback KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 75. Langton Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone. In other words, what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost. r =7.00% Year CFS CFL a. $185.90 b. $197.01 c. $208.11 d. $219.22 e. $230.32 ANSWER: RATIONALE:

0 −$1,100 −$2,750

1 $550 $725

2 $600 $725

3 $100 $800

4 $100 $1,400

a First, recognize that NPV makes theoretically correct capital budgeting decisions, so the higher NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs. We then see what NPV would result if the decision were based on the IRR and the MIRR. Under some conditions, MIRR will choose the project with the higher NPV while the IRR chooses the lower NPV project. Then, the difference between the NPVs is the

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows loss incurred if the IRR criterion is used. Of course, it's possible that both the MIRR and the IRR could choose the wrong project; with this set of cash flows, that happens at 8.62133% < WACC < 10.53093%.

WACC: Year CFS Compounded CFs: CFL Compounded CFs: Δ

7.00% 0 1 −$1,100 $550 673.77 686.94 −$2,750 $725 888.16 830.05 −$1,650 $175

Crossover rate = 10.53093% MIRRS = MIRRL = MIRR Choice: NPV based on MIRR:

2 $600 107.00 $725 856.00 $125

3 $100 100.00 $800 1,400.00 $700

4 $100 $1,567.71 $1,400 $3,974.21 $1,300

TV

IRR/MIRR 12.2416% 9.2618% 10.9810% 9.6426%

At interest rates < crossover rate, conflict exists between IRR and NPV.

9.2618%IRRS = 9.6426%IRRL = LIRR Choice: NPV based on $281.90IRR:

12.2416%NPVS = 10.9810%NPVL = SNPV Choice: NPV using $96.00NPV:

$96.00 $281.90 L $281.90

Lost value using IRR versus MIRR: NPVL − NPVS = $185.90 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.04 - LO: 10-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IRR vs. MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 76. For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Modified IRR Bloom’s: Knowledge 8/9/2018 11:03 AM 8/9/2018 11:03 AM

77. Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Modified IRR KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 78. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Modified IRR KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 79. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 80. The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 81. The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is less than the projects' cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 82. No conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital exceeds the rate at which the projects' NPV profiles cross. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV vs. IRR KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 83. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows. a. A project's MIRR is always less than its regular IRR. b. If a project's IRR is greater than its cost of capital, then its MIRR will be greater than the IRR. c. To find a project's MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost. d. To find a project's MIRR, the textbook procedure compounds cash inflows at the cost of capital and then finds the discount rate that causes the PV of the terminal value to equal the initial cost. e. A project's MIRR is always greater than its regular IRR. ANSWER: d RATIONALE: Answer d is essentially the definition of the MIRR; hence, it is correct.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 84. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's MIRR is always less than its regular IRR. b. If a project's IRR is greater than its cost of capital, then the MIRR will be less than the IRR. c. If a project's IRR is greater than its cost of capital, then the MIRR will be greater than the IRR. d. To find a project's MIRR, we compound cash inflows at the IRR and then discount the terminal value back to t = 0 at the cost of capital. e. A project's MIRR is always greater than its regular IRR. ANSWER: b RATIONALE: One could prove that (1) if the IRR is equal to the WACC, then the MIRR and the IRR will be equal, (2) if the IRR is greater than the WACC, the MIRR will be less than the IRR, and (3) the MIRR will be greater than the IRR if the IRR is less than the WACC. This situation exists because the MIRR assumes reinvestment at the WACC and therefore compounds at that rate, while the IRR assumes reinvestment at the IRR itself and therefore compounds at the IRR. Therefore, if the IRR exceeds the WACC, the TV found under the IRR method will be larger, and vice versa. The IRR and the MIRR are found as the rate that causes the PV of the TV to equal the cost. Therefore, if the IRR exceeds the WACC, causing the IRR's TV to be larger, then the IRR will exceed the MIRR, and vice versa. As a result, statement b is correct⎯if the IRR exceeds the WACC, the IRR will exceed the MIRR. The other statements are false. Note too that this answer could also be confirmed with a numerical example.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows 85. Computer Consultants Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r =10.00% Year 0 1 2 3 Cash flows −$1,000 $450 $450 $450 a. 9.32% b. 10.35% c. 11.50% d. 12.78% e. 14.20% ANSWER: e RATIONALE: WACC: 10.00% Year 0 1 2 3 Cash flows −$1,000 $450 $450 $450 Compounded values, FVs $544.50 $495.00 $450.00 TV = Sum of compounded inflows: $1,489.50 Found as discount rate that equates PV of TV to cost, discounted back MIRR = 14.20% 3 years @ WACC MIRR = 14.20% Alternative calculation, using Excel's MIRR function POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 86. Wiley's Wire Products is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r =11.00% Year 0 Cash flows −$800 a. 8.86% b. 9.84% c. 10.94% d. 12.15%

1 $350

Copyright Cengage Learning. Powered by Cognero.

2 $350

3 $350

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows e. 13.50% ANSWER: RATIONALE:

e WACC: 11.00% Year 0 1 2 3 Cash flows −$800 $350 $350 $350 Compounded values, FVs $431.24 $388.50 $350.00 TV = Sum of compounded inflows: $1,169.74 Found as discount rate that equates PV of TV to cost, discounted back MIRR = 13.50% 3 years @ WACC MIRR = 13.50% Alternative calculation, using Excel's MIRR function POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 87. Watts Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r = 10.00% Year 0 1 2 3 4 Cash flows −$850 $300 $320 $340 $360 a. 14.08% b. 15.65% c. 17.21% d. 18.94% e. 20.83% ANSWER: b RATIONALE: WACC: 10.00% Year 0 1 2 3 4 Cash flows −$850 $300 $320 $340 $360 Compounded values $399.30 $387.20 $374.00 $360.00 TV = Sum of comp'ed inflows: $1,520.50 Found as discount rate that equates PV of TV to cost, discounted back MIRR = 15.65% 4 years @ WACC MIRR = 15.65% Alternative calculation, using Excel's MIRR function POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 88. Westwood Painting Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r = 12.25% Year 0 1 2 3 4 Cash flows −$850 $300 $320 $340 $360 a. 13.42% b. 14.91% c. 16.56% d. 18.22% e. 20.04% ANSWER: c RATIONALE: WACC: 12.25% Year 0 1 2 3 4 Cash flows −$850 $300 $320 $340 $360 Compounded values $424.31 $403.20 $381.65 $360.00 TV = Sum of comp'ed inflows: $1,569.16 Found as discount rate that equates PV of TV to cost, discounted back MIRR = 16.56% 4 years @ WACC MIRR = 16.56% Alternative calculation, using Excel's MIRR function POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.05 - LO: 10-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MIRR KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

89. One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback period KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 90. The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. a. True b. False ANSWER: False RATIONALE: The discounted payback corrects the fault of not considering the timing of cash flows, but it does not correct for the nonconsideration of after-payback cash flows.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discounted payback KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 91. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows a. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money. b. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. c. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. d. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. e. The regular payback method recognizes all cash flows over a project's life.

ANSWER: c RATIONALE: Statement d is true. The payback does indicate how long it should take to recover the investment; hence, it is a measure of liquidity.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 92. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money. b. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. c. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. d. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time. e. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 93. Which of the following statements is CORRECT? a. One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. b. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. c. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. d. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback. e. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 94. Which of the following statements is NOT a disadvantage of the regular payback method? a. Ignores cash flows beyond the payback period. b. Does not directly account for the time value of money. c. Does not provide any indication regarding a project's liquidity or risk. d. Does not take account of differences in size among projects. e. Lacks an objective, market-determined benchmark for making decisions.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 95. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). b. The firm will accept too many projects in all economic states because a 4-year payback is too low. c. The firm will accept too few projects in all economic states because a 4-year payback is too high. d. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak. e. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

ANSWER: d RATIONALE: Statement d is correct. In a weak economy, the interest rates and the WACC are likely to be low, and these conditions favor long-term projects. But the constant 4-year payback would not recognize this situation.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 96. Which of the following statements is CORRECT? a. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. b. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows regular IRR. c. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. d. The percentage difference between the MIRR and the IRR is equal to the project's cost of capital. e. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV, IRR, and MIRR KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 97. Which of the following statements is CORRECT? a. The discounted payback method eliminates all of the problems associated with the payback method. b. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. c. To find the MIRR, we discount the TV at the IRR. d. A project's NPV profile must intersect the X-axis at the project's cost of capital. e. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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8/9/2018 11:03 AM

98. McGlothin Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 1.86 years b. 2.07 years c. 2.30 years d. 2.53 years e. 2.78 years ANSWER: RATIONALE:

0 −$1,150

1 $500

2 $500

c Year Cash flows Cumulative CF

3 $500

0 −$1,150 −$1,150

1 $500 −$650

2 $500 −$150

3 $500 $350

Payback = 2.30 years − − − 2.30 Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 99. Garner Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 1.42 years b. 1.58 years c. 1.75 years d. 1.93 years e. 2.12 years ANSWER: RATIONALE:

0 −$350

1 $200

c Year Cash flows Cumulative CF

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2 $200

3 $200

0 −$350 −$350

1 $200 −$150

2 $200 $50

3 $200 $250 Page 64

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Payback = 1.75 years − − 1.75 − Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 100. Worthington Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.03 years b. 2.25 years c. 2.50 years d. 2.75 years e. 3.03 years ANSWER: RATIONALE:

0 −$500

1 $150

c Year Cash flows Cumulative CF

2 $200

3 $300

0 −$500 −$500

1 $150 −$350

2 $200 −$150

3 $300 $150

Payback = 2.50 years − − − 2.50 Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

101. Poder Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 1.91 years b. 2.12 years c. 2.36 years d. 2.59 years e. 2.85 years ANSWER: RATIONALE:

0 −$750

1 $300

2 $325

c Year Cash flows Cumulative CF

3 $350

0 −$750 −$750

1 $300 −$450

2 $325 −$125

3 $350 $225

Payback = 2.36 years − − − 2.36 Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 102. Suzanne's Cleaners is considering a project that has the following cash flow data. What is the project's payback?

Year 0 Cash flows −$1,100 a. 2.31 years b. 2.56 years c. 2.85 years d. 3.16 years e. 3.52 years

1 $300

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2 $310

3 $320

4 $330

5 $340

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows ANSWER: RATIONALE:

e Year Cash flows Cumulative CF

0 −$1,100 −$1,100

1 $300 −$800

2 $310 −$490

3 $320 −$170

4 $330 $160

5 $340 $500

Payback = 3.52 years − − − − 3.52 − POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payback KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 103. Craig's Car Wash Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's discounted payback? r = 10.00% Year 0 1 Cash flows −$900 $500 a. 1.88 years b. 2.09 years c. 2.29 years d. 2.52 years e. 2.78 years ANSWER: b RATIONALE: WACC: Year Cash flows PV of CFs Cumulative CF

2 $500

3 $500

10.00% 0 −$900 −$900 −$900

Payback = 2.09 years − POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

1 $500 $455 −$445

2 $500 $413 −$32

3 $500 $376 $343

−

−

2.09

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Discounted payback Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:03 AM 8/9/2018 11:03 AM

104. Shannon Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's discounted payback? r = 10.00% Year 0 1 Cash flows −$950 $525 a. 1.61 years b. 1.79 years c. 1.99 years d. 2.22 years e. 2.44 years ANSWER: d RATIONALE: WACC: Year Cash flows PV of CFs Cumulative CF

2 $485

10.00% 0 −$950 −$950 −$950

3 $445

1 $525 $477 −$473

4 $405

2 $485 $401 −$72

3 $445 $334 $262

4 $405 $277 $539

Payback = 2.22 years − − − 2.22 − POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.07 - LO: 10-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discounted payback KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 105. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.08 - LO: 10-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital budgeting methods KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 106. If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake. a. True b. False ANSWER: False RATIONALE: One project might have cash flows that extend well past the payback year, leading to different rankings.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.08 - LO: 10-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital budgeting methods KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 107. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's NPV increases as the cost of capital declines. b. A project's MIRR is unaffected by changes in the cost of capital. c. A project's regular payback increases as the cost of capital declines. d. A project's discounted payback increases as the cost of capital declines. e. A project's IRR increases as the cost of capital declines.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.08 - LO: 10-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital budgeting methods KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM 108. Which of the following statements is CORRECT? a. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.10.08 - LO: 10-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital budgeting methods KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 8/9/2018 11:03 AM

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Chapter 11: Cash Flow Estimation and Risk Analysis 1. Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow estimation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 2. Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow estimation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 3. Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.

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Chapter 11: Cash Flow Estimation and Risk Analysis a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow estimation KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 4. Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 5. If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 6. If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 7. Any cash flows that can be classified as incremental to a particular project⎯i.e., results directly from the decision to undertake the project⎯should be reflected in the capital budgeting analysis. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 8. We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Externalities KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 9. In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Externalities Bloom’s: Knowledge 8/9/2018 11:04 AM 8/9/2018 11:04 AM

10. Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision⎯estimates of its effect would really just be guesses. In this case, the externality should be ignored⎯i.e., not considered at all⎯because if it were considered it would make the analysis appear more precise than it really is. a. True b. False ANSWER: False RATIONALE: If the externality is potentially important, it should not be ignored, because then a large error might be made. At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of the possible effects of the externality.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Externalities KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 11. Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Cash flow estimation Bloom’s: Comprehension 8/9/2018 11:04 AM 8/9/2018 11:04 AM

12. 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 often used for such projects along with discounted cash flow analysis. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow estimation KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 13. The two cardinal rules that financial analysts should follow to avoid capital budgeting errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Relevant cash flows Bloom’s: Comprehension 8/9/2018 11:04 AM 8/9/2018 11:04 AM

14. Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opportunity costs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 15. Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sunk costs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis 16. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? a. Shipping and installation costs. b. Cannibalization effects. c. Opportunity costs. d. Sunk costs that have been expensed for tax purposes. e. Changes in net working capital.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow issues KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 17. Which of the following statements is CORRECT? a. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. b. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. c. Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project. d. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores. e. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Sunk costs Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

18. Which of the following statements is CORRECT? a. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. b. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices. c. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. d. If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be. e. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sunk costs KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 19. Which of the following statements is CORRECT? a. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. b. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. c. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. d. Identifying an externality can never lead to an increase in the calculated NPV. e. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

ANSWER: a POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Externalities KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 20. Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. b. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. c. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. d. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself. e. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Externalities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 21. The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

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Chapter 11: Cash Flow Estimation and Risk Analysis a. All sunk costs that have been incurred relating to the project. b. All interest expenses on debt used to help finance the project. c. The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life. d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. e. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 22. Which of the following factors should be included in the cash flows used to estimate a project's NPV? a. Interest on funds borrowed to help finance the project. b. The end-of-project recovery of any working capital required to operate the project. c. Cannibalization effects, but only if those effects increase the project's projected cash flows. d. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. e. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Relevant cash flows Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

23. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. b. The value of a building owned by the firm that will be used for this project. c. A decline in the sales of an existing product, provided that decline is directly attributable to this project. d. The salvage value of assets used for the project that will be recovered at the end of the project's life. e. Changes in net working capital attributable to the project.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 24. While developing a new product line, Cook Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Cook owns the building free and clear⎯there is no mortgage on it. Which of the following statements is CORRECT? a. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. b. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. c. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. d. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. e. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

ANSWER: a POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 25. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. b. The company has spent and expensed $1 million on R&D associated with the new project. c. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. d. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. e. The new project is expected to reduce sales of one of the company's existing products by 5%.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 26. Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

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Chapter 11: Cash Flow Estimation and Risk Analysis a. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. b. The company has spent and expensed for tax purposes $3 million on research related to the new detergent.

These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. c. The new product will cut into sales of some of the firm's other products. d. If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project's life. e. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 27. Which of the following rules is CORRECT for capital budgeting analysis? a. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. b. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. c. A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted. d. If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis. e. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 28. Which of the following statements is CORRECT? a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. b. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. c. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. d. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. e. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. ANSWER: c RATIONALE: Regarding e and a, note that since interest should not be considered, exclusion will not lead to any type of bias, positive or negative.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis DATE MODIFIED:

8/9/2018 11:04 AM

29. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. b. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. c. A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. d. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. e. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Incremental cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 30. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. Revenues from an existing product would be lost as a result of customers switching to the new product. b. Shipping and installation costs associated with a machine that would be used to produce the new product. c. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. d. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm. e. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Incremental cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 31. Which of the following statements is CORRECT? a. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase. b. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. c. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. d. Identifying an externality can never lead to an increase in the calculated NPV. e. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.01 - LO: 11-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Externalities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 32. Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in NWC KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 33. The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 34. The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 35. Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 36. A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 37. Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 38. The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Net working capital Bloom’s: Comprehension 8/9/2018 11:04 AM 8/9/2018 11:04 AM

39. The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation cash flows KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 40. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. b. Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. c. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. d. Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV. e. Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 41. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. b. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. c. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV. d. Using accelerated depreciation rather than straight line normally has no effect on a project's total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project. e. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 42. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. b. If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. c. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

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Chapter 11: Cash Flow Estimation and Risk Analysis d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes. e. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 43. To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is CORRECT? a. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. b. When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. c. Capital budgeting decisions should be based on before-tax cash flows. d. The cost of capital used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. e. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the cost of capital. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

New project cash flows Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

44. Which of the following statements is CORRECT? a. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. b. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life. c. If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. d. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in longterm assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. e. If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CFs and accounting measures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 45. You have just landed an internship in the CFO's office of Hawkesworth Inc. Your first task is to estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?

Sales revenues Depreciation Other operating costs Tax rate Copyright Cengage Learning. Powered by Cognero.

$13,000 $4,000 $6,000 25.0% Page 24

Chapter 11: Cash Flow Estimation and Risk Analysis a. $6,250 b. $6,406 c. $6,566 d. $6,731 e. $6,899 ANSWER: RATIONALE:

a Sales revenues $13,000 − Operating costs (excl. deprec.)

6,000 − Depreciation 4,000 Operating income (EBIT) $ 3,000 − Taxes Rate = 25% 750 After-tax EBIT $ 2,250 + Depreciation 4,000 Cash flow, Year 1 $ 6,250 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 7:54 PM 46. In your first job with TBL Inc. your task is to consider a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues Depreciation Other operating costs Tax rate a. $9,115 b. $9,397 c. $9,688 d. $9,978 e. $10,277 ANSWER:

$22,250 $8,000 $12,000 25.0%

c

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Chapter 11: Cash Flow Estimation and Risk Analysis RATIONALE:

Sales revenues $22,250 − Operating costs (excl. deprec.)

12,000 − Depreciation 8,000 Operating income (EBIT) $ 2,250 − Taxes Rate = 25% 563 After-tax EBIT $ 1,688 + Depreciation 8,000 Cash flow, Year 1 $ 9,688 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 7:56 PM 47. Fitzgerald Computers is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?

Equipment cost (depreciable basis) Straight-line depreciation rate Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. $29,351 b. $30,103 c. $30,875 d. $31,667 e. $32,458 ANSWER: d RATIONALE: Equipment life, years Equipment cost Depreciation:

$65,000 33.333% $60,000 $25,000 25.0%

Rate = 33.333%

3 $65,000 $21,667

Sales revenues

$60,000

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Chapter 11: Cash Flow Estimation and Risk Analysis − Basis × rate = depreciation 21,667 − Operating costs (excl. deprec.)

25,000 Operating income (EBIT) $13,333 − Taxes Rate = 25.0% 3,333 After-tax EBIT $10,000 + Depreciation 21,667 Cash flow, Year 1 $31,667 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 7:59 PM 48. VR Corporation has the opportunity to invest in a new project, the details of which are shown below. What is the Year 1 cash flow for the project?

Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate a. $17,614 b. $18,541 c. $19,517 d. $20,544 e. $21,625 ANSWER: RATIONALE:

$42,500 $10,000 $17,000 $4,000 25.0%

e This problem is a bit harder than some of the other ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.

Sales revenues $42,500 − Operating costs (excl. deprec.)

17,000 − Depreciation 10,000 Operating income (EBIT) $15,500

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Chapter 11: Cash Flow Estimation and Risk Analysis − Taxes Rate = 25% 3,875 After-tax EBIT $11,625 + Depreciation 10,000 Cash flow, Year 1 $21,625 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:01 PM 49. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate a. $28,619 b. $30,125 c. $31,631 d. $33,213 e. $34,873 ANSWER: RATIONALE:

$62,500 $8,000 $25,000 $8,000 25.0%

b This problem is a bit harder than some of the other ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.

Sales revenues $62,500 − Operating costs (excl. deprec.)

25,000 − Depreciation 8,000 Operating income (EBIT) $29,500 − Taxes Rate = 25% 7,375 After-tax EBIT $22,125 + Depreciation 8,000

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Chapter 11: Cash Flow Estimation and Risk Analysis Cash flow, Year 1 $30,125 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:03 PM 50. Your new employer, Freeman Software, is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. $31,666 b. $31,849 c. $33,442 d. $35,114 e. $36,869 ANSWER: a RATIONALE: Equipment cost Depreciation rate

$65,000 $60,000 $25,000 25.0%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow, Year 1 Copyright Cengage Learning. Powered by Cognero.

$65,000 33.33%

Rate = 25%

$60,000 25,000 21,665 $13,336 3,334 $10,002 21,665 $31,666 Page 29

Chapter 11: Cash Flow Estimation and Risk Analysis POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF MACRS KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:30 PM 51. Whitestone Products is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4.

Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. $13,016 b. $13,701 c. $14,422 d. $15,143 e. $15,900 ANSWER: c RATIONALE: Equipment cost Depreciation rate, Year 4

POINTS:

$70,000 $42,500 $25,000 25.0%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow, Year 4 1

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$70,000 7.41%

Rate = 25%

$42,500 25,000 5,187 $12,313 3,078 $9,235 5,187 $14,422 Page 30

Chapter 11: Cash Flow Estimation and Risk Analysis DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual CF MACRS KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:08 PM 52. DeVault Services recently hired you as a consultant to help with its capital budgeting process. The company is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Risk-adjusted cost of capital 10.0% Net investment cost (depreciable basis) $65,000 Straight-line deprec. rate 33.3333% Sales revenues, each year $65,500 Operating costs (excl. deprec.), each year $25,000 Tax rate 25.0% a. $34,515 b. $36,331 c. $38,243 d. $40,256 e. $42,375 ANSWER: e RATIONALE: RATIONAL WACC 10.0% E: Tax rate 25% Depreciation rate 33.33% Year 0 Investment cost −$65,000 Sales revenues −Op.costs (excl. depr.) −Depreciation (33.333%) Operating income Copyright Cengage Learning. Powered by Cognero.

1

2

3

$65,500 25,000

$65,500 25,000

$65,500 25,000

21,667

21,667

21,667

$18,833

$18,833

$18,833 Page 31

Chapter 11: Cash Flow Estimation and Risk Analysis (EBIT) −Taxes (25%) After-tax EBIT + Depreciation Cash flow NPV

−$65,000

4,708 $14,125 21,667 $35,792

4,708 $14,125 21,667 $35,792

4,708 $14,125 21,667 $35,792

$42,375

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVE FMTP.EHRH.20.11.02 - LO: 11-2 S: NATIONAL STANDARD United States - BUSPROG: Analytic S: STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:13 PM 53. Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an end. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 25%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale. a. $5,611 b. $5,906 c. $6,202 d. $6,512 e. $6,837 Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis ANSWER: RATIONALE:

b % depreciated on equip.

Tax rate

75% 25%

Equipment cost $22,500 − Accumulated deprec.

16,875 Current book value of equipment $ 5,625 Market value of equipment 6,000 Gain (or loss): Market value − Book value $ 375 Taxes paid on gain (−) or credited (+) on loss −94 AT salvage value = market value +/− taxes $ 5,906 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Salvage value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:19 PM 54. McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation.

The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 25%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

Year 1 2 3 4 5 6 a. $9,367 b. $9,860 c. $10,379 d. $10,925 e. $11,500 ANSWER: RATIONALE:

Depreciation Rate 0.20 0.32 0.19 0.12 0.11 0.06

e

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Deprec.

Annual

Year-end Page 33

Chapter 11: Cash Flow Estimation and Risk Analysis Year 1 2 3 4 5 6

Rate Basis Deprec.

Book Value 0.20 $50,000 $10,000 $40,000 0.32 50,000 16,000 24,000 0.19 50,000 9,500 14,500 0.12 50,000 6,000 8,500 0.11 50,000 5,500 3,000 0.06 50,000 3,000 0 1.00 $50,000 Gross sales proceeds (Market value) $12,500 Book value, end of Year 4 8,500 Profit $ 4,000 Tax on profit Rate = 25% 1,000 AT salvage value = market value +/− taxes $11,500 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Salvage value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic.

The additional work will increase the length of time that students need to find the correct answer.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:21 PM 55. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other Weston's products and would reduce their pretax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

Cost of capital Pre-tax cash flow reduction for other products (cannibalization) Investment cost (depreciable basis) Straight-line deprec. rate Sales revenues, each year for 3 years Annual operating costs (excl. deprec.)

Tax rate a. $6,196 b. $6,522 c. $6,848 d. $7,190 e. $7,550 Copyright Cengage Learning. Powered by Cognero.

10.0% $5,000 $80,000 33.333% $67,500 $25,000 25.0%

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Chapter 11: Cash Flow Estimation and Risk Analysis ANSWER: RATIONALE:

b t=0 t=1 t=2 t=3 WACC = 10% −$80,000 $67,500 $67,500 $67,500 5,000 5,000 5,000 25,000 25,000 25,000 Rate = 33.33% 26,667 26,667 26,667 $10,833 $10,833 $10,833 Rate = 25% 2,708 2,708 2,708 $8,125 $8,125 $8,125 26,667 26,667 26,667 −$80,000 $34,792 $34,792 $34,792 $6,522

Investment (Basis) Sales revenues − Cannibalization cost − Operating costs (excl. deprec.) − Basis × rate = deprec.

Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow NPV POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:25 PM

56. Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

Project cost of capital (r) Opportunity cost Net equipment cost (depreciable basis) Straight-line deprec. rate for equipment Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. $26,796 b. $28,207 c. $29,691 d. $31,254 e. $32,817 Copyright Cengage Learning. Powered by Cognero.

10.0% $100,000 $65,000 33.333% $123,000 $25,000 25%

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Chapter 11: Cash Flow Estimation and Risk Analysis ANSWER: RATIONALE:

d t=0 −$ 65,000

t=1

t=2

t=3

Investment WACC = 10% Opportunity cost −100,000 Revenues $123,000 $123,000 $123,000 − Operating costs (excl.

25,000 25,000 25,000 deprec.) − Basis × rate = deprec.

Rate = 33.33% 21,667 21,667 21,667 Operating income (EBIT) $ 76,333 $ 76,333 $ 76,333 − Taxes Rate = 25% 19,083 19,083 19,083 After-tax EBIT $57,250 $57,250 $57,250 + Depreciation 21,667 21,667 21,667 Cash flow −$165,000 $ 78,917 $ 78,917 $ 78,917 NPV $31,254 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:28 PM 57. Garden-Grow Products is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)

Project cost of capital (r) Net investment in fixed assets (basis) Required new working capital Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. $30,069 b. $31,573 c. $33,152 d. $34,809 e. $36,550 Copyright Cengage Learning. Powered by Cognero.

10.0% $75,000 $15,000 33.333% $75,000 $25,000 25.0%

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Chapter 11: Cash Flow Estimation and Risk Analysis ANSWER: RATIONALE:

a Investment in fixed assets Investment in net working capital Sales revenues − Operating costs (excl. deprec.)

Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow from operations Recovery of working capital Total cash flows NPV

t=0 WACC = 10% −$15,000

t=1 −$75,000

t=2

t=3

$75,000 25,000

$18,750 25,000 $43,750

$75,000 25,000 25,000 $25,000 6,250 $18,750 25,000 $43,750

$43,750

$43,750

$75,000 25,000 25,000 $25,000 6,250 $18,750 25,000 $43,750 15,000 $58,750

Rate = 33.333% $25,000 Rate = 25%

−$90,000 −$90,000 $30,069

25,000 6,250

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:35 PM 58. Sheridan Films is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Project cost of capital (r) Net investment in fixed assets (depreciable basis) Required new working capital Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Expected pretax salvage value Tax rate a. $25,964 b. $27,330 c. $28,768 Copyright Cengage Learning. Powered by Cognero.

10.0% $70,000 $10,000 33.333% $75,000 $30,000 $5,000 25.0%

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Chapter 11: Cash Flow Estimation and Risk Analysis d. $30,207 e. $31,717 ANSWER: RATIONALE:

c Investment in fixed assets Investment in net working capital Sales revenues − Operating costs (excl. deprec.)

Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow from operations Recovery of working capital Salvage value, pre-tax − Tax on salvage value Total cash flows NPV

WACC = 10% −10,000

t=0 −$70,000

t=1

$75,000 30,000

$16,250 23,333 $39,583

$75,000 30,000 23,333 $21,667 5,417 $16,250 23,333 $39,583

$39,583

$39,583

Rate = 33.333% $21,667 Rate = 25%

−$80,000

Rate = 25% −$80,000 $28,768

t=2

23,333 5,417

t=3

$75,000 30,000 23,333 $21,667 5,417 $16,250 23,333 $39,583 10,000 5,000 1,250 $53,333

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 9:11 PM 59. Shultz Business Systems is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV? Project cost of capital (r) Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed op. cost excl. deprec. (constant) Variable op. cost/unit, Year 1 Copyright Cengage Learning. Powered by Cognero.

10.0% $200,000 50,000 $25.00 $150,000 $20.20 Page 38

Chapter 11: Cash Flow Estimation and Risk Analysis Annual depreciation rate Expected inflation rate per year Tax rate a. $27,625 b. $29,079 c. $30,610 d. $32,140 e. $33,747 ANSWER: c Base Case Calculations RATIONALE:

33.333% 5.00% 25.0%

t=0 Investment cost Inflation Price per unit VC per unit Units sold

WACC = 10%

Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Rate = 33.333% Operating income (EBIT) − Taxes Rate = 25% After-tax EBIT + Depreciation Cash flow −$200,000 NPV $30,610

t=1 −$200,000 5.0% $25.00 $20.20 50,000

t=2

t=3

5.0% $26.25 $21.21 50,000

5.0% $27.56 $22.27 50,000

$1,250,000

$1,312,500

$1,378,125

150,000

150,000

150,000

1,010,000 66,667 $ 23,333

1,060,500 66,667 $ 35,333 5,833 $ 26,500 66,667 $ 93,167

1,113,525 66,667 $ 47,933 8,833 11,983 $ 35,950 66,667 $ 102,617

$ 17,500 66,667 $ 84,167

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV including inflation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:44 PM 60. Sylvester Media is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

Project cost of capital (r) Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed op. cost excl. deprec. (constant) Variable op. cost/unit, Year 1 Annual depreciation rate Expected inflation Tax rate a. $15,330 b. $16,136 c. $16,986 d. $17,835 e. $18,727 ANSWER: c NPV with no adjustment RATIONALE:

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 4.00% 25.0%

t=0 Investment cost Inflation (set to 0%) Price per unit VC per unit Units sold Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow NPV w/o infl. adjustment NPV with adjustment

WACC=10%

per unit = $20.20 Rate = 33.3% Rate = 25% −$200,000

Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes Copyright Cengage Learning. Powered by Cognero.

t=2

t=3

0.0% $25.00 $20.20 50,000

0.0% $25.00 $20.20 50,000

$1,250,000

$1,250,000

$1,250,000

150,000

150,000

150,000

1,010,000 66,667 $ 23,333 5,833 $ 17,500 66,667 $ 84,167

1,010,000 66,667 $ 23,333 5,833 $ 17,500 66,667 $ 84,167

1,010,000 66,667 $ 23,333 5,833 $ 17,500 66,667 $ 84,167

t=1 −$200,000 4.0% $25.00 $20.20 50,000

t=2

t=3

4.0% $26.00 $21.01 50,000

4.0% $27.04 $21.85 50,000

$1,250,000

$1,300,000

$1,352,000

150,000

150,000

150,000

1,010,000 66,667 $ 23,333 5,833

1,050,400 66,667 $ 32,933 8,233

1,092,416 66,667 $ 42,917 10,729

$9,310 t=0

Investment cost Inflation Price per unit VC per unit Units sold

t=1 −$200,000 0.0% $25.00 $20.20 50,000

WACC=10%

per unit = $20.20 Rate = 33.3% Rate = 25%

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Chapter 11: Cash Flow Estimation and Risk Analysis After-tax EBIT + Depreciation Cash flow −$200,000 NPV w/infl. adjustment $26,296 Increase w/infl. adjustment $16,986

$ 17,500 66,667 $ 84,167

$ 24,700 66,667 $91,367

$32,188 66,667 $ 98,855

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.02 - LO: 11-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NPV including inflation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/27/2019 8:50 PM 61. If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted discount rate KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 62. Which of the following procedures best accounts for the relative risk of a proposed project? a. Adjusting the discount rate downward if the project is judged to have above-average risk. b. Reducing the NPV by 10% for risky projects.

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Chapter 11: Cash Flow Estimation and Risk Analysis c. Picking a risk factor equal to the average discount rate. d. Ignoring risk because project risk cannot be measured accurately. e. Adjusting the discount rate upward if the project is judged to have above-average risk.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk adjustment KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 63. Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects? a. Project B, which has below-average risk and an IRR = 8.5%. b. Project C, which has above-average risk and an IRR = 11%. c. Without information about the projects' NPVs we cannot determine which project(s) should be accepted. d. All of these projects should be accepted. e. Project A, which has average risk and an IRR = 9%.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted discount rate KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM

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Chapter 11: Cash Flow Estimation and Risk Analysis 64. Tallant Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Expected NPV Standard deviation (σNPV) Project beta (vs. market)

Project X $500,000 $200,000 1.4

Project Y $500,000 $250,000 0.8

Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.

Which of the following statements is CORRECT? a. Project X has more corporate (or within-firm) risk than Project Y. b. Project X has more market risk than Project Y. c. Project X has the same level of corporate risk as Project Y. d. Project X has less market risk than Project Y. e. Project X has more stand-alone risk than Project Y. ANSWER: b RATIONALE: Statement b is true, while the other statements are false. Stand-alone risk is measured by standard deviation. Therefore, since Y's standard deviation is higher than X's, Y has higher stand-alone risk than X. Statement a is false because corporate risk is affected by the correlation of project cash flows with other company cash flows, and since Y's cash flows are more highly correlated with the cash flows of existing projects than X's, Y has more corporate risk than X. Market risk is measured by beta. Therefore, since X's beta is greater than Y's, statement b is true.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 65. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT? a. The proposed new project would increase the firm's corporate risk. b. The proposed new project would increase the firm's market risk.

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Chapter 11: Cash Flow Estimation and Risk Analysis c. The proposed new project would not affect the firm's risk at all. d. The proposed new project would have less stand-alone risk than the firm's typical project. e. The proposed new project would have more stand-alone risk than the firm's typical project.

ANSWER: e RATIONALE: Statement e is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other firms' revenues, hence its within-firm and market risks would be relatively low.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 66. A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated NPV of the project to reflect its greater risk. b. Reject the project, since its acceptance would increase the firm's risk. c. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. d. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. e. Increase the estimated IRR of the project to reflect its greater risk.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project's effect on firm risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis DATE CREATED: DATE MODIFIED:

8/9/2018 11:04 AM 8/9/2018 11:04 AM

67. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%.

The company is considering the following projects: Project Risk Expected Return A High 15% B Average 12% C High 11% D Low 9% E Low 6% Which set of projects would maximize shareholder wealth? a. A and B. b. A, B, and C. c. A, B, and D. d. A, B, C, and D. e. A, B, C, D, and E. ANSWER: c RATIONALE: Statement b is true; the others are false. The following table shows the required return for each project on the basis of its risk level.

Expected Req'd Return Project Risk Return for This Risk Decision A High 15% 12% Accept B Average 12% 10% Accept C High 11% 12% Reject D Low 9% 8% Accept E Low 6% 8% Reject POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk-adjusted discount rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 68. Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

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Chapter 11: Cash Flow Estimation and Risk Analysis a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 69. Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.05 - LO: 11-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sensitivity analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 70. Spot-Free Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units.

If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV decline?

(Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)

Project cost of capital (r) Net investment cost (depreciable basis) Copyright Cengage Learning. Powered by Cognero.

10.0% $60,000 Page 46

Chapter 11: Cash Flow Estimation and Risk Analysis Number of cars washed Average price per car Fixed op. cost (excl. deprec.)

Variable op. cost/unit (i.e., VC per car washed) Annual depreciation Tax rate a. $33,391 b. $35,149 c. $36,999 d. $38,946 e. $40,996 ANSWER: e Base Case Calculations RATIONALE: Investment cost Cars washed Price per car Variable cost/unit Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow Base-Case NPV Bad Case Calculations Investment cost Cars washed Price per car Variable cost/unit Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow Bad-Case NPV Decline in NPV

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2,800 $25.00 $10,000 $5.375 $20,000 25.0%

WACC: 10% 2,800 $25.00 $5.375

$10,000 $5.375 Rate = 33.333%

t=0 −$60,000

$70,000 10,000

$24,950 Rate = 25%

−$60,000 $36,272

$18,713 20,000 $38,713

t=0 −$60,000 Declines by: 40%

−$60,000 −$4,723 $40,996

t=1

t=2

t=3

2,800 $25.00 $5.375

2,800 $25.00 $5.375

2,800 $25.00 $5.375

$70,000 10,000 15,050 20,000 $24,950 6,238 $18,713 20,000 $38,713

$70,000 10,000 15,050 20,000 6,238

15,050 20,000 $24,950 6,238 $18,713 20,000 $38,713

t=1

t=2

t=3

1,680 $25.00 $5.375

1,680 $25.00 $5.375

1,680 $25.00 $5.375

$42,000 10,000 9,030 20,000 $ 2,970 743 $2,228 20,000 $22,228

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

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Chapter 11: Cash Flow Estimation and Risk Analysis

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.05 - LO: 11-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS:

LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Sensitivity analysis Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 1/27/2019 8:59 PM

71. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.06 - LO: 11-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Coefficient of variation Bloom’s: Knowledge 8/9/2018 11:04 AM 8/9/2018 11:04 AM

72. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.06 - LO: 11-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CV vs. SD KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 73. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation? a. 1.20 b. 1.26 c. 1.32 d. 1.39 e. 1.46 ANSWER: a RATIONALE: Expected return 25.0% Standard deviation 30.0% Coefficient of variation = Std dev/Expected return = 1.20 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.06 - LO: 11-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 8/9/2018 11:04 AM

74. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation? a. 0.67 b. 0.73 c. 0.81 d. 0.89 e. 0.98 ANSWER: a RATIONALE: Expected return 15.0% Standard deviation 10.0% Coefficient of variation = Std dev/Expected return = 0.67 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.06 - LO: 11-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 75. Which of the following statements is CORRECT? a. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. b. Well-diversified stockholders do not need to consider market risk when determining required rates of return. c. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. d. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. e. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.07 - LO: 11-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sensitivity, scenario, & sim.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 76. Which of the following statements is CORRECT? a. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV. b. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. c. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. d. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. e. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.07 - LO: 11-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sensitivity, scenario, & sim.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 77. Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. b. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be Copyright Cengage Learning. Powered by Cognero.

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Chapter 11: Cash Flow Estimation and Risk Analysis appropriate if the project's returns were negatively correlated. c. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure. d. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately. e. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.07 - LO: 11-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk adjustment KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 78. Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?

a. $55.08 b. $57.98 c. $61.03 d. $64.08 e. $67.29 ANSWER:

c

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Chapter 11: Cash Flow Estimation and Risk Analysis RATIONALE:

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.11.10 - LO: 11-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Phased decision Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 8/9/2018 11:04 AM

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Chapter 12: Corporate Valuation and Financial Planning 1. Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.01 - LO: 12-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating plans KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 2. One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.01 - LO: 12-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial plans KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 3. Which of the following is NOT one of the steps taken in the financial planning process? a. Monitor operations after implementing the plan to spot any deviations and then take corrective actions. b. Determine the amount of capital that will be needed to support the plan. c. Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.

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Chapter 12: Corporate Valuation and Financial Planning d. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors. e. Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.01 - LO: 12-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial planning KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 4. One of the first steps in arriving at a firm's forecasted financial statements is a review of industry-average operating ratios relative to these same ratios for the firm to determine whether changes to the ratios need to be made. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.02 - LO: 12-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasted statements KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 5. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial forecasting KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Judd Enterprises These are the simplified financial statements for Judd Enterprises.

Income statement Current Projected Sales na 1,000 Costs na 720 Profit before tax na 280 Taxes (25%) na 70 Net income na 210 Dividends na 63 Balance sheets Current assets Net fixed assets

Current 100 900

Projected 115 1,080

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 400 300 230

6. Refer to the Judd Enterprises financial statements. What is Judd’s projected retained earnings under this plan? a. $339 b. $377 c. $396 d. $415 e. $440 ANSWER: b RATIONALE: Retained earnings = old retained earnings + new net income - new dividends = 230 + 210 63 = 377 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Judd Enterprises LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Projecting financial statements Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:02 AM 8/9/2018 11:02 AM

7. Refer to the Judd Enterprises financial statements. If Judd does not plan on issuing new stock or additional long-term debt, then what is the additional net financing needed for the projected year? a. $30 b. $33 c. $37 d. $339 e. $396 ANSWER: c RATIONALE: Additional net financing = Projected assets - Projected liabilities and equity = 1,195 - (81 + 400 + 300 + (230 + 210 - 63)) = 37 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Judd Enterprises LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Projecting financial statements KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Decker Enterprises Below are the simplified current and projected financial statements for Decker Enterprises.

All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities.

Income statement Sales Costs Profit before tax Taxes (25%) Net income Dividends

CurrentProjected na 1,500 na 1,080 na 420 na 105 na 315 na 95

Balance sheets Current assets Net fixed assets

Current Projected 100 115 1,200 1,440

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Current liabilities Long-term debt Common stock

Current Projected 70 81 300 360 500 500 Page 4

Chapter 12: Corporate Valuation and Financial Planning Retained earnings

430

650

8. Based on the projections, Decker will have a. a financing surplus of $36 b. a financing deficit of $36 c. a financing surplus of $255 d. a financing deficit of $255 e. zero financing surplus or deficit ANSWER: a RATIONALE: Financing deficit = additional net financing = projected assets - projected liabilities and equity If financing deficit < 0 then instead, financing surplus = -financing deficit. Financing deficit = 1,555 - (81 + 360 + 500 + 650) = -36 so financing surplus = 36.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Decker Enterprises LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 9. If Decker had a financing surplus, it could remedy the situation by a. borrowing on its line of credit. b. issuing more common stock. c. reducing its dividend. d. borrowing from its retained earnings e. paying a special dividend ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Decker Enterprises LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning DATE MODIFIED:

8/9/2018 11:02 AM

10. If Decker had a financing deficit, it could remedy the situation by a. buying back common stock b. paying a special dividend c. paying down its long-term debt d. borrowing on its line of credit e. borrowing from retained earnings ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Decker Enterprises LEARNING OBJECTIVES: FMTP.EHRH.20.12.05 - LO: 12-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 11. As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 12. Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest source of capital. Consequently, the firm should make arrangements with its suppliers to use as much of this credit as possible.

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Chapter 12: Corporate Valuation and Financial Planning a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 13. A firm will use spontaneous funds to the extent possible; however, due to credit terms, contracts with workers, and tax laws there is little flexibility in their usage. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 14. As long as a firm does not pay out 100% of its earnings, the firm's annual profit that is retained in the business (i.e., the addition to retained earnings) is another source of funds for a firm's expansion. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Addition to ret. earnings KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 15. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Asset increase KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 16. A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Additional funds needed Bloom’s: Knowledge 8/9/2018 11:02 AM 8/9/2018 11:02 AM

17. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 18. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 19. The capital intensity ratio is the amount of assets required per dollar of sales and it has a major impact on a firm's Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning capital requirements. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 20. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 21. A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 22. Companies with relatively high assets-to-sales ratios require a relatively large amount of new assets for any given increase in sales; hence, they have a greater need for external financing. There are currently no alternatives for these types of firms to lower their asset requirements. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 23. Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of growth with fewer assets and consequently less external capital. For example, just-in-time inventory systems, multiple shifts for labor, and outsourcing production are all feasible ways for firms to reduce their capital intensity ratios. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Capital intensity ratio Bloom’s: Comprehension 8/9/2018 11:02 AM 8/9/2018 11:02 AM

24. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 25. If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning DATE CREATED: DATE MODIFIED:

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26. The minimum growth rate that a firm can achieve with no access to external capital is called the firm's sustainable growth rate. It can be calculated by using the AFN equation with AFN equal to zero and solving for g. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sustainable growth rate KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 27. Which of the following assumptions is embodied in the AFN equation? a. Accounts payable and accruals are tied directly to sales. b. Common stock and long-term debt are tied directly to sales. c. Fixed assets, but not current assets, are tied directly to sales. d. Last year's total assets were not optimal for last year's sales. e. None of the firm's ratios will change.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN equation KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning 28. F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)? a. A switch to a just-in-time inventory system and outsourcing production. b. The company reduces its dividend payout ratio. c. The company switches its materials purchases to a supplier that offers a longer credit period (with all other terms held equal). d. The company discovers that it has excess capacity in its fixed assets. e. A sharp increase in its forecasted sales.

ANSWER: e RATIONALE: Answer e is obviously correct. A switch to a just-in-time inventory system and outsourcing production would lower the firm's capital intensity ratio, which would lower AFN. Note that with a longer credit period (and all other terms held equal) offered by the new supplier, accounts payable will either go up or remain the same, but definitely not go down.

Therefore, changing to the new supplier will not increase AFN. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 29. The term "additional funds needed (AFN)" is generally defined as follows: a. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. b. The amount of assets required per dollar of sales. c. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth. d. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant. e. Funds that are obtained automatically from routine business transactions.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Additional funds needed Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:02 AM 8/9/2018 11:02 AM

30. The capital intensity ratio is generally defined as follows: a. The percentage of liabilities that increase spontaneously as a percentage of sales. b. The ratio of sales to current assets. c. The ratio of current assets to sales. d. The amount of assets required per dollar of sales, or A0*/S0. e. Sales divided by total assets, i.e., the total assets turnover ratio.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 31. Spontaneous funds are generally defined as follows: a. A forecasting approach in which the forecasted percentage of sales for each item is held constant. b. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. c. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. d. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm's growth. e. Assets required per dollar of sales.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous funds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 32. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? a. The company increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly. c. The company's profit margin increases. d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 33. Which of the following statements is CORRECT? a. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets.

Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets. b. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. c. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them. d. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning e. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 34. Which of the following statements is CORRECT? a. The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet.

Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet. b. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast. c. A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed. d. If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method. e. Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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35. Which of the following statements is CORRECT? a. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative. b. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN. c. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. d. Dividend policy does not affect the requirement for external funds based on the AFN equation. e. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN equation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 36. Daniel Sawyer, the CEO of the Sawyer Group, is initiating planning for the company's operations next year, and he wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions. $350Last year's accounts payable Last year's sales = S0 Sales growth rate = g 30%Last year's notes payable $500Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 5%Target payout ratio a. $102.8 b. $108.2 c. $113.9 d. $119.9 e. $125.9 ANSWER: d RATIONALE: Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) ΔS = change in sales = S1 − S0 = S0 × g Copyright Cengage Learning. Powered by Cognero.

$40 $50 $30 60%

$350 30% $455 $105 Page 18

Chapter 12: Corporate Valuation and Financial Planning $500 Last year's total assets = A0* = A0* since full capacity Last year's accounts payable $40 Last year's notes payable. Not spontaneous, so does not enter AFN calculation $50 Last year's accruals $30 * $70 L0 = payables + accruals Profit margin = M 5.0% Target payout ratio 60.0% * * AFN = (A0 /S0)ΔS − (L0 /S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $150.0 − $21.0 − $9.1 = $119.9 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Positive AFN KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 37. In your internship with Lewis, Lee, & Taylor Inc. you have been asked to forecast the firm's additional funds needed (AFN) for next year. The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? $200,000Last year's accounts payable Last year's sales = S0 Sales growth rate = g 40%Last year's notes payable $135,000Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 20.0%Target payout ratio a. −$14,440 b. −$15,200 c. −$16,000 d. −$16,800 e. −$17,640 ANSWER: c RATIONALE: Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) ΔS = change in sales = S1 − S0 = S0 × g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, Copyright Cengage Learning. Powered by Cognero.

$50,000 $15,000 $20,000 25.0%

$200,000 40% $280,000 $80,000 $135,000 $50,000 Page 19

Chapter 12: Corporate Valuation and Financial Planning so does not enter AFN calculation $15,000 Last year's accruals $20,000 * $70,000 L0 = payables + accruals Profit margin = M 20.0% Target payout ratio 25.0% * * AFN = (A0 /S0)ΔS − (L0 /S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $54,000 − $28,000 − $42,000 = −$16,000 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Negative AFN KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 38. You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level?

All dollars are in millions. $300.0Last year's accounts payable Last year's sales = S0 Sales growth rate = g 40%Last year's notes payable $500.0Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 20.0%Initial payout ratio a. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9 ANSWER: b RATIONALE: Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) ΔS = change in sales = S1 − S0 = S0 × g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, Copyright Cengage Learning. Powered by Cognero.

$50.0 $15.0 $20.0 10.0%

$300 40% $420 $120 $500 $50 Page 20

Chapter 12: Corporate Valuation and Financial Planning so does not enter AFN calculation $15 Last year's accruals $20 * $70 L0 = payables + accruals Profit margin = M 20% Initial payout ratio 10% New payout ratio 50% * * AFN = (A0 /S0)ΔS − (L0 /S0)ΔS − Profit margin × S1 × (1 − Payout) Old AFN = $200.0 − $28.0 − $75.6 = $96.4 New AFN = $200.0 − $28.0 − $42.0 = $130.0 Change in AFN = $33.6 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.08 - LO: 12-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN–changing div. payout KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 39. The AFN equation assumes that the ratios of assets and liabilities to sales remain constant over time. However, this assumption can be relaxed when we use the forecasted financial statement method. Three conditions where constant ratios cannot be assumed are economies of scale, lumpy assets, and excess capacity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasting when ratios chg.

KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 40. Which of the following statements is CORRECT? a. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales.

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Chapter 12: Corporate Valuation and Financial Planning b. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management's historical performance is evaluated. c. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets. d. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. e. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasting concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 41. Which of the following statements is CORRECT? a. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. b. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. c. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. d. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. e. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Forecasting financial reqs.

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:02 AM 8/9/2018 11:02 AM

42. The Besnier Company had $250 million of sales last year, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity? a. $312.5 b. $328.1 c. $344.5 d. $361.8 e. $379.8 ANSWER: a RATIONALE: Sales $250 Fixed assets $75.0 % of capacity utilized 80.0% Full capacity sales = Actual sales/% of capacity used = $312.5 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Excess capacity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 43. Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron's sales increase before it is required to increase its fixed assets? a. $170.09 b. $179.04 c. $188.46 d. $197.88 e. $207.78 ANSWER: c RATIONALE: Sales $350 Fixed assets (not used in calculations) $270 % of capacity utilized 65% Sales at full capacity = Actual sales/% of capacity used = $538.46 Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning Additional sales without adding FA = Full capacity sales − Actual sales = $188.46 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Excess capacity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 44. North Construction had $850 million of sales last year, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate North could achieve before it had to increase its fixed assets? a. 54.30% b. 57.16% c. 60.17% d. 63.33% e. 66.67% ANSWER: e RATIONALE: Sales $850 Fixed assets (not used in calculations) $425 % of capacity utilized 60% Sales at full capacity = Actual sales/% of capacity used = $1,416.67 Additional sales without adding FA = Full capacity sales − Actual sales = $566.67 Percent growth in sales = Additional sales/Old sales = 66.67% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Excess capacity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning 45. Last year National Aeronautics had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100 million of fixed assets. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% ANSWER: b RATIONALE: Sales $250 Fixed assets $100 % of capacity utilized 75% Sales at full capacity = Actual sales/% of capacity used = $333.33 Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30.0% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding target FA/S ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM 46. Weber Interstate Paving Co. had $450 million of sales and $225 million of fixed assets last year, so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated? a. $74.81 b. $78.75 c. $82.69 d. $86.82 e. $91.16 ANSWER: b RATIONALE: Sales $450 Fixed assets $225 % of capacity utilized 65% Sales at full capacity = Actual sales/% of capacity used = $692.31 Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = 32.50% Optimal FA = Sales × Target FA/Sales ratio = $146.25 Cash generated = Actual FA − Optimal FA = $78.75 Copyright Cengage Learning. Powered by Cognero.

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Chapter 12: Corporate Valuation and Financial Planning POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.12.09 - LO: 12-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding target FA/S ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 8/9/2018 11:02 AM

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Chapter 13: Corporate Governance 1. Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 2. A poison pill is also known as a corporate restructuring. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 3. The CEO of D'Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D'Amico's stock underperforms the market, these options will necessarily be worthless. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock options KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 4. Which of the following is NOT normally regarded as being a barrier to hostile takeovers? a. Targeted share repurchases. b. Shareholder rights provisions. c. Restricted voting rights. d. Poison pills. e. Abnormally high executive compensation.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 5. ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.03 - LO: 13-3 Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ESOP KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 6. Which of the following is NOT normally regarded as being a good reason to establish an ESOP? a. To enable the firm to borrow at a below-market interest rate. b. To make it easier to grant stock options to employees. c. To help prevent a hostile takeover. d. To help retain valued employees. e. To increase worker productivity.

ANSWER: b RATIONALE: Statement b is the correct answer, because firms can easily grant stock options to employees without an ESOP. POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.03 - LO: 13-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ESOP KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 7. Which one of the following statements is TRUE? a. An agency relationship is when someone hires someone else to perform a service and gives them decisionmaking authority. b. An agency relationship is when an agent hires a principal to perform a service. c. An agency relationship is when a principal works for an agent. d. In an agency relationship, the agent delegates authority to the principal. e. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 8. Which one of the following statements is TRUE? a. An agency relationship is when a principal hires an agent to perform a service and gives them decision-making authority. b. An agency relationship is when a principal works for an agent. c. In an agency relationship, the agent delegates authority to the principal. d. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. e. An example of an agency relationship is when a supervisor hires a forklift operator.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 9. Which one of the following statements is TRUE? a. In an agency relationship, the principal delegates decision-making authority to the agent. b. In an agency relationship, the agent delegates authority to the principal. c. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. d. An example of an agency relationship is when a supervisor hires a forklift operator. e. The supervisor-employee relation between a production line supervisor and a production line operator is an Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance example of an agency relationship.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 10. Which one of the following statements is TRUE? a. An example of an agency relationship is when the board of directors hires a CEO to run a company. b. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. c. An example of an agency relationship is when a supervisor hires a forklift operator. d. The supervisor-employee relation between a production line supervisor and a production line operator is an example of an agency relationship. e. An agency cost is the wage required to pay someone who is hired to perform a service.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 11. Which one of the following statements is TRUE? a. An example of an agency relationship is when a private individual hires a lawyer to prepare her defense in a lawsuit.

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Chapter 13: Corporate Governance b. An example of an agency relationship is when a supervisor hires a forklift operator. c. The supervisor-employee relation between a production line supervisor and a production line operator is an example of an agency relationship. d. An agency cost is the wage required to pay someone who is hired to perform a service. e. An example of an agency cost is when the board of directors pays a dividend to shareholders.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 12. Which one of the following statements is TRUE? a. An agency cost is the reduction in firm value due to agency conflicts. b. An agency cost is the wage required to pay someone who is hired to perform a service. c. An example of an agency cost is when the board of directors pays a dividend to shareholders. d. An example of an agency cost is when an attorney hires an expert witness for a trial. e. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance 13. Which one of the following statements is TRUE? a. An example of an agency cost is when an outside investor is only willing to pay less for stock because she thinks the original owner will consume too many perquisites. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. e. An example of an agency cost is the salary of the agent hired to work for the principal.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 14. Which one of the following statements is TRUE? a. Asset switching occurs when a company borrows money for a safe investment but uses it for a risky investment. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. e. An example of an agency cost is the salary of the agent hired to work for the principal.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:02 AM 11/16/2018 9:24 AM

15. Which one of the following statements is TRUE? a. An example of asset switching is when a company borrows for a new manufacturing facility but then uses it to repurchase its own stock. b. An example of an agency cost is when an attorney hires an expert witness for a trial. c. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. d. An example of an agency cost is the salary of the agent hired to work for the principal. e. Creditors have a claim on a firm's earning stream through the dividend payments they receive.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 16. Which one of the following statements is TRUE? a. An example of asset switching is borrowing money to buy equipment but instead taking it to Las Vegas to gamble with it. b. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. c. An example of an agency cost is the salary of the agent hired to work for the principal. d. Creditors have a claim on a firm's earning stream through the dividend payments they receive. e. An example of asset switching is an option to exchange one piece of real estate for another.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:02 AM 11/16/2018 9:24 AM

17. Which one of the following statements is TRUE? a. Lenders will protect themselves from asset switching by charging a higher interest rate. b. Creditors have a claim on a firm's earning stream through the dividend payments they receive. c. An example of asset switching is an option to exchange one piece of real estate for another. d. Lenders can't legally prevent a firm from engaging in asset switching. e. Firms borrowing money have greater flexibility to use that money when there are debt covenants.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Response HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 18. Which one of the following statements is TRUE? a. Lenders will protect themselves from the risk of asset switching by writing debt covenants into loans. b. Lenders can't legally prevent a firm from engaging in asset switching. c. Firms borrowing money have greater flexibility to use that money when there are debt covenants. d. When lenders protect themselves from the risk of asset switching by charging a higher interest rate, the firm's WACC can decrease. e. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:02 AM 11/16/2018 9:24 AM

19. Which one of the following statements is TRUE? a. When lenders protect themselves from the risk of asset switching, the firm's WACC can increase. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. An example of asset switching is an option to exchange one piece of real estate for another. e. Lenders can't legally prevent a firm from engaging in asset switching.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:02 AM DATE MODIFIED: 11/16/2018 9:24 AM 20. Which one of the following statements is TRUE? a. When lenders protect themselves from the risk of asset switching, the borrowing firms will be limited in the projects they can profitably undertake. b. An agency relationship is when a principal works for an agent. c. In an agency relationship, the agent delegates authority to the principal. d. Firms borrowing money have greater flexibility to use that money when there are debt covenants. e. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 21. Which one of the following statements is TRUE? a. An agency problem occurs when an owner/manager sells stock to an outsider but continues to consume perquisites. b. Firms borrowing money have greater flexibility to use that money when there are debt covenants. c. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. d. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching. e. A supplier substituting a lower-quality raw material without approval is an example of asset switching.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 22. Which one of the following statements is TRUE? a. Outside shareholders will pay less for stock if they think the original owners will consume perquisites. b. Creditors have a claim on a firm's earning stream through the dividend payments they receive. c. An example of asset switching is an option to exchange one piece of real estate for another. d. An agency cost is the wage required to pay someone who is hired to perform a service. e. An example of an agency cost is when an attorney hires an expert witness for a trial.

ANSWER: a POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 23. Which one of the following statements is TRUE? a. When an owner/manager sells stock to an outsider, that outsider now bears some of the costs of the owner/manager's perquisite consumption. b. Lenders can't legally prevent a firm from engaging in asset switching. c. Firms borrowing money have greater flexibility to use that money when there are debt covenants. d. When lenders protect themselves from the risk of asset switching, the firm's WACC can decrease. e. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 24. Which one of the following statements is TRUE? a. A corporate golf club membership is an example of a nonpecuniary benefit b. Firms borrowing money have greater flexibility to use that money when there are debt covenants. c. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. d. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching.

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Chapter 13: Corporate Governance e. A supplier substituting a lower-quality raw material without approval is an example of asset switching.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 25. Which one of the following statements is TRUE? a. A corporate executive health club is an example of a nonpecuniary benefit. b. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. c. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching. d. A supplier substituting a lower-quality raw material without approval is an example of asset switching. e. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 26. Which one of the following statements is TRUE? a. Personal use of the corporate jet is an example of a nonpecuniary benefit.

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Chapter 13: Corporate Governance b. A supplier substituting a lower-quality raw material without approval is an example of asset switching. c. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites. d. An agency conflict between inside owners/managers and outside owners occurs when the outside owners sell their shares to someone else. e. A quarter-end bonus is an example of a nonpecuniary benefit.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 27. Which one of the following statements is TRUE? a. A manager/shareholder agency conflict arises when the manager's actions aren't in the company's best interest. b. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites. c. An agency conflict between inside owners/managers and outside owners occurs when the outside owners sell their shares to someone else. d. A quarter-end bonus is an example of a nonpecuniary benefit. e. A company's matching contribution to a retirement plan is a nonpecuniary benefit.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance DATE MODIFIED:

11/16/2018 9:24 AM

28. Which one of the following statements is TRUE? a. A manager avoiding a positive NPV but risky project is an example of a manager-shareholder conflict. b. Management is said to be entrenched when the company is doing badly and is "stuck in a rut." c. A quarter-end bonus is an example of a nonpecuniary benefit. d. A company's matching contribution to a retirement plan is a nonpecuniary benefit. e. Company sponsorship of a local charity is an example of a nonpecuniary benefit.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 29. Which one of the following statements is TRUE? a. A manager not closing a factory that is losing money but which is in his hometown is an example of a manager-shareholder conflict. b. Management is said to be entrenched when the senior managers are consuming excessive perquisites c. A company's matching contribution to a retirement plan is a nonpecuniary benefit. d. Company sponsorship of a local charity is an example of a nonpecuniary benefit. e. A manager/shareholder agency conflict arises when shareholders sell their stock even though management says the stock is undervalued.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

30. Which one of the following statements is TRUE? a. Management is said to be entrenched when senior managers are unlikely to be fired. b. A company's matching contribution to a retirement plan is a nonpecuniary benefit. c. Company sponsorship of a local charity is an example of a nonpecuniary benefit. d. A manager/shareholder agency conflict arises when shareholders sell their stock even though management says the stock is undervalued. e. A manager/shareholder agency conflict arises when the board of directors pays a larger dividend than the firm's earnings could support.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.01 - LO: 13-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 31. Which one of the following statements is TRUE? a. One tool of corporate governance is the threat of removing current management. b. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. c. One tool of corporate governance is the choice of how much dividends to pay. d. Corporate governance is when an officer of a corporation is elected to public office. e. One tool of corporate governance is the location of the company headquarters.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

32. Which one of the following statements is TRUE? a. One tool of corporate governance is monitoring management. b. One tool of corporate governance is the choice of how much dividends to pay. c. A company's matching contribution to a retirement plan is a nonpecuniary benefit d. One tool of corporate governance is stock repurchases. e. Corporate governance is better when Directors are also employees of the company so they know the business very well.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 33. Which one of the following statements is TRUE? a. One tool of corporate governance is how the company's charter affects the likelihood of a takeover. b. One tool of corporate governance is stock repurchases. c. One tool of corporate governance is a company's tax avoidance strategy. d. One tool of corporate governance is choosing a good investment banker. e. Creditors have a claim on a firm's earning stream through the dividend payments they receive.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

34. Which one of the following statements is TRUE? a. One tool of corporate governance is the use of accounting control systems. b. An example of asset switching is an option to exchange one piece of real estate for another. c. One tool of corporate governance is the location of the company headquarters. d. An example of an agency relationship is when a supervisor hires a forklift operator. e. One tool of corporate governance is a company's tax avoidance strategy.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 35. Which one of the following statements is TRUE? a. A classified board is one in which the board members have staggered terms. b. One tool of corporate governance is a company's tax avoidance strategy. c. One tool of corporate governance is choosing a good investment banker. d. A classified board is one in which the board members serve anonymously. e. A classified board is one in which an announcement requesting applications for board members appears in the newspaper.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

36. Which one of the following statements is TRUE? a. If a company has a classified board, fewer board seats are filled each year. b. One tool of corporate governance is choosing a good investment banker. c. A classified board is one in which the board members serve anonymously. d. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. e. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 37. Which one of the following statements is TRUE? a. It is harder for dissidents to gain board seats if a company's board is classified. b. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. c. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. d. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. e. Management is said to be entrenched when the senior managers are consuming excessive perquisites.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 38. Which one of the following statements is TRUE? a. An inside director is a board member who also holds a managerial position in the company. b. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. c. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. d. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. e. Company sponsorship of a local charity is an example of a nonpecuniary benefit.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 39. Which one of the following statements is TRUE? a. An outside director is a board member who has no other affiliation with the company. b. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. c. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. d. Inside directors are more concerned with shareholders' interests since they are more closely concerned with Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance firm operations. e. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 40. Which one of the following statements is TRUE? a. Inside directors are likely to side with the CEO since they are employees. b. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. c. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. d. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. e. The more members of a board of directors, the better its function.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 41. Which one of the following statements is TRUE? Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance a. Frequently, large boards of directors are less effective than small boards of directors. b. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. c. The more members of a board of directors, the better its function. d. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. e. A company whose board members are elected in staggered terms is said to be an interlocking board of directors.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 42. Which one of the following statements is TRUE? a. Companies with interlocking boards of directors have directors that serve on both boards. b. The more members of a board of directors, the better its function. c. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. d. A company whose board members are elected in staggered terms is said to be an interlocking board of directors. e. A shareholder-friendly charter will make it harder for a company to be acquired.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

43. Which one of the following statements is TRUE? a. A shareholder-friendly charter will make it easier for a company to be acquired. b. A company whose board members are elected in staggered terms is said to be an interlocking board of directors. c. A shareholder-friendly charter will make it easier for shareholders to meet with the CEO if they have concerns. d. A targeted share repurchase can be used to encourage a hostile takeover. e. An example of an agency cost is when the board of directors pays a dividend to shareholders.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 44. Which one of the following statements is TRUE? a. A targeted share repurchase is when the company purchases stock from one shareholder at a higher price than it offers to other shareholders. b. An example of asset switching is an option to exchange one piece of real estate for another. c. A shareholder-friendly charter will make it harder for a company to be acquired. d. A targeted share repurchase can be used to encourage a hostile takeover. e. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Corporate governance Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:03 AM 11/16/2018 9:24 AM

45. Which one of the following statements is TRUE? a. A targeted share repurchase can be used to prevent a hostile takeover. b. A targeted share repurchase can be used to increase the stock price if the company is undervalued. c. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price. d. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. e. One tool of corporate governance is choosing a good investment banker.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 46. Which one of the following statements is TRUE? a. Shareholders benefit when the company is acquired because they usually receive a higher price for their shares b. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price. c. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. d. A shareholder rights provision encourages takeovers because shareholders have the right to approve the takeover if the terms are good. e. A classified board is one in which the board members serve anonymously.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 47. Which one of the following statements is TRUE? a. A shareholder rights provision discourages takeovers because the acquiring company will suffer dilution. b. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. c. A company whose board members are elected in staggered terms is said to have an interlocking board of directors. d. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. e. A classified board is one in which the board members serve anonymously.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 48. A company issues bonds saying that it will use the proceeds for a safe investment. Instead, it uses the proceeds for a risky investment. Which of the following statements is true about this situation. a. This is an example of asset switching or bait and switch. b. What the company does with the funds once it raises them isn't the business of the debtholders. c. This will result in an increase in the value of the debt because the company is riskier. d. All of the above. e. None of the above.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 49. A company issues bonds saying that it will use the proceeds for a safe investment. Instead, it uses the proceeds for a risky investment. Which of the following statements is true about this situation. a. This will result in a decrease in the value of the debt because the company is riskier. b. This will result in a decrease in the value of the equity because the company is riskier. c. This will result in a lawsuit from the stockholders because it is bait and switch. d. This will cause bondholders to convert their bonds to stock. e. Dividends will go up to compensate shareholders for their increased risk.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 50. Which one of the following corporate board characteristics usually improves corporate governance? a. CEO is not the chairman of the board. b. The board has many outsiders who have lots of other important commitments. c. The board is as large as is possible. d. Board members are paid at a rate higher than their peers and their payment is mostly cash. e. The board has a majority of insiders from company management on it who bring first-hand knowledge of how the company operates.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 13: Corporate Governance POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM 51. Which one of the following corporate board characteristics usually improves corporate governance? a. The board has a majority of outsiders who have experience and aren't too busy. b. CEO is the chairman of the board. c. The board is as large as is possible. d. Board members are paid at a rate higher than their peers and their payment is mostly cash. e. The board has a majority of insiders from company management on it who bring first-hand knowledge of how the company operates.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.13.02 - LO: 13-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:03 AM DATE MODIFIED: 11/16/2018 9:24 AM

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases 1. Which of the following statements is correct? a. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. b. Stock repurchases can be used by a firm that wants to increase its debt ratio. c. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding. e. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.10 - LO: 14-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock repurchases and DRIPs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 2. Which of the following statements is correct? a. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends. b. Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced.

The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities. c. If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense. d. Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities. e. If a company offers a dividend reinvestment plan, almost all of its shareholders enroll in the plan.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.14 - LO: 14-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Dividend policy United States - OH - Default City - TBA Dividends, DRIPs, and repurchases Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 11/13/2018 4:56 PM

3. Which of the following statements is correct? a. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase. b. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model. c. Companies may pay too high a price in a large open market repurchase if it takes too long to complete. d. An investor’s capital gains from selling stock in a repurchase are always taxed at a higher rate than if the distribution were dividends. e. The tax code encourages companies to pay dividends rather than reinvest earnings.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.10 - LO: 14-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend policy and stock repurchases KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 12/5/2018 1:01 PM 4. Which of the following statements is correct? a. Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases. b. Very often, a company's stock price will rise when it announces that it plans to commence a share repurchase program because a repurchase announcement usually is seen as a positive signal from management. c. Stock repurchases increase the number of outstanding shares. d. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter. e. If a company has a 2-for-1 stock split, its stock price should roughly double.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.10 - LO: 14-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous dividend concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 12/5/2018 1:09 PM 5. The following data apply to Garber Industries, Inc. (GII): Value of operations $1,000 Short-term investments $100 Debt $300 Number of shares 100 The company plans on distributing $100 as dividend payments. What will the intrinsic per share stock price be immediately after the distribution? a. $6.32 b. $6.65 c. $7.00 d. $7.35 e. $7.72 ANSWER: c RATIONALE: Prior to After Distribution Distribution Value of operations $1,000.00 $1,000.00 + Value of nonoperating assets 100.00 0.00 Total intrinsic value of firm $1,100.00 $1,000.00 −Debt 300.00 300.00 Intrinsic value of equity $ 800.00 $ 700.00 ÷ Number of shares 100.00 100.00 Intrinsic price per share $ 8.00 $ 7.00 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.09 - LO: 14-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividends and intrinsic stock price KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases DATE CREATED: DATE MODIFIED:

zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

6. The following data apply to Elizabeth's Electrical Equipment: Value of operations $20,000 Short-term investments $1,000 Debt $6,000 Number of shares 300 The company plans on distributing $1,000 by repurchasing stock. What will the intrinsic per share stock price be immediately after the repurchase? a. $47.50 b. $50.00 c. $52.50 d. $55.13 e. $57.88 ANSWER: b RATIONALE: Prior to After Distribution Distribution Value of operations $20,000 $20,000 + Value of nonoperating assets $ 1,000 $0 Total intrinsic value of firm $21,000 $20,000 − Debt $ 6,000 $ 6,000 Intrinsic value of equity $15,000 $14,000 ÷ Number of shares 300 280 Intrinsic price per share $ 50.00 $ 50.00 # shares repurchased = Value of nonoperating assets / Price prior to distribution

$20.00

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.09 - LO: 14-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Repurchases and intrinsic stock price KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases 7. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal distribution policy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 8. The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend irrelevance KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 9. MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend irrelevance KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 10. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investors' dividend preferences KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 11. The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividends and stock prices KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases DATE MODIFIED:

8/9/2018 11:04 AM

12. Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend irrelevance KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 13. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend-growth tradeoff KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 14. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that a. investors require that the dividend yield and capital gains yield equal a constant. b. capital gains are taxed at a higher rate than dividends. c. investors view dividends as being less risky than potential future capital gains. d. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases the lower tax rate on capital gains. e. investors are indifferent between dividends and capital gains.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividends versus capital gains KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 15. Which of the following should not influence a firm's dividend policy decision? a. A strong preference by most shareholders for current cash income versus capital gains. b. Constraints imposed by the firm's bond indenture. c. The fact that much of the firm's equipment has been leased rather than bought and owned. d. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains. e. The firm's ability to accelerate or delay investment projects.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.03 - LO: 14-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 16. If the signaling, hypothesis (which is also called the information content hypothesis) is correct, then changes in dividend policy can have an important effect on the firm's value and capital costs. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.05 - LO: 14-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Signaling hypothesis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 17. Which of the following statements about dividend policies is correct? a. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. c. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. d. The clientele effect suggests that companies should follow a stable dividend policy. e. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.05 - LO: 14-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend theories KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 18. In the real world, dividends a. are usually more stable than earnings. b. fluctuate more widely than earnings. c. tend to be a lower percentage of earnings for mature firms. d. are usually changed every year to reflect earnings changes, and these changes are randomly higher or lower, depending on whether earnings increased or decreased.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS will equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the actual dividend depends strictly on earnings.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.06 - LO: 14-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend payout KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 19. If a firm adopts a residual distribution policy, distributions are determined as a residual after funding the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio should be. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual distribution policy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 20. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual distribution policy. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual distribution policy KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 21. If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities or earnings from year to year. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and dividend policy KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 22. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio? a. Its access to the capital markets increases. b. Its R&D efforts pay off, and it now has more high-return investment opportunities. c. Its accounts receivable decrease due to a change in its credit policy. d. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages. e. Its earnings become more stable.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Dividend payout Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

23. Reynolds Paper Products Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share? a. The company increases the percentage of equity in its target capital structure. b. The number of profitable potential projects increases. c. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed. d. Earnings are unchanged, but the firm issues new shares of common stock. e. The firm's net income increases.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 24. The projected capital budget of Kandell Corporation is $1,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $550,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out? a. $122,176 b. $128,606 c. $135,375 d. $142,500 e. $150,000 ANSWER: e RATIONALE: Capital budget $1,000,000 % Equity 40% Net income (NI) $550,000 Dividends paid = NI − [% Equity(Capital budget)] $150,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual model-divs paid, divs always positive KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 25. Grandin Inc. is evaluating its dividend policy. It has a capital budget of $625,000, and it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio? a. 40.61% b. 42.75% c. 45.00% d. 47.37% e. 49.74% ANSWER: d RATIONALE: Capital budget $625,000 Equity ratio 40% Net income (NI) $475,000 Dividends paid = NI − (Equity ratio)(Capital budget) $225,000 Dividend payout ratio = Dividends paid/NI 47.37% POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend model–dividend payout ratio KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 26. The capital budget of Creative Ventures Inc. is $1,000,000. The company wants to maintain a target capital structure that is 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If the company Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases follows a residual dividend policy, what will be its total dividend payment? a. $100,000 b. $200,000 c. $300,000 d. $400,000 e. $500,000 ANSWER: a RATIONALE: The amount of new investment which must be financed with equity is: $1,000,000 × 70% = $700,000. Since the firm has $800,000 of net income only $100,000 will be left for dividends.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy–nonalgorithmic KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 27. Rohter Galeano Inc. is considering how to set its dividend policy. It has a capital budget of $3,000,000. The company wants to maintain a target capital structure that is 15% debt and 85% equity. The company forecasts that its net income this year will be $3,500,000. If the company follows a residual dividend policy, what will be its total dividend payment? a. $205,000 b. $500,000 c. $950,000 d. $2,550,000 e. $3,050,000 ANSWER: c RATIONALE: The amount of new investment which must be financed with equity is: $3,000,000 × 85% = $2,550,000. Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 − $2,550,000 will be left for dividends.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Residual dividend policy–nonalgorithmic Bloom’s: Application TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

28. Sanchez Company has planned capital expenditures that total $2,000,000. The company wants to maintain a target capital structure that is 35% debt and 65% equity. The company forecasts that its net income this year will be $1,800,000.

If the company follows a residual dividend policy, what will be its total dividend payment? a. $100,000 b. $200,000 c. $300,000 d. $400,000 e. $500,000 ANSWER: e RATIONALE: The amount of new investment which must be financed with equity is: $2,000,000 × 65% = $1,300,000. Since the firm has $1,800,000 of net income only $500,000 = $1,800,000 − $1,300,000 will be left for dividends.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy–nonalgorithmic KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 29. McCann Publishing has a target capital structure of 35% debt and 65% equity. This year's capital budget is $850,000 and it wants to pay a dividend of $400,000. If the company follows a residual dividend policy, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance? a. $904,875 b. $952,500 c. $1,000,125 d. $1,050,131 e. $1,102,638 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases ANSWER: RATIONALE:

b Capital budget $850,000 Equity ratio 65% Dividends to be paid $400,000 Required net income = Dividends + (Capital budget × % Equity) $952,500 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend model–find net income KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 30. Harvey's Industrial Plumbing Supply's target capital structure consists of 40% debt and 60% equity. Its capital budget this year is forecast to be $650,000. It also wants to pay a dividend of $225,000. If the company follows the residual dividend policy, how much net income must it earn to meet its capital requirements, pay the dividend, and keep the capital structure in balance? a. $584,250 b. $615,000 c. $645,750 d. $678,038 e. $711,939 ANSWER: b RATIONALE: Capital budget $650,000 % Equity 60% Dividends to be paid $225,000 Required net income = Dividends + (Capital budget × % Equity) $615,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend model–find net income KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases OTHER: NOTES: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

31. Victor Rumsfeld Inc.'s dividend policy is under review by its board. Its projected capital budget is $2,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $600,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out? a. $240,000 b. $228,000 c. $216,600 d. $205,770 e. $0 ANSWER: e RATIONALE: Capital budget $2,000,000 % Equity 40% Net income (NI) $600,000 Dividends paid = NI − [% Equity(Capital Budget)] $0 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual model–divs paid, divs are zero KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 32. The capital budget forecast for the Santano Company is $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and it also wants to pay dividends of $500,000. If the company follows the residual dividend policy, how much income must it earn, and what will its dividend payout ratio be?

Net Income Payout a. $ 898,750 55.63% b. $ 943,688 58.41% c. $ 990,872 61.34% d. $1,040,415 64.40% e. $1,092,436 67.62% ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases RATIONALE:

Capital budget $725,000 Equity ratio 55% Dividends paid $500,000 NI = Divs + (Eq % × Cap Bud) $898,750 Payout = Dividends/NI 55.63% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual model–find NI, then divs and payout KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 33. United Builders wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is $550,000, and because of market conditions, the company will not issue any new stock during the coming year. If the firm follows the residual dividend policy, what is the maximum capital budget that is consistent with maintaining the target capital structure? a. $673,652 b. $709,107 c. $746,429 d. $785,714 e. $825,000 ANSWER: d RATIONALE: % Debt 30% % Equity 70% Net income $550,000 Max capital budget = NI/% Equity $785,714 Check: Is calculated max cap bud × %Equity = NI? $550,000= net income POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

34. Silvana Inc. projects the following data for the coming year. If the firm follows the residual dividend policy and also maintains its target capital structure, what will its payout ratio be?

EBIT Interest rate Debt outstanding Shares outstanding a. 46.9% b. 49.3% c. 51.9% d. 54.7% e. 57.4% ANSWER: RATIONALE:

$2,000,000Capital budget 10%% Debt $5,000,000% Equity $5,000,000Tax rate

$850,000 40% 60% 25%

d EBIT $2,000,000Capital budget Interest rate 10%% Debt Debt outstanding $5,000,000% Equity Shares outstanding $5,000,000Tax rate EBIT − Interest expense = interest rate × debt Taxable income − Taxes = Tax rate × income Net income (NI) − Equity needed for capital budget = % Equity(capital budget) = Dividends = NI − Equity needed Payout ratio = Dividends/NI

$850,000 40% 60% 25% $2,000,000 500,000 $1,500,000 375,000 $1,125,000 510,000 $ 615,000 54.67%

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases DATE MODIFIED:

1/27/2019 9:18 PM

35. David Rose Inc. forecasts a capital budget of $500,000 next year with forecasted net income of $400,000. The company wants to maintain a target capital structure of 30% debt and 70% equity. If the company follows the residual dividend policy, how much in dividends, if any, will it pay? a. $42,869 b. $45,125 c. $47,500 d. $50,000 e. $52,500 ANSWER: d RATIONALE: % Debt 30% % Debt 70% Capital budget $500,000 Net income $400,000 Equity requirement = Cap Bud × % Equity = $350,000 Dividends = NI − Equity requirement = $50,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy Dividend may be zero KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 36. Warren Supply Inc. is evaluating its capital budget. The company finances with debt and common equity, but because of market conditions, wants to avoid issuing any new common stock during the coming year. It is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per share. Given these constraints, what percentage of the capital budget must be financed with debt? a. 30.54% b. 32.15% c. 33.84% d. 35.63% e. 37.50% ANSWER: e RATIONALE: EPS $3.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases Shares outstanding 500,000 DPS $2.00 Capital budget $800,000 Net income = EPS × Shares outstanding = $1,500,000 Dividends paid = DPS × Shares outstanding = $1,000,000 Retained earnings available $500,000 Capital budget − Retained earnings = Debt needed $300,000 Debt needed/Capital budget = % Debt financing 37.5% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend model–req'd debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 37. Getler Inc.'s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity, and its forecasted net income is $1,000,000. If the company follows a residual dividend policy, how much dividends will it pay or, alternatively, how much new stock must it issue?

Dividends Stock Issued a. $514,425 $162,901 b. $541,500 $171,475 c. $570,000 $180,500 d. $600,000 $190,000 e. $ 0 $200,000 ANSWER: e RATIONALE: Capital budget % Equity Net income (NI) Dividends paid = NI − [% Equity(Cap. Bud)], stock issued if dividends zero or neg POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

$2,000,000 60% $1,000,000 Dividends:or new stock: $0$200,000

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Dividend policy United States - OH - Default City - TBA Residual model–divs paid or stock issued Bloom’s: Analysis TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

38. Norton Electrical has quite a few positive NPV projects from which to choose. The problem is that it has more of these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in the foreseeable future. Norton's projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.

Increase in Capital Budget Increase Lower Debt to 75% Payout to 20% Do both a. $114.0 $73.3 $333.9 b. $120.0 $77.2 $351.5 c. $126.4 $81.2 $370.0 d. $133.0 $85.5 $389.5 e. $140.0 $90.0 $410.0 ANSWER: e RATIONALE:

NI %Debt %Equity % Payout Dividends Retained earnings Max. capital budget = RE/%Equity Increase over current: Changed amt − Current max.

Current maximum $150.0 25.0% 75.0% 65.0% $97.5 $52.5 $70.0 NA

New Maximums: If increase If lower debt payout $150.0 $150.0 75.0% 25.0% 25.0% 75.0% 65.0% 20.0% $97.5 $30.0 $52.5 $120.0 $210.0 $160.0 $140.0

$90.0

If do both $150.0 75.0% 25.0% 20.0% $30.0 $120.0 $480.0 $410.0

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.07 - LO: 14-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Residual model–divs paid or stock issued Bloom’s: Analysis TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

39. If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay a. no dividends to common stockholders. b. dividends only out of funds raised by the sale of new common stock. c. dividends only out of funds raised by borrowing money (i.e., issue debt). d. dividends only out of funds raised by selling off fixed assets. e. no dividends except out of past retained earnings.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.08 - LO: 14-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 40. If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that a. the dividend payout ratio is increasing. b. no dividends were paid during the year. c. the dividend payout ratio is decreasing. d. the dollar amount of investments has decreased. e. the dividend payout ratio has remained constant.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.08 - LO: 14-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Residual dividend policy Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

41. Which of the following statements is correct? a. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. b. An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM. c. If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price. d. Stock repurchases make the most sense at times when a company believes its stock is undervalued. e. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.12 - LO: 14-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend theories KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 42. Which of the following statements is correct? a. If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy. b. If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve. c. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios. d. Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees. e. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.12 - LO: 14-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 43. Consider two very different firms, M and N. Firm M is a mature firm in a mature industry. Its annual net income and net cash flows are both consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new firm in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is correct? a. Firm M probably has a higher dividend payout ratio than Firm N. b. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. c. The two firms are equally likely to pay high dividends. d. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income. e. Firm M probably has a lower debt ratio than Firm N. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.12 - LO: 14-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous dividend concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 44. Which of the following statements is correct? a. The clientele effect can explain why so many firms change their dividend policies so often. b. One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele. c. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the firm's total amount of book equity. d. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases dividends are received. e. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.12 - LO: 14-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 45. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock dividends and stock splits KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 46. A reverse split reduces the number of shares outstanding. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Reflective Thinking United States - AK - DISC: Dividend policy United States - OH - Default City - TBA Reverse split Bloom’s: Knowledge 8/9/2018 11:04 AM 8/9/2018 11:04 AM

47. Even if a stock split has no information content, and even if the dividend per share adjusted for the split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a split, but any such benefit is probably small. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 48. Poff Industries' stock currently sells for $120 a share. You own 100 shares of the stock. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place? a. You will have 200 shares of stock, and the stock will trade at or near $60 a share. b. You will have 100 shares of stock, and the stock will trade at or near $60 a share. c. You will have 50 shares of stock, and the stock will trade at or near $120 a share. d. You will have 50 shares of stock, and the stock will trade at or near $60 a share. e. You will have 200 shares of stock, and the stock will trade at or near $120 a share.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

49. Which of the following statements is CORRECT? a. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today. b. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits. c. When a company declares a stock split, the price of the stock typically declines⎯by about 50% after a 2-for-1 split⎯and this necessarily reduces the total market value of the equity. d. If a firm's stock price is quite high relative to most stocks⎯say $500 per share⎯then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share. e. When firms are deciding on the size of stock splits⎯say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock dividends and stock splits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 50. Which of the following statements is correct? a. An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers. b. Stock repurchases tend to reduce financial leverage. c. If a company declares a 2-for-1 stock split, its stock price should roughly double. d. One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory. e. If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

ANSWER: e POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous dividend concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 51. Yesterday, Berryman Investments was selling for $90 per share. Today, the company completed a 7-for-2 stock split.

If the total market value was unchanged by the split, what is the price of the stock today? a. $23.21 b. $24.43 c. $25.71 d. $27.00 e. $28.35 ANSWER: c RATIONALE: Number of new shares 7 Number of old shares 2 Old (pre-split) price $90 New price = Old price × (Old shrs/New shrs) $25.71 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits–fractional splits KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 52. Last week, Weschler Paint Corp. completed a 3-for-1 stock split. Immediately prior to the split, its stock sold for $150 per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's post-split price? a. $50.00 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases b. $52.50 c. $55.13 d. $57.88 e. $60.78 ANSWER: RATIONALE:

a Number of new shares 3 Number of old shares 1 Pre-split stock price $150 $50.00 Post-split stock price: P0/New per old = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits–simple splits KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 53. In recent years Constable Inc. has suffered losses, and its stock currently sells for only $0.50 per share. Management wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $25 per share. How many of the old shares must be given up for one new share to achieve the $25 price, assuming this transaction has no effect on total market value? a. 47.50 b. 49.88 c. 50.00 d. 52.50 e. 55.13 ANSWER: c RATIONALE: Current price $0.50 Target price $25.00 Old shares surrendered per 1 new share = Target price/Old price 50.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Stock splits–reverse split Bloom’s: Analysis TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

54. Brinkley Resources stock has increased significantly over the last five years, selling now for $175 per share.

Management feels this price is too high for the average investor and wants to get the price down to a more typical level, which it thinks is $25 per share. What stock split would be required to get to this price, assuming the transaction has no effect on the total market value? Put another way, how many new shares should be given per one old share? a. 6.65 b. 6.98 c. 7.00 d. 7.35 e. 7.72 ANSWER: c RATIONALE: Current price $175.00 Target price $25.00 No. of new shares per 1 old share = Current price/Target price 7.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits–optimal stock split KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 55. Downie Foods recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If the firm's total market value increased by 5% as a result of increased liquidity caused by the split, what was the stock price following the split? a. $28.43 b. $29.93 c. $31.50 d. $33.08 Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases e. $34.73 ANSWER: RATIONALE:

c New shares per 1 old share 4 Pre-split stock price $120 % value increase 5% $31.50 Post-split stock price = (P0/New per old)(% Value increase) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock splits–positive market reaction KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 56. The Meltzer Corporation is contemplating a 7-for-3 stock split. The current stock price is $75.00 per share, and the firm believes that its total market value would increase by 5% as a result of the improved liquidity that it thinks would follow the split. What is the stock's expected price following the split? a. $32.06 b. $33.75 c. $35.44 d. $37.21 e. $39.07 ANSWER: b RATIONALE: Number of new shares 7 Number of old shares 3 Old (pre-split) price $75.00 % Increase in value 5% New price before value increase = Old price/(Old shares/New shares) $32.14 New price after value increase = Prior × (1 + % Value increase) $33.75 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.13 - LO: 14-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Stock splits–positive market reaction Bloom’s: Analysis TYPE: Multiple Choice: Problem With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

57. Which of the following actions will best enable a company to raise additional equity capital? a. Declare a stock split. b. Begin an open-market purchase dividend reinvestment plan. c. Initiate a stock repurchase program. d. Begin a new-stock dividend reinvestment plan. e. Refund long-term debt with lower cost short-term debt.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.14.14 - LO: 14-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous dividend concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 58. Which of the following statements is NOT correct? a. After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will rise. b. Investors can interpret a stock repurchase program as a signal that the firm's managers believe the stock is undervalued. c. Companies can repurchase shares to distribute large inflows of cash, say from the sale of a division, to stockholders without paying cash dividends. d. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan. e. Stock repurchases can be used by a firm as part of a plan to change its capital structure.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 14: Distributions to Shareholders: Dividends and Repurchases LEARNING OBJECTIVES: FMTP.EHRH.20.14.14 - LO: 14-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Dividend policy LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock repurchases and stock splits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM

Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 1. Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy costs KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 2. A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 3. Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 4. As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 5. A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 6. Whenever a firm borrows money, it is using financial leverage. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 7. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Use of financial leverage KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 8. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating and financial leverage KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 9. If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Use of debt in financing KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 10. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage.

Therefore, the variability of both firms' expected EBITs could actually be identical. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 11. Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business risk KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 12. It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS. a. True b. False ANSWER: True RATIONALE: If one firm's sales and earnings were more volatile than those of the other, it could have greater EPS variability in spite of identical financial and operating leverage.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating and financial leverage KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 13. Which of these items will not generally be affected by an increase in the debt ratio? a. Total risk. b. Financial risk. c. Market risk. d. The firm's beta.

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Chapter 15: Capital Structure Decisions e. Business risk.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 14. Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations. a. Sales price variability. b. The extent to which operating costs are fixed. c. The extent to which interest rates on the firm's debt fluctuate. d. Input price variability. e. Demand variability.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 15. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will a. normally lead to a decrease in its business risk. b. normally lead to a decrease in the standard deviation of its expected EBIT. c. normally lead to a decrease in the variability of its expected EPS. d. normally lead to a reduction in its fixed assets turnover ratio.

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Chapter 15: Capital Structure Decisions e. normally lead to an increase in its fixed assets turnover ratio.

ANSWER: d RATIONALE: More operating leverage generally means a greater use of automation, which means more fixed assets. If fixed assets increase, but sales do not, then the fixed asset turnover (S/FA) will decline.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating leverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 16. If debt financing is used, which of the following is CORRECT? a. The percentage change in net operating income will be equal to a given percentage change in net income. b. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. c. The percentage change in net income will be greater than the percentage change in net operating income. d. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. e. The percentage change in net operating income will be greater than a given percentage change in net income.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Use of financial leverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 17. Which of the following statements is CORRECT, holding other things constant? a. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.

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Chapter 15: Capital Structure Decisions b. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. c. An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. d. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. e. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage and capital structure KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 18. Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? a. The costs that would be incurred in the event of bankruptcy increase. b. Management believes that the firm's stock has become overvalued. c. Its degree of operating leverage increases. d. The corporate tax rate increases. e. Its sales become less stable over time.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage and capital structure KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 19. Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's return on invested capital (ROIC), which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan? a. The company's earnings per share would decline. b. The company's cost of equity would increase. c. The company's ROA would increase. d. The company's ROE would decline. e. The company's net income would increase.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage and capital structure KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/14/2018 6:51 AM 20. Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its return on invested operating capital (ROIC) is 14.5%. The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would remain unchanged. b. The ROIC would decline. c. The ROIC would increase. d. The ROE would increase. e. The ROA would increase.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure, ROA, and ROE Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 11/14/2018 6:54 AM

21. Which of the following statements is CORRECT? a. There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. b. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. c. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. d. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing. e. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous capital structure concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 22. Which of the following statements is CORRECT? a. A change in the personal tax rate should not affect firms' capital structure decisions. b. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. c. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. d. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. e. If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller taxadjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous capital structure concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 23. The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even? a. $600,000 b. $466,667 c. $333,333 d. $200,000 e. None of the above ANSWER: d RATIONALE: $7(200,000) − $5(200,000) − F = 0; F = $400,000. $7(200,000) − $4(200,000) − F = 0; F = $600,000. $600,000 − $400,000 = $200,000.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Breakeven point–nonalgorithmic KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 24. Larsen Films' is analyzing its cost structure. Its fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit. What is the company's breakeven point, i.e., at what unit sales volume would income equal costs? a. 391,667 b. 411,250 c. 431,813 d. 453,403 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions e. 476,073 ANSWER: RATIONALE:

a Fixed operating costs Variable costs per unit Sales price per unit Breakeven volume (units) = FC/(P − VC) = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Breakeven analysis KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM

$470,000 $2.80 $4.00 391,667

25. A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000. What sales volume would be required in order to break even, i.e., to have an EBIT of zero for the stereo business? a. 86,640 b. 91,200 c. 96,000 d. 100,800 e. 105,840 ANSWER: c RATIONALE: VC/unit $2.50 Price multiple over VC 1.50 Price $3.75 Fixed costs $120,000 Breakeven volume (units) = FC/(P − VC) = 96,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Breakeven analysis KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 8/9/2018 11:04 AM

26. Hernandez Corporation expects to have the following data during the coming year. What is Hernandez's expected ROE? Assets D/A EBIT a. 15.64% b. 16.43% c. 17.25% d. 18.11% e. 19.01% ANSWER: RATIONALE:

$200,000Interest rate 65%Tax rate $25,000

a Assets D/A EBIT Interest rate Tax rate

8% 25%

$200,000 65% $25,000 8% 25%

EBIT $25,000 − Interest 10,400 EBT $14,600 − Tax 3,650 NI $10,950 ROE = NI avail to common/Common equity ROE = 15.64% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt's effect on ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/3/2019 11:23 PM 27. After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions level of output will the two methods produce the same net operating income (EBIT)? a. 5,000 decks b. 10,000 decks c. 15,000 decks d. 20,000 decks e. 25,000 decks ANSWER: b RATIONALE: Total cost Method 1 = $1.00Q + $10,000. Total cost Method 2 = $1.50Q + $5,000. Set equal and solve for Q: Q + $10,000 = $1.50Q + $5,000; $5,000 = $0.5Q; 10,000 = Q. POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating income–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 28. A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more.

What sales volume would be required in order to meet this profit goal? a. 4,513 b. 4,750 c. 5,000 d. 5,250 e. 5,513 ANSWER: c RATIONALE: VC/unit $250 Price multiple over VC 2 Price $500 Fixed costs $750,000 Profit target $500,000 Volume (units) to meet profit goal = (FC + Profit)/(P − VC) = 5,000 Check: Op profit = (P − VC) × Units − FC = $500,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - ak - DISC: Capital structure United States - OH - Default City - TBA EBIT and setting the price Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 8/9/2018 11:04 AM

29. Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt⎯HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? Applicable to Both Firms Firm HD's Data Firm LD's Data Assets $200Debt ratio 50%Debt ratio 30% EBIT $40Interest rate 12%Interest rate 10% Tax rate 25% a. 2.51% b. 2.65% c. 2.79% d. 2.93% e. 3.07% ANSWER: c RATIONALE: Applicable to Both Firms Firm HD's Data Firm LD's Data Assets $200Debt ratio 50%Debt ratio 30% EBIT $40Interest rate 12%Interest rate 10% Tax rate 25% Debt = $100.0 $60.0 Interest = I = $12.0 $6.0 Taxable income = EBIT − I = $28.0 $34.0 NI = (Taxable Income)(1 − T) = $21.0 $25.5 Equity = A − Debt = $100.0 $140.0 ROE = NI/Equity = 21.00% 18.21% Difference in ROEs = 2.79% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Differences in ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 12:22 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 30. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.04 - LO: 15-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade-off theory KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 31. If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.04 - LO: 15-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy costs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 32. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? a. An increase in the personal tax rate. b. An increase in the company's operating leverage. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new high. e. An increase in the corporate tax rate.

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Chapter 15: Capital Structure Decisions ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Target debt ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 33. Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new low. e. An increase in costs incurred when filing for bankruptcy.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.04 - LO: 15-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage and capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 34. Which of the following statements is CORRECT? a. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. b. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. c. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions d. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt. e. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure and WACC KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 35. The Miller model begins with the MM model with corporate taxes and then adds personal taxes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miller model KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 36. The Miller model begins with the MM model without corporate taxes and then adds personal taxes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miller model KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 37. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM models KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 38. The MM model is the same as the Miller model, but with zero corporate taxes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM models KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 39. The major contribution of the Miller model is that it demonstrates that Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions a. personal taxes decrease the value of using corporate debt. b. financial distress and agency costs reduce the value of using corporate debt. c. equity costs increase with financial leverage. d. debt costs increase with financial leverage. e. personal taxes increase the value of using corporate debt.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miller model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 40. Which of the following statements concerning capital structure theory is NOT CORRECT? a. Under MM with zero taxes, financial leverage has no effect on a firm's value. b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt. c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing. d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU. e. The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM and Miller KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions DATE MODIFIED:

8/9/2018 11:04 AM

Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.

41. Refer to the data for Eccles Incorporated. What is the value of the firm according to MM with corporate taxes? a. $480,938 b. $534,375 c. $593,750 d. $653,125 e. $718,438 ANSWER: c RATIONALE: EBIT: $100,000 Tc: 25% rsU: 16%

Debt: $500,000 VU = EBIT(1 – T)/rsU = $100,000(0.75)/0.16 =$468,750

VL = VU + TD = $468,750 + 0.25($500,000) =

$593,750

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Eccles Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM with taxes model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Eccles Inc.MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 12:26 AM 42. Refer to the data for Eccles Incorporated.What is the firm's cost of equity according to MM with corporate taxes? a. 21.0% b. 23.3% c. 25.9% d. 28.8% e. 32.0% ANSWER: e RATIONALE: EBIT: $100,000 Tc: 25% Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions Debt: $500,000

rsU: 16%

VU = EBIT(1 – T)/rsU = VU = $100,000(0.75)/0.16 =$468,750 VL = VU + TD = VL = $468,750 + 0.25($500,000) =$593,750

S =VE = VL - D = S = $593,750 - $500,000 =$93,750 rsL = rsU + (rsU – rd)(1 – T)(D/S) = rsL = 16% + (16% – 12%)(0.75)($500,000/$93,750) = 32.0%

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Eccles Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM with taxes model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Eccles Inc. MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/3/2019 11:28 PM 43. Refer to the data for Eccles Incorporated. Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income? a. 12.8% b. 14.2% c. 15.8% d. 17.6% e. 19.6% ANSWER: e RATIONALE: Gain from leverage: $126,666 Tc: 25% Debt: $500,000 Ts: 20% Gain/debt: 0.25333 VL = VU + [1 − (1 − Tc)(1 − Ts)/(1 − Td)]D [1 − (1 − Tc)(1 − Ts)/(1 − VL- VU Td)]D = Copyright Cengage Learning. Powered by Cognero.

= Gain from debt Page 22

Chapter 15: Capital Structure Decisions [1 −0.56/(1 − Td)]($500,000)$126,666 = 1 − 0.56/(1 − Td) =0.25333 0.56/(1 − Td) =0.74667

= Gain = Gain/Debt = 1 - (Gain/Debt)

= 0.56/[1(Gain/Debt)]

(1 − Td) =0.80357 Td =19.64%

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Eccles Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.03 - LO: 15-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miller model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the the data for Eccles Inc. MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/3/2019 11:44 PM 44. Which of the following statements is CORRECT? a. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. b. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. c. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. d. Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital. e. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.05 - LO: 15-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - ak - DISC: Capital structure United States - OH - Default City - TBA Variations in capital structures Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

45. Which of the following statements is CORRECT? a. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. b. Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.

However, this action still may raise the company's WACC. c. Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.

However, this action still may lower the company's WACC. d. Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. e. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure and WACC KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 46. Which of the following statements is CORRECT? a. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. b. The capital structure that minimizes the required return on equity also maximizes the stock price. c. The capital structure that minimizes the WACC also maximizes the price per share of common stock. d. The capital structure that gives the firm the best credit rating also maximizes the stock price. e. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 47. Based on the information below for Benson Corporation, what is the optimal capital structure? a. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. b. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. c. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. d. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. e. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 48. Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____. a. stock price. b. cost of equity. c. cost of debt. d. cost of preferred stock. e. earnings per share (EPS).

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 49. Which of the following statements is CORRECT? a. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. b. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. c. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. d. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. e. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 50. The firm's target capital structure should be consistent with which of the following statements? a. Minimize the cost of debt (rd). b. Obtain the highest possible bond rating. c. Minimize the cost of equity (rs). d. Minimize the weighted average cost of capital (WACC). e. Maximize the earnings per share (EPS).

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Target capital structure KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 51. Which of the following statements is CORRECT? a. The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.

Unfortunately, these factors are generally beyond the control of the firm's management. b. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. c. A firm's financial risk can be minimized by diversification. d. The amount of debt in its capital structure can under no circumstances affect a company's business risk. e. A firm's business risk is determined solely by the financial characteristics of its industry.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.05 - LO: 15-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business & fin. risk & cap. struc.

KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 52. Which of the following statements is CORRECT? a. If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. b. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. c. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its return on invested capital. (Assume that the repurchase has no impact on the company's operating income.) d. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. e. Increasing financial leverage is one way to increase a firm's return on invested capital.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage and EPS KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/14/2018 7:06 AM 53. Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC exceeds their after-tax cost of debt, (1-T) rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? a. Company HD has a lower ROA than Company LD. b. Company HD has a lower ROE than Company LD. c. The two companies have the same ROA. d. The two companies have the same ROE. e. Company HD has a higher net income than Company LD. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 54. Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 4.8%. Both firms have positive net income. Which of the following statements is CORRECT? a. Firm L has a lower ROA than Firm U. b. Firm L has a lower ROE than Firm U. c. Firm L has the higher times interest earned (TIE) ratio. d. Firm L has a higher EBIT than Firm U. Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions e. The two companies have the same times interest earned (TIE) ratio.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 55. Two operationally similar companies, HD and LD, have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T)rd. Which of the following statements is CORRECT? a. HD should have a higher times interest earned (TIE) ratio than LD. b. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. c. Given that ROIC > (1-T) rd, HD's stock price must exceed that of LD. d. Given that ROIC > (1-T) rd, LD's stock price must exceed that of HD. e. HD should have a higher return on assets (ROA) than LD. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 56. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. b. All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions ratio. c. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. d. Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC. e. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage and capital structure KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 57. Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) rd. Which of the following statements is CORRECT? a. Company HD has a higher times interest earned (TIE) ratio than Company LD. b. Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's. c. The two companies have the same ROE. d. Company HD's ROE would be higher if it had no debt. e. Company HD has a higher return on assets (ROA) than Company LD. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.02 - LO: 15-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions 58. Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta? a. 0.60 b. 0.63 c. 0.66 d. 0.70 e. 0.73 ANSWER: e RATIONALE: 1.10 bL D/A 0.40 Tax rate 25% D/E = (D/A)/(1 − D/A) 0.67 0.73 bU = bL/(1 + (D/E) × (1 − T)) POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating the unlevered beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 12:37 AM 59. The following information has been presented to you about the Gibson Corporation.

Total assets $3,000 millionTax rate 25% Operating income (EBIT) $800 millionDebt ratio 0% Interest expense $0 millionWACC 10% Net income $480 millionM/B ratio 1.00× Share price $32.00EPS = DPS $3.20 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS).

The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 8%. If the company makes this change, what would be the total market value (in millions) of the firm? a. $4,400 b. $4,800 c. $5,200 d. $5,400 e. $6,000 ANSWER: e RATIONALE: Step 1: Find the new WACC: Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions WACC = wcrs + wd(1 − T)rd = (0.8(0.11)) + (0.2(1 − 0.25)0.08) = 0.10.

Step 2:

Step 3:

Find the free cash flow: Because there is no growth, there is no investment in capital, hence FCF is equal to NOPAT: FCF = NOPAT − Investment in capital = EBIT(1 − T) −0 = $800(1 − 0.25) = $600 million.

Find the new value of the firm: V = FCF/(WACC − g) = $600/0.10 = $6,000 million.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure and value–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 12:40 AM 60. Morales Publishing's tax rate is 25%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity? a. 1.91% b. 2.12% c. 2.33% d. 2.57% e. 2.82% ANSWER: b RATIONALE: 1.10 bU = Target % Debt = 30% Target D/E = 0.43 T= 25% 1.45 bL = bU × (1+ (D/E) × (1 − T)) 5.00% rRF = 6.00% RPM = 11.60% rsU = rRF + bU(RPM) = 13.72% rsL = rRF + bL(RPM) = Change in equity cost = 2.12% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating levered beta and cost of equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 10:30 PM 61. Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 25%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity? a. −5.40% b. −6.00% c. −6.60% d. −7.26% e. −7.99% ANSWER: b RATIONALE: 1.60 bL = Current Debt% 80% Target Debt% 25% Current D/E = D%/(1 − D%) 4.00 Target D/E = D%/(1 − D%) 0.67 Tax rate = 25% 0.4000 bU = bL/(1 + (D/E)(1 − T)) 0.6000 new bL = bU × (1 + (D/E) × (1 − T)) 5.00% rRF = 6.00% RPM 14.60% rs 80% D = rRF + b80% D(RPM) = 8.60% rs 40% D = rRF + b40% D (RPM) = Change in equity cost −6.00% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating levered beta and cost of equity KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:04 AM 1/28/2019 10:34 PM

62. Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.

The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 25%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.) a. 11.50% b. 12.50% c. 13.58% d. 14.77% e. 16.05% ANSWER: e RATIONALE: 11.5% Original rs Current D/A 25% 5% rRF 6% RPM Tax rate 25% Target D/A 60% Original b: 1.083 rs = rRF + bL(RPM); b = (rs − rRF)/RPM = Original D/E: D/A/(1 − D/A) = 0.3333 Unlevered beta: 0.87 bU = bL/(1 + (D/E)(1 − T)) Target D/E = 1.50 New beta: 1.8417 bL = bU (1+ (D/E)(1 − T)) 16.05% rs New = rRF + bL New (RPM) = POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of equity–unlevering and relevering betas KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 10:36 PM 63. An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 25%.

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Chapter 15: Capital Structure Decisions The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization? a. $70.31 b. $74.01 c. $77.71 d. $81.60 e. $85.68 ANSWER: b RATIONALE: Shares outstanding 200,000Interest rate 10% EBIT $2,000,000Risk-free rate 6.5% Dividend payout ratio 100%Market risk premium 5.0% Tax rate 25%Beta − before recap 0.90 Bonds issued = stock repurchased $5,000,000Beta − after recap 1.10 Before the recapitalization 11.00% rs = rRF + bold(RPM) DPS = EPS = (EBIT)(1 − T)/Shares $7.50 $68.18 P0 = DPS/rs 73,333 Shares repurchased = Bonds issued/P0 After the recapitalization rs = rRF + bnew(RPM) DPS = EPS = (EBIT − rd × Bonds)(1 − T)/Shares P0 = DPS/rs POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Recapitalization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 10:38 PM

12.00% $8.88 $74.01

64. Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value. Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM − rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%. What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

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Chapter 15: Capital Structure Decisions a. 13.00% b. 13.65% c. 14.84% d. 15.58% e. 16.00% ANSWER: RATIONALE:

c Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 25%.

Step 1: Find the firm's current levered beta using the CAPM: rs = rRF + RPM(b) b = (rs - rRF)/RPM b = (0.12 - 0.06)/0.05 = 1.20 Step 2:

Step 3:

Step 4:

Find the firm's unlevered beta using the Hamada equation: b = bU[1 + (1 − T)(D/S)] bU = b/[1 + (1 − T)(D/S)] bU = 1.20/[1 + (1 - 0.25)(0.25)] bU = 1.0105 Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 − T)(D/S)] b = 1.0105[1 + (1 - 0.25)(0.50/0.50)] b = 1.7684 Find the firm's new cost of equity given its new beta and the CAPM: rs = rRF + RPM(b) rs = 6% + 5%(1.76846) rs = 14.84%.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Hamada equation and cost of equity–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/3/2019 11:55 PM 65. LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.

The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions produced the following table: Percent financed Percent financed Debt-to-equity Bond Before-tax Rating cost of debt with debt (wd) with equity (ws) ratio = wd/ws = (D/S) 0.10 0.90 0.10/0.90 = 0.11 AAA 7.0% 0.20 0.80 0.20/0.80 = 0.25 AA 7.2 0.30 0.70 0.30/0.70 = 0.43 A 8.0 0.40 0.60 0.40/0.60 = 0.67 BBB 8.8 0.50 0.50 0.50/0.50 = 1.00 BB 9.6 The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5% and the market risk premium is 6%. LeCompte estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 25%.

On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure? a. ws = 0.9; wd = 0.1; WACC = 11.73% b. ws = 0.8; wd = 0.2; WACC = 10.78% c. ws = 0.7; wd = 0.3; WACC = 9.11% d. ws = 0.6; wd = 0.4; WACC = 9.50% e. ws = 0.5; wd = 0.5; WACC = 11.37% ANSWER: RATIONALE:

d

POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES:

1 Difficulty: Challenging Multiple Choice False

rRF = 5%; rM − rRF = 6%. rs = rRF + (rM − rRF)b. WACC = rd × wd × (1 − T) + rs × ws. You need to use the D/S ratio given for each capital structure to find the levered beta using the Hamada equation. Then, use each of these betas with the CAPM to find the rs for that capital structure. Use this rs and rd for each capital structure to find the WACC. The optimal capital structure is the one that minimizes the WACC. (D/S) b = bU[1 + (1 − T)(D/S)] rs = rRF + (rM − rRF)b rd WACC ws wd 0.11 1.0833 11.5000% 7.0% 0.9 0.1 10.87% 0.25 1.1875 12.1250% 7.2% 0.8 0.2 10.78% 0.43 1.3215 12.9287% 8.0% 0.7 0.3 10.85% 0.67 1.5000 14.0002% 8.8% 0.6 0.4 11.04% 1.00 1.7500 15.5000% 9.6% 0.5 0.5 11.35% For example, if the D/S is 0.11: b = 1.0[1 + (1 − T)(D/S)] = 1.0[1 + (1 − 0.25)(0.1111)] = 1.0833 rs = rRF + (rM − rRF)b = 5% + 6%(1.0833) = 11.4998%.

The weights are given at 0.9 and 0.1 for equity and debt, respectively, and the rd for that capital structure is given as 7%.

WACC = rd × wd × (1 − T) + rs × ws = 7% × 0.1 × (1 − 0.25) + 11.4998% × 0.9 = 10.87%.

Do the same calculation for each of the capital structures and find each WACC. The optimal capital structure is the one that minimizes the WACC, which is 10.78%. Therefore, the optimal capital structure is 20% debt and 80% equity.

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Chapter 15: Capital Structure Decisions LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opt cap struc, Hamada equation–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 1/28/2019 11:02 PM Pennewell Publishing Inc. (PP) Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.

66. Refer to the data for Pennewell Publishing Inc. (PP). PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values. The debt would have an interest rate of 8%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%. If this plan were carried out, what would be PP's new value of operations? a. $552,941 b. $588,235 c. $617,647 d. $648,529 e. $680,956 ANSWER: b RATIONALE: EBIT = $80,000 g = 0% rsU = 10%

wd = 30%

T = 25%

ws = 70%

nPrior = 10,000

rd = 8%

PPrior = $48.00

rs = 12%

= wsrs + wd(1 − T)rd = (0.7)(0.12) + (0.3)(1 − 0.25)(0.08) = 10.2000% NOPAT = EBIT(1 − T) = $60,000 FCF = NOPAT because g = 0 = $60,000 V = FCF/WACC because g = 0 = $60,000/0.1020 = $588,235.29 ≈ $588,235 WACC

POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES: PREFACE NAME:

1 Difficulty: Moderate Multiple Choice False Pennewell Publishing Inc. (PP)

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Chapter 15: Capital Structure Decisions LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Pennewell Publishing Inc. (PP) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:12 AM VanMannen Foundations, Inc. (VF) VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below.

EBIT = Growth = Orig cost of equity, rs = No. of shares = Price per share = Tax rate =

$80,000 0% 10.0% 10,000 $60.00 25%

67. Refer to the data for VanMannen Foundations, Inc. (VF). Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, what would be VF's new WACC and its new value of operations?

New interest rate = rd =

6.00%

New cost of equity = rs =

10.75%

New Debt/Value = wd =

20%

New Equity/Value = ws =

80%

WACC Value a. 9.50% $631,579 b. 9.80% $644,211 c. 10.10% $657,095 d. 10.40% $670,237 e. 10.70% $683,641 ANSWER: a RATIONALE: EBIT = $80,000 Tax rate = 25% WACC = wd(1 − T)rd + wsrs = 20%(1 - 0.25)(6%) + 80%(10.75%) = 9.5000% Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T).

V = $80,000(1 - 0.25)/0.095 V = $631,579 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: VanMannen Foundations, Inc. (VF) LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and recapitalization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for VanMannen Foundations, Inc. (VF) MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:10 AM Best Bagels, Inc. (BB) Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

68. Refer to the data for Best Bagels, Inc. (BB). BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 8.2%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 13.9%. If this plan were carried out, what would BB's new value of operations be? a. $789,474 b. $821,053 c. $853,895 d. $888,051 e. $923,573 ANSWER: a RATIONALE: EBIT = $130,000 g = 0%

WACC

rsU= 13%

wd= 20%

T = 25%

ws= 80%

nPrior = 30,000

rd= 8.200%

PPrior= $25.00

rs= 13.900%

= wsrs + wd(1 − T)rd = (0.8)(0.139) + (0.2)(1 - 0.25)(0.082) = 12.3500%.

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Chapter 15: Capital Structure Decisions NOPAT = EBIT(1 − T) = $100,000(1 - 0.25) = $97,500 FCF = NOPAT because g = 0 = $97,500.00 V = FCF/WACC because g = 0 = $97,500(0.1235) = $789,473.68 ≈ $789,474 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Best Bagels, Inc. (BB) LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Best Bagels, Inc. (BB) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:15 AM Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

69. Refer to the data for the Anson Jackson Court Company (AJC). What is AJC's current total market value and weighted average cost of capital?

Total Market Value; WACC a. $650,000; 8.9% b. $650,000; 9.4% c. $750,000; 8.4% d. $750,000; 8.9% e. $750,000; 9.4% ANSWER: d RATIONALE: Prior Value of Debt (D) = $150,000 T = 25% rd= 6.000%

rs = 10.000%

EBIT = $89,000

nPrior = 10,000

g = 0%

PPrior= $60.00

V

= Debt + Equity = $150,000 + $60(10,000) = $750,000 wd = 20%; ws = 80% WACC = (wsrs) + wd(1 − T)rd Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions = (0.80)(10.00) + (0.20)(1 - 0.25)(0.06) = 8.9000% As a check, V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T) NOPAT = EBIT(1 − T) = $89,000(1 - 0.25) = $66,750 FCF = NOPAT because g = 0 = $66,750.00 V = FCC/WACC because g = 0 = $66,750/0.089 = $750,000.00 ≈ $750,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Anson Jackson Court Company (AJC) LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value and WACC–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for the Anson Jackson Court Company (AJC) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:22 AM 70. Refer to the data for Anson Jackson Court (AJC). AJC is considering moving to a capital structure that is comprised of 25% debt and 75% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 6.56%, while the required rate of return on equity would rise to 10.07%. If this plan were carried out, what would be AJC's new WACC and total value?

WACC; Total Market Value a. 8.28%; $690,034 b. 8.78%; $760,034 c. 9.28%; $660,034 d. 9.28%; $820,034 ANSWER: b RATIONALE: Inputs: In both prior and post, g = 0% and T = 25% $190,008 D prior = $150,000 D post = .54 rdprior = 6.000% EBIT = $89,000

rdpost = 6.5600% EBIT = $89,000

rsprior= 10.000%

rspost = 10.0700%

nPrior = 10,000

nPost =

PPrior = $60.00

PPost =

wdPrior = 20% Copyright Cengage Learning. Powered by Cognero.

wdpost = 25.00% Page 42

Chapter 15: Capital Structure Decisions wsPrior = 80%

wspost = 75.00%

Solution: WACC = wsrs + wd(1 − T)rd = (0.6)(0.107) + (0.4)(1 − 0.25)(0.0656) = 8.7825%.

V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T).

V = $89,000(1 − 0.25)/0.087825 = $760,034.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Anson Jackson Court Company (AJC) LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WACC and recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for the Anson Jackson Court Company (AJC) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 11:37 AM 71. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.

The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS).

Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. If the plan reduces the WACC, the stock price is also likely to decline. b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. c. If the plan does increase the EPS, the stock price will automatically increase at the same rate. d. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Financial leverage and EPS Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:04 AM 8/9/2018 11:04 AM

72. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. b. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC. d. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. e. The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure, WACC, TIE, and EPS KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 73. Merriwether Building has operating income of $20 million, a tax rate of 25%, and no debt. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $27 per share, and it has 5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure? a. $28 b. $30 c. $33 d. $35 e. $40 ANSWER: b RATIONALE: Step 1: Find the new value of the firm after the recapitalization. Because growth is zero, Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions free cash flow is equal to NOPAT: V = FCF/WACC = NOPAT/WACC = EBIT(1 − T)/WACC = $20(1 − 0.25)/0.1 = $150 million = $150.00 Step 2:

Find the new value of equity and debt after the recapitalization: S = wsV = 0.6($150) = $90 million = $90 D = wdV = 0.4($150) = $60 million = $60

Step 3:

Find the new price per share after the recapitalization: P = [S + (D − D0)]/n0 = [$90 + ($60 − 0)]/5 = $30.00

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure and stock price–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 11:41 AM Pennewell Publishing Inc. (PP) Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.

74. Refer to the data for Pennewell Publishing Inc. (PP). Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.125% and a new value of operations of $657,534. Assume PP raises $230,137 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? a. $55.04 b. $61.15 c. $65.75 d. $71.01 e. $74.56 ANSWER: c RATIONALE: Value of operations $510,638 + value of T-bills 178,723 Total value $689,361 − value of debt 178,723 Value of equity $510,638 Divide by # shares 10,000 Price per share $51.06 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pennewell Publishing Inc. (PP) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Pennewell Publishing Inc. (PP) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 11:45 AM 75. Refer to the data for Pennewell Publishing Inc. (PP). Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.125% and a new value of operations of $657,534. Assume PP raises $230,137 in new debt and purchases T-bills to hold until it makes the stock repurchase. PP then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Remaining Shares; P Post a. 7,500; $86.18 b. 7,000; $74.26 c. 6,500; $65.75 d. 6,649; $63.48 e. 6,959; $58.03 ANSWER: c RATIONALE: First, find the stock price after issuing debt but prior to repurchase: Value of operations $657,534 + value of T-bills $230,137 Total value $887,671 − value of debt $230,137 Value of equity $657,534 Divide by # shares 10,000 Price per share $65.75 The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount used to repurchase shares divided by the price per share: Number shares repurchased = $230,137/$65.75 = 3,500. Number shares remaining = 10,000 − 3,500 = 6,500.

As a check, the price per share after repurchase is: Value of operations $657,534 + value of T-bills 0 Total value $657,534 − repurchase $230,137 Value of equity $427,397 Divide by # shares 6,500 Price per share $65.75 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Pennewell Publishing Inc. (PP) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Pennewell Publishing Inc. (PP) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 11:54 AM VanMannen Foundations, Inc. (VF) VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below.

EBIT = Growth = Orig cost of equity, rs = No. of shares = Price per share = Tax rate =

$80,000 0% 10.0% 10,000 $60.00 25%

76. Refer to the data for VanMannen Foundations, Inc. (VF). Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Debt/Value = Equity/Value = a. $66.67 b. $70.18 c. $73.68 d. $77.37 e. $81.24 ANSWER: RATIONALE:

40%Value of new debt = 60%New WACC =

b Value of operations = EBIT(1 − T)/WACC + value of T-bills Total value − value of debt Value of equity

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$280,702 8.55%

$701,754 280,702 $982,456 −280,702 $701,754 Page 47

Chapter 15: Capital Structure Decisions Divide by # shares 10,000 Price per share $70.18 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: VanMannen Foundations, Inc. (VF) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for VanMannen Foundations, Inc. (VF) MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:02 PM 77. Refer to the data for VanMannen Foundations, Inc. (VF). What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock? a. $65.04 b. $66.71 c. $68.42 d. $70.18 e. $73.68 ANSWER: d RATIONALE: The price per share does not change in the repurchase.

As a check, consider the following data: Value of operations = EBIT(1 − T)/WACC $701,754 + value of T-bills 0 Total value $701,754 − repurchase −280,702 Value of equity $421,052 New shares = old − Debt/Price = 6,000 Stock price = Equity divided by # shares $70.18 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: VanMannen Foundations, Inc. (VF) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Stock price, recapitalization Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to the Preface for the data for VanMannen Foundations, Inc. (VF) MUST be kept together.

8/9/2018 11:04 AM 2/4/2019 12:05 PM

Best Bagels, Inc. (BB) Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

78. Refer to the data for Best Bagels, Inc. (BB). Now assume that BB is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. This results in a weighted average cost of capital equal to 11.7% and a new value of operations of $833,333. Assume BB raises $333,333 in new debt and purchases T-bills to hold until it makes the stock repurchase. BB then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Remaining shares; Stock price after repurchase a. 18,000; $27.78 b. 19,400; $29.44 c. 20,800; $31.51 d. 21,800; $34.34 e. 23,500; $35.71 ANSWER: a RATIONALE: Inputs: Value of operations = $833,333 Debt = $333,333 30,000 nPrior= Solution: First, find the stock price after issuing debt but prior to repurchase: Value of operations $833,333 + value of T-bills $333,333 Total value $1,166,666 − value of debt $333,333 Value of equity $833,333 Divide by # shares 30,000 Price per share $27.78 The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount used to repurchase shares divided by the price per share: Number shares repurchased = $333,333/$27.78 = 12,000. Number shares remaining = 30,000 − 12,000 = 18,000. As a check, the price per share after repurchase is: Value of operations $833,333 + value of T-bills 0 Total value $833,333 − value of debt $333,333 Value of equity $500,000 Divide by # shares 18,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions Price per share

$27.78

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Best Bagels, Inc. (BB) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Best Bagels, Inc. (BB) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:23 PM 79. Refer to the data for Best Bagels, Inc. (BB). Now assume that BB is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. This results in a weighted average cost of capital equal to 11.7% and a new value of operations of $833,333. Assume BB raises $333,333 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? a. $18.58 b. $20.65 c. $25.00 d. $27.78 e. $30.19 ANSWER: d RATIONALE: Inputs: Value of operations =

$833,333

Debt =

$333,333

nPrior=

30,000

Solution:

POINTS:

Value of operations + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share 1

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$833,333 333,333 $1,166,666 333,333 $833,333 30,000 $27.78 Page 50

Chapter 15: Capital Structure Decisions DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Best Bagels, Inc. (BB) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Best Bagels, Inc. (BB) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:25 PM Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

80. Refer to the data for the Anson Jackson Court Company (AJC). Now assume that AJC is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. If it makes this change, its resulting market value would be $791,667. What would be its new stock price per share? a. $60.17 b. $61.17 c. $62.27 d. $63.27 e. $64.17 ANSWER: c RATIONALE: Inputs: V = $791,667 w_d = 40% D_0 = $150,000 n_0 = $10,000 Solution: Step 1. Find the new value of equity and debt after the recapitalization: S = S = wsV = 0.6($791,667) = $475,000 D = D = wdV = 0.4($820,000) = $316,667 Step 2. Find the new price per share after the recapitalization: P = [S+ (D−D0)]/n0= [$475,000 + ($316,667 − $150,000)]/10,000 = $64.17 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Anson Jackson Court Company (AJC) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: No. shares repurchased–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for the Anson Jackson Court Company (AJC) MUST be kept together, and they cannot be changed algorithmically.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 2/4/2019 12:36 PM 81. Refer to the data for the Anson Jackson Court Company (AJC). Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share? a. $58 b. $59 c. $60 d. $61 e. $62 ANSWER: e RATIONALE: Step 1.

Find the new value of equity and debt after the recapitalization: S = wcV = 0.5($820,000) = $410,000.

D = wdV = 0.5($820,000) = $410,000.

Step 2.

Find the new price per share after the recapitalization: P= [S+ (D − D0)]/n0 = [$410,000 + ($410,000 − $200,000)]/10,000 = $62.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Anson Jackson Court Company (AJC) LEARNING OBJECTIVES: FMTP.EHRH.20.15.07 - LO: 15-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock price, recapitalization–nonalgorithmic KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions OTHER: NOTES: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Multi-part The problems referring to the Preface for the data for the Anson Jackson Court Company (AJC) MUST be kept together, and they cannot be changed algorithmically.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

82. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.06 - LO: 15-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial leverage KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 83. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.08 - LO: 15-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity as an option KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 84. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.15.08 - LO: 15-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity as an option KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

85. Refer to the data for Wilson Dover Inc. What is the value (in millions) of Wilson Dover's equity if it is viewed as an option? a. $228.77 b. $254.19 c. $282.43 d. $313.81 e. $345.19 ANSWER: d RATIONALE: Total value = P = $500.0 d1 = 1.910485 Debt = X = $200.0 Volatility (σ) = 0.6

N(d1) = 0.9720 d2 = 1.310485 N(d2) = 0.9050

rRF = 5% Vs = PN(d1) − Xe−RFtN(d2) = $500(0.9720) − $200e−0.05(1)(0.9050) = $485.98 − $172.17 = $313.81 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Wilson Dover Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.08 - LO: 15-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Capital Structure Decisions LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Equity as an option Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to the Preface for the data for Wilson Dover Inc. MUST be kept together.

8/9/2018 11:04 AM 8/9/2018 11:04 AM

86. Refer to the data for Wilson Dover Inc. What is the value (in millions) of Wilson Dover's debt if its equity is viewed as an option? a. $167.57 b. $186.19 c. $204.81 d. $225.29 e. $247.82 ANSWER: b RATIONALE: VDebt = VTotal − VEquity = $500 − $313.81 = $186.19 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Wilson Dover Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.08 - LO: 15-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity as an option KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Wilson Dover Inc. MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 8/9/2018 11:04 AM 87. Refer to the data for Wilson Dover Inc. What is the yield on Wilson Dover's debt? a. 6.04% b. 6.36% c. 6.70% d. 7.05% e. 7.42% ANSWER: e RATIONALE: Yield = [(Face Value/Price)1/Maturity] −1.0 = [$200/$186.19]1 − 1.0 = 7.42% POINTS:

1

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Chapter 15: Capital Structure Decisions DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Wilson Dover Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.15.08 - LO: 15-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity as an option KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Wilson Dover Inc. MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM

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Chapter 15: Web 15B Bond Refunding 1. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable. a. True b. False ANSWER: False False. Since long-term rates have not fallen, the yield on new bonds would be the same as RATIONALE: the coupon rate on the old bonds, hence there would be no interest savings to offset the call premium and the new flotation costs.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond refunding KEYWORDS: Bloom’s: Comprehension DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 2. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding discount rate KEYWORDS: Bloom’s: Comprehension DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 3. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding b. False ANSWER: RATIONALE:

False False. If there is a fairly high probability that interest rates are going to decline further, then it might be better to delay the refunding.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Comprehension DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 4. When a firm refunds a debt issue, the firm's stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding and callable bonds KEYWORDS: Bloom’s: Comprehension DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 5. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time? a. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates. b. The flotation costs associated with issuing new bonds rise. c. The firm's CFO believes that interest rates are likely to decline in the future. d. The firm's CFO believes that corporate tax rates are likely to be increased in the future. e. The yield to maturity on the company's outstanding bonds increases due to a weakening of the firm's financial Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding situation.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 6. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant. a. $453,443 b. $476,115 c. $499,921 d. $524,917 e. $551,163 ANSWER: a RATIONALE: Call premium: 6%Old rate: 8% Flotation %: 2%New rate: 6% Amount: $3,000,000Years: 20 Cost of refunding: Call premium = 6%($3,000,000) $180,000 Flotation cost = 2%($3,000,000) $ 60,000 Total investment outlay: $240,000 Interest on old bond per 6 months: $120,000 Interest on new bond per 6 months: $ 90,000 Savings per six months: $ 30,000 PV of savings, 40 periods @ new rate/2 = $693,443 NPV of refunding = PV of savings − Cost of refunding = $453,443 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing United States - OH - Default City - TBA Refunding NPV Bloom’s: Analysis TYPE: Multiple Choice: Problem 1/16/2018 1:04 PM 1/16/2018 1:04 PM

NorthWest Water (NWW) Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called.

7. Refer to the data for NorthWest Water (NWW). What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding? a. $5,049,939 b. $5,315,725 c. $5,595,500 d. $5,890,000 e. $6,200,000 ANSWER: e Amount: $50,000,000Call premium %: 14% RATIONALE: Old rate: 14.00%Tax rate: 40% Original life: 30New rate: 11.67% Years ago issued: 5New life: 25 Orig. flotation cost: $3,000,000New flotation cost: $3,000,000 Years remaining on old bond: 25 Old issue flotation costs: Remaining unexpensed = (25/30)($3) = $2,500,000 Tax saving on unexpensed float −1,000,000 cost = $2.5(T) = $2.5(0.4) = After tax cost of call premium: 4,200,000 0.14($50)(0.6) = Flotation costs on new issue: 3,000,000 Net after-tax cost to call the bonds: 6,200,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: NorthWest Water (NWW) LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding

LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

hybrid financing United States - OH - Default City - TBA Refunding investment outlay Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to the Preface for the data for NorthWest Water (NWW) MUST be kept together.

1/16/2018 1:04 PM 1/16/2018 1:04 PM

8. Refer to the data for NorthWest Water (NWW). What will the after-tax annual interest savings for NWW be if the refunding takes place? a. $664,050 b. $699,000 c. $768,900 d. $845,790 e. $930,369 ANSWER: b Old interest: $50,000,000(0.14)(0.6) = $4,200,000 RATIONALE: New interest: $50,000,000(0.1167)(0.6) = (3,501,000) Net annual interest savings $ 699,000 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: NorthWest Water (NWW) LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding interest savings KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for NorthWest Water (NWW).

MUST be kept together.

DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 9. Refer to the data for NorthWest Water (NWW). The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place? a. $6,480 b. $7,200 c. $8,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding d. $8,800 e. $9,680 ANSWER: RATIONALE:

c Flotation costs benefit, new: ($3.00/25)(0.4) = $48,000 Flotation costs lost, old: ($3.00/30)(0.4) = (40,000) Net annual amortization tax effects = $ 8,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: NorthWest Water (NWW) LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding flotation costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for NorthWest Water (NWW).

MUST be kept together.

DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 10. Refer to the data for NorthWest Water (NWW). What is the NPV if NWW refunds its bonds today? a. $1,746,987 b. $1,838,933 c. $1,935,719 d. $2,037,599 e. $2,241,359 ANSWER: d Appropriate discount rate = New bond cost × (1 − T) = 7.002% Financial calculator RATIONALE: solution: Inputs: N = 25; I/YR = 7.0; PMT = 699,000 + 8,000 = 707,000; FV = 0.

Output: PV = −$8,237,599 = PV of savings = $8,237,599 Cost to refund = 6,200,000 NPV of the refunding = $2,037,599 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: NorthWest Water (NWW) LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Refunding flotation costs Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to the Preface for the data for NorthWest Water (NWW) MUST be kept together.

1/16/2018 1:04 PM 1/16/2018 1:04 PM

11. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant. a. $278,606 b. $292,536 c. $307,163 d. $322,521 e. $338,647 ANSWER: a RATIONALE: Call premium: 5%Old rate: 7% Flotation %: 2%New rate: 5% Amount: $2,000,000Years: 15 Cost of refunding: Call premium = 5% ($2,000,000) $100,000 Flotation cost = 2% ($2,000,000) $ 40,000 Total investment outlay: $140,000 Interest on old bond per 6 months: Old rate/2 × Amount = $ 70,000 Interest on new bond per 6 months: New rate/2 × Amount $ 50,000 = Savings per six months: $ 20,000 PV of savings, 30 periods @ new rate/2 = $418,606 NPV of refunding = PV of savings − Cost of refunding = $278,606 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 1/16/2018 1:04 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding DATE MODIFIED:

1/16/2018 1:04 PM

12. Which of the following statements is most CORRECT? a. The key benefits associated with refunding debt are the reduction in the firm's debt ratio and the creation of more reserve borrowing capacity. b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates. c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen. d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done.

The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings. e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the beforetax cost of new debt.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 13. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯assume that the firm's tax rate is zero.

The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds.

What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds? a. 9.57% b. 10.07% c. 10.60% d. 11.16% e. 11.72% ANSWER: d RATIONALE: Call premium: $50 Old rate: 12.0% Flotation cost per bond: $10 Years to maturity: 15 Amount of issue: $5,000,000 Number of bonds: 5,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding Par value of bonds: $1,000 Cost of refunding: Call premium per bond × number of bonds = $250,000 Flotation cost = $10 × Number of bonds issued = $ 50,000 Total investment outlay: $300,000 Interest on old bond per year = Old rate × Amount = $600,000 If the company does not call the bonds, it will have to pay $600,000 per year for 15 years, plus $5,000,000 at Year 15. If it goes ahead and calls the bonds, it will have to pay $300,000 + $5,000,000 = $5,300,000 today. We can find the discount rate that equates these cash flows. Here is the time line: ∙∙∙ 0 1 2 3 15 −300000 $600,000 $600,000 $600,000 $ 600,000 −5000000 $5,000,000 −5300000 600000 600000 600000 $5,600,000 If you enter these cash flows in the cash flow register of a calculator and then press the IRR key, you will get the breakeven rate, which is 11.1583%, rounded to 11.16%. You can do the same thing with Excel. Note that the annual savings at this lower rate would be (0.12 − 0.111583) × $5,000,000 = $42,084.78. The PV of that amount, discounted back for 15 years at 11.16%, is $300,000.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding Breakeven interest rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM 14. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual "breakeven rate"? a. 9.29% b. 9.78% c. 10.29% d. 10.81% e. 11.35% ANSWER: c RATIONALE: Call price of bonds: $1,060Old rate: 12.0% Flotation cost per bond: $45Years to maturity: 10 Par value of bonds: $1,000Semiannual periods: 20 Copyright Cengage Learning. Powered by Cognero.

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Chapter 15: Web 15B Bond Refunding Cost of refunding: Call price per bond: $1,060 Flotation cost per bond: $ 45 Total investment outlay per bond: $1,105 Interest on old bond per year = Old rate × Amount = $ 120 Interest per period: $ 60 If the company does not call the bonds, it will have to pay $60 for 20 periods, plus $1,000 at Period 20. If it goes ahead and calls the bonds now, it will have to pay $1,060 + $45 = $1,105 today. We can find the discount rate that equates these cash flows. Here is the time line: ∙∙∙ 0 1 2 3 20 −$1,105 $60 $60 $60 $ 60 $1,000 −$1,105 $60 $60 $60 $1,060 If you enter these cash flows in the cash flow register of a calculator and then press the IRR key, you will get the breakeven rate, which is 5.1469%, rounded to 5.15%. You can do the same thing with Excel. Note that the semiannual savings at this lower rate would be (0.12/2 − 0.051469) × $1,000 = $8.53. The PV of that amount, discounted back for 20 periods at 5.15%, is $105.00, which is the cost of the refunding. The semiannual discount, when doubled, is the breakeven nominal rate. Required nominal annual rate to break even: 10.29% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: IFMG.DAVE.19.WEB17B.01 - LO: WEB17B-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Breakeven rate for bond refunding KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 1/16/2018 1:04 PM DATE MODIFIED: 1/16/2018 1:04 PM

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Chapter 16: Supply Chains and Working Capital Management 1. Which of the following will cause an increase in net working capital, other things held constant? a. A cash dividend is declared and paid. b. Merchandise is sold at a profit, but the sale is on credit. c. Long-term bonds are retired with the proceeds of a preferred stock issue. d. Missing inventory is written off against retained earnings. e. Cash is used to buy marketable securities.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.01 - LO: 16-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 2. Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.01 - LO: 16-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net working capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 3. Net working capital is defined as current assets divided by current liabilities. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.01 - LO: 16-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net working capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 4. Net operating working capital is defined as operating current assets minus operating current liabilities.. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.01 - LO: 16-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 5. Short-term marketable securities are held for two separate and distinct purposes: (1) to provide liquidity as a substitute for cash and (2) as a non-operating investment. Marketable securities held while awaiting reinvestment are not available for liquidity purposes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.01 - LO: 16-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term mkt. securities Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Knowledge 8/9/2018 11:06 AM 8/9/2018 11:06 AM

6. Buchholz Corporation follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy. The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 25%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? a. 5.32% b. 5.91% c. 6.56% d. 7.22% e. 7.94% ANSWER: c RATIONALE: Sales $400,000Debt ratio 50%Interest rate 10% Fixed assets $100,000EBIT $35,000Tax rate 25% CA/Sales, restricted 15%CA/Sales, relaxed 25% Restricted Relaxed CA $ 60,000 $100,000 FA 100,000 100,000 Total assets $160,000 $200,000 Debt Equity Total liab. & capital

$ 80,000 80,000 $160,000

$100,000 100,000 $200,000

EBIT Interest EBT Taxes NI

$ 35,000 8,000 $ 27,000 6,750 $ 20,250

$ 35,000 10,000 $ 25,000 6,250 $ 18,750

ROE 25.31% 18.75% Difference in ROE = 6.56% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ROE and WC policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 1/27/2019 10:07 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management Hardwig Inc. Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

7. Refer to the data for Hardwig Inc. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy? a. $8,418 b. $8,861 c. $9,327 d. $9,818 e. $10,309 ANSWER: d RATIONALE: Annual sales $3,600,000 Fixed assets turnover (FATO) 4.0 Debt/TA 50.00% Equity/TA 50.00% EBIT $150,000 Interest rate 10.00% Tax rate 25.00% Total assets turnover (restricted) 2.5 Total assets turnover (relaxed) 2.2 FA turnover= Sales/Net FA 4.0= $3,600,000/Net FA Net FA= $900,000 Restricted: TATO= Sales/Total assets 2.5= $3,600,000/Total assets Total assets= $1,440,000 Relaxed: TATO= Sales/Total assets 2.2= $3,600,000/Total assets Total assets= $1,636,364 Balance Sheets: Restricted Relaxed Current assets $ 540,000 $ 736,364 Fixed assets 900,000 900,000 Total assets $1,440,000 $1,636,364 Debt Equity Total liab. & equity Interest: Difference in interest = $9,818 POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES:

$ 720,000 720,000 $1,440,000

$ 818,182 818,182 $1,636,364

$72,000

$81,818

1 Difficulty: Moderate Multiple Choice False

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Chapter 16: Supply Chains and Working Capital Management PREFACE NAME: Hardwig Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WC investment policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: All problems referring to the Preface for the data for Hardwig Inc. should be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 12/5/2018 4:40 PM 8. Refer to the data for Hardwig, Inc. What's the difference in the projected ROEs under the restricted and relaxed policies? a. 1.50% b. 1.88% c. 2.25% d. 2.70% e. 3.24% ANSWER: b RATIONALE: Restricted Relaxed EBIT $150,000 $150,000 Interest 72,000 81,818 EBT $ 78,000 $ 68,182 Taxes 19,500 17,045 Net income $ 58,500 $51,136 ROE = Net income/Equity 8.13% 6.25% Difference in ROEs = 1.88% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Hardwig Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WC investment, ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: All problems referring to the Preface for the data for Hardwig, Inc. should be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 1/27/2019 10:11 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management 9. Refer to the data for Hardwig, Inc.Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies? a. 2.79% b. 3.07% c. 3.38% d. 3.72% e. 4.09% ANSWER: a RATIONALE: % Change in sales −15.00% % Change in EBIT −10.00% New sales New EBIT Restricted: TATO= Sales/Total assets 2.5= $3,060,000/Total assets Total assets= $1,224,000 Balance Sheet:

$3,060,000 $135,000

Restricted

Total assets

$1,224,000

Debt Equity Total liab. & equity

$ 612,000 612,000 $1,224,000

Income Statement: Restricted EBIT $ 135,000 Interest 61,200 EBT $ 73,800 Taxes 18,450 Net income $ 55,350 ROE = Net income/Equity = 9.04% Relaxed ROE from previous problem: 6.25% Difference in ROE = 2.79% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Hardwig Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WC investment, ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management NOTES: DATE CREATED: DATE MODIFIED:

All problems referring to the Preface for the data for Hardwig, Inc. should be kept together.

8/9/2018 11:06 AM 1/27/2019 10:14 PM

10. Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital management KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 11. An increase in any current asset must be accompanied by an equal increase in some current liability. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital financing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 12. The concept of permanent current operating assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent current operating assets represent a minimum level of current assets that must be financed. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Permanent curr. oper. assets KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 13. A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conservative fin. approach KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 14. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive current operating asset financing strategy because of the inherent risks of using short-term financing. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Aggressive fin. approach Bloom’s: Knowledge 8/9/2018 11:06 AM 8/9/2018 11:06 AM

15. Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 16. The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates.

When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

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Chapter 16: Supply Chains and Working Capital Management 17. A firm that follows an aggressive current asset financing approach uses primarily short-term credit and thus is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Aggressive financing KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 18. The relative profitability of a firm that employs an aggressive current asset financing policy will improve if the yield curve changes from upward sloping to downward sloping. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Aggressive financing KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 19. Firms generally choose to finance temporary current operating assets with short-term debt because a. short-term interest rates have traditionally been more stable than long-term interest rates. b. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term. c. the yield curve is normally downward sloping. d. short-term debt has a higher cost than equity capital. e. matching the maturities of assets and liabilities reduces risk under some circumstances, and also because shortterm debt is often less expensive than long-term capital.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 20. Summary balance sheet data for Greener Gardens Co. is shown below (in thousands of dollars). The company is in a highly seasonal business, and the data show its assets and liabilities at peak and off-peak seasons: Cash Marketable securities Accounts receivable Inventories Net fixed assets Total assets

Peak $ 50 0 40 100 500 $690

Off-Peak $ 30 20 20 50 500 $620

Payables and accruals Short-term bank debt Long-term debt Common equity Total claims

$ 30 50 300 310 $690

$ 10 0 300 310 $620

From this data we may conclude that a. Greener Gardens' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. b. Greener Gardens follows a relatively conservative approach to current asset financing; that is, some of its short-term needs are met by permanent capital. c. Without income statement data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. d. Without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. e. Greener Gardens' current asset financing policy calls for exactly matching asset and liability maturities.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Working capital management United States - OH - Default City - TBA Current asset financing Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:06 AM 8/9/2018 11:06 AM

21. Which of the following statements is CORRECT? a. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of shortterm debt is considered to be an aggressive strategy because of the inherent risks associated with using shortterm financing. b. If a company follows a policy of "matching maturities," this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt. c. Net working capital is defined as current assets minus the sum of payables and accruals, and any decrease in the current ratio automatically indicates that net working capital has decreased. d. If a company follows a policy of "matching maturities," this means that it matches its use of short-term debt with its use of long-term debt. e. Net working capital is defined as current assets minus the sum of payables and accruals, and any increase in the current ratio automatically indicates that net working capital has increased.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 22. Which of the following is NOT a situation that might lead a firm to increase its holdings of short-term marketable securities? a. The firm is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline. b. The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases. c. The firm has just sold long-term securities and has not yet invested the proceeds in operating assets. d. The firm just won a product liability suit one of its customers had brought against it. e. The firm must make a known future payment, such as paying for a new plant that is under construction.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Marketable securities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 23. Albrecht Inc. is a no-growth firm whose sales fluctuate seasonally, causing total assets to vary from $320,000 to $410,000, but fixed assets remain constant at $260,000. If the firm follows a maturity matching (or moderate) working capital financing policy, what is the most likely total of long-term debt plus equity capital? a. $260,642 b. $274,360 c. $288,800 d. $304,000 e. $320,000 ANSWER: e RATIONALE: Lower total asset range $320,000 Upper total asset range $410,000 Minimum total assets = FA + Min. CA = $320,000 = LT Debt + Equity A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. This is its most likely level of long-term financing.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.02 - LO: 16-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 24. If a firm takes actions that reduce its days sales outstanding (DSO), then, other things held constant, this will lengthen its cash conversion cycle (CCC).

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Chapter 16: Supply Chains and Working Capital Management a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 25. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC). a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 26. The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 27. The cash conversion cycle (CCC) combines three factors: The inventory conversion period, the average collection period, and the payables deferral period, and its purpose is to show how long a firm must finance its working capital.

Other things held constant, the shorter the CCC, the more effective the firm's working capital management. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 28. Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle? a. Take steps to reduce the DSO. b. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales. c. Sell common stock to retire long-term bonds. d. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock. e. Increase average inventory without increasing sales.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:06 AM 8/9/2018 11:06 AM

29. Other things held constant, which of the following would tend to reduce the cash conversion cycle? a. Place larger orders for raw materials to take advantage of price breaks. b. Take all cash discounts that are offered. c. Continue to take all cash discounts that are offered and pay on the net date. d. Offer longer payment terms to customers. e. Carry a constant amount of receivables as sales decline.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 30. Which of the following actions would be likely to shorten the cash conversion cycle? a. Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50. b. Begin to take cash discounts on inventory purchases; the terms are 2/10 net 30. c. Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days. d. Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60. e. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:06 AM 8/9/2018 11:06 AM

31. Brothers Breads has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = 50 days Average collection period = 17 days Payables deferral period = 25 days a. 31 days b. 34 days c. 38 days d. 42 days e. 46 days ANSWER: d RATIONALE: Inventory conversion period = 50 days Average collection period = 17 days Payables deferral period = 25 days CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 42 days POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 32. Fireside Inc. has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = 38 days Average collection period = 19 days Payables deferral period = 20 days a. 33 days b. 37 days c. 41 days d. 45 days e. 49 days ANSWER: b RATIONALE: Inventory conversion period = Copyright Cengage Learning. Powered by Cognero.

38 days Page 17

Chapter 16: Supply Chains and Working Capital Management Average collection period = 19 days Payables deferral period = 20 days CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 37 days POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 33. Whaley & Whaley has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = 41 days Average collection period = 31 days Payables deferral period = 38 days a. 31 days b. 34 days c. 37 days d. 41 days e. 45 days ANSWER: b RATIONALE: Inventory conversion period = 41 days Average collection period = 31 days Payables deferral period = 38 days CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34 days POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management 34. Mark's Manufacturing's average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle? a. 63 days b. 67 days c. 70 days d. 74 days e. 78 days ANSWER: d RATIONALE: CCC = Inv. conv. period + Avg. coll. period − Pay. deferral period Age of receivables = Avg. coll. period = 45 days Age of inventory = Inv. conv. period = 69 days Age of payables = Pay. def. period = 40 days CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 74 days POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 35. Data on Nathan Enterprises for the most recent year are shown below, along with the days sales outstanding of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its receivables enough to reduce its DSO to the benchmarks' average. If this were done, by how much would receivables decline? Use a 365-day year.

Sales Accounts receivable Days sales outstanding (DSO) Benchmark days sales outstanding (DSO) a. $8,078 b. $8,975 c. $9,973 d. $10,970 e. $12,067 ANSWER: c RATIONALE:

Sales Receivables and DSO Copyright Cengage Learning. Powered by Cognero.

$110,000 $16,000 53.09 20.00

Original

Benchmark

Data

Related DSO

$110,000 $16,000

53.09

Receivables at Benchmark DSO Level 20.00 Page 19

Chapter 16: Supply Chains and Working Capital Management New receivables = DSO × (Sales/365) = Reduction in receivables = Original receivables − New receivables = Alternative solution: (Change in DSO/Original DSO) × Orig. receivables = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Days sales outstanding (DSO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

$6,027 $9,973

$9,973

36. Thornton Universal Sales' cost of goods sold (COGS) average $2,000,000 per month, and it keeps inventory equal to 50% of its monthly COGS on hand at all times. Using a 365-day year, what is its inventory conversion period? a. 11.7 days b. 13.0 days c. 14.4 days d. 15.2 days e. 16.7 days ANSWER: d RATIONALE: Monthly COGS = $2,000,000 Inventory/COGS = 50.0% Annual COGS = $24,000,000 Avg. inventory = $1,000,000 Inv. conv. period = Inv./COGS per day = Inv./(Annual COGS/365) = 15.2 days POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory conv. period KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 8/9/2018 11:06 AM

37. Data on Liu Inc. for the most recent year are shown below, along with the inventory conversion period (ICP) of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its inventory enough to reduce its ICP to the benchmarks' average. If this were done, by how much would inventories decline? Use a 365-day year.

Cost of goods sold = Inventory = Inventory conversion period (ICP) = Benchmark inventory conversion period (ICP) = a. $7,316 b. $8,129 c. $9,032 d. $10,036 e. $11,151 ANSWER: e RATIONALE:

Cost of goods sold Inventory and ICP New inventory = ICP × (COGS/365) = Reduction in inventories = Original Inv. − New Inv. =

$85,000 $20,000 85.88 38.00

Original

Benchmark

Data

Related ICP

ICP

$85,000 $20,000

85.88

38.00

Alternative solution: (Change in ICP/Original ICP) × Orig. Inv. = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory conv. period KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

ICP at Benchmark Level

$8,849 $11,151

$11,151

38. Data on Mertz Co. for the most recent year are shown below, along with the payables deferral period (PDP) for the firms against which it benchmarks. The firm's new CFO believes that the company could delay payments enough to increase its PDP to the benchmarks' average. If this were done, by how much would payables increase? Use a 365-day Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management year.

Cost of goods sold = Payables = Payables deferral period (PDP) = Benchmark payables deferral period = a. $764 b. $849 c. $943 d. $1,048 e. $1,164 ANSWER: e RATIONALE:

$75,000 $5,000 24.33 30.00

Original

Benchmark

Data

Related PDP

Cost of goods sold $75,000 Inventory and PDP $5,000 New payables = PDP × (COGS/365) = Increase in payables = New Payables − Original Payables =

24.33

Alternative solution: (Change in PDP/Original PDP) × Orig. Payables = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payables deferral period KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

Payables at Benchmark PDP Level 30.00 $6,164 $1,164

$1,164

39. Marshall Inc. recently hired your consulting firm to improve the company's performance. It has been highly profitable but has been experiencing cash shortages due to its high growth rate. As one part of your analysis, you want to determine the firm's cash conversion cycle. Using the following information and a 365-day year, what is the firm's present cash conversion cycle?

Average inventory = Annual sales = Annual cost of goods sold = Average accounts receivable = Average accounts payable = a. 120.6 days Copyright Cengage Learning. Powered by Cognero.

$75,000 $600,000 $360,000 $160,000 $25,000 Page 22

Chapter 16: Supply Chains and Working Capital Management b. 126.9 days c. 133.6 days d. 140.6 days e. 148.0 days ANSWER: RATIONALE:

e Avg. inventory = $75,000Annual sales = Avg. receivables = $160,000Annual COGS = Avg. payables = $25,000Days in year = Inv. conv. period = Inv./(COGS/365) 76.0 + DSO = Receivables/(Sales/365) 97.3 − Payables deferral = Payables/(COGS/365) −25.3 Cash conversion cycle (CCC) 148.0 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

$600,000 $360,000 365

40. Frosty Corporation has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = $45,000 Annual cost of goods sold = $31,500 Inventory = $4,000 Accounts receivable = $2,000 Accounts payable = $2,400 a. 25 days b. 28 days c. 31 days d. 35 days e. 38 days ANSWER: d RATIONALE: Annual sales Annual cost of goods sold (COGS) Inventory Accounts receivable Accounts payable Days in year Sales per day = Copyright Cengage Learning. Powered by Cognero.

$45,000 $31,500 $4,000 $2,000 $2,400 365 $123.29 Page 23

Chapter 16: Supply Chains and Working Capital Management COGS per day = $86.30 Inv. conv. period = Inv./COGS per day = 46.35 Avg. coll. period = Receivables/Sales per day = 16.22 Pay. def. period = Accounts payable/COGS per day = 27.81 CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34.76 days POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 41. Shulman Inc. has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = $45,000 Annual cost of goods sold = $30,000 Inventory = $4,500 Accounts receivable = $1,800 Accounts payable = $2,500 a. 28 days b. 32 days c. 35 days d. 39 days e. 43 days ANSWER: d RATIONALE: Annual sales $45,000 Annual cost of goods sold (COGS) $30,000 Inventory $4,500 Accounts receivable $1,800 Accounts payable $2,500 Days in year 365 Sales per day = $123.29 COGS per day = $82.19 Inv. conv. period = Inv./COGS per day = 54.75 Avg. coll. period = Receivables/Sales per day = 14.60 Pay. def. period = Accounts payable/COGS per day = 30.42 CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 38.93 days POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 42. Kiley Corporation had the following data for the most recent year (in millions). The new CFO believes (1) that an improved inventory management system could lower the average inventory by $4,000, (2) that improvements in the credit department could reduce receivables by $2,000, and (3) that the purchasing department could negotiate better credit terms and thereby increase accounts payable by $2,000. Furthermore, she thinks that these changes would not affect either sales or the costs of goods sold. If these changes were made, by how many days would the cash conversion cycle be lowered?

Original Annual sales: unchanged $110,000 Cost of goods sold: unchanged $80,000 Average inventory: lowered by $4,000 $20,000 Average receivables: lowered by $2,000 $16,000 Average payables: increased by $2,000 $10,000 Days in year 365 a. 34.0 b. 37.4 c. 41.2 d. 45.3 e. 49.8 ANSWER: a RATIONALE: Annual sales: unchanged Cost of goods sold: unchanged Average inventory: lowered by $4,000 Average receivables: lowered by $2,000 Average payables: increased by $2,000 Days in year Inv. conv. period = Inv./(COGS/365) = DSO = Receivables/(Sales/365) = Payables deferral = Payables/(COGS/365) = CCC = Inv. conv. + DSO − Pay. def. period = Change = 34.01 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365

Original $110,000 $80,000 $20,000 $16,000 $10,000 365 91.25 53.09 45.63 98.72

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365 73.00 46.45 54.75 64.70

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Chapter 16: Supply Chains and Working Capital Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Cash conversion cycle Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 8/9/2018 11:06 AM

43. Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual sales of $36,500,000, or $100,000 a day on a 365-day basis. The firm's cost of goods sold is 75% of sales. On average, the company has $9,000,000 in inventory and $8,000,000 in accounts receivable. Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable. She also anticipates that these policies would reduce sales by 10%, while the payables deferral period would remain unchanged at 35 days. What effect would these policies have on the company's cash conversion cycle? Round to the nearest whole day. a. −26 days b. −22 days c. −18 days d. −14 days e. −11 days ANSWER: b RATIONALE: Original New Annual sales $36,500,000 $32,850,000 Days in year 365 365 Sales per day $100,000 $90,000 COGS/Sales 75% 75% COGS per day $75,000 $67,500 Inventory $9,000,000 $7,200,000 Accounts receivable $8,000,000 $6,400,000 Pay. deferral period 35 35 % Reduction in Inv. 20% % Reduction in Rec. 20% % Reduction in Sales 10% Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 120.00 + 80.00 − 35.00 = 165.00 CCCNew = 106.67 + 71.11 − 35.00 = 142.78 CCCNew − CCCOrig = 142.78 − 165.00 = −22.22 days POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DATE CREATED: DATE MODIFIED:

8/9/2018 11:06 AM 8/9/2018 11:06 AM

44. Pascarella Inc. is revising its payables policy. It has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year? a. −26.6 days b. −29.5 days c. −32.8 days d. −36.4 days e. −40.5 days ANSWER: e RATIONALE: Original New Annual sales $50,735,000 $50,735,000 Days in year 365 365 Sales per day $139,000 $139,000 COGS/Sales 85% 85% COGS per day $118,150 $118,150 Inventory $15,012,000 $13,062,000 Accounts receivable $10,008,000 $8,062,000 Pay. deferral period 30 40 $ Reduction in Inv. $1,946,000 $ Reduction in Rec. $1,946,000 Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 127.06 + 72.00 − 30.00 = 169.06 CCCNew = 110.59 + 58.00 − 40.00 = 128.59 CCCNew − CCCOrig = 128.59 − 169.06 = −40.47 days POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 45. Fontana Painting had the following data for the most recent year (in millions). The new CFO believes that the company could improve its working capital management sufficiently to bring its NWC and CCC up to the benchmark companies' level without affecting either sales or the costs of goods sold. Fontana finances its net working capital with a bank loan at an 8% annual interest rate, and it uses a 365-day year. If these changes had been made, by how much would Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management the firm's pre-tax income have increased?

Original Data $100,000 $ 80,000 $ 20,000 $ 16,000 $ 5,000

Sales Cost of goods sold Inventory (ICP) Receivables (DSO) Payables (PDP) a. 1,901 b. 2,092 c. 2,301 d. 2,531 e. 2,784 ANSWER: RATIONALE:

Benchmark Related CCC CCC

91.25 58.40 22.81 126.84

38.00 20.00 30.00 28.00

a Original Data $100,000 $ 80,000

Benchmark Related CCC

Benchmark CCC Levels

Sales Cost of goods sold Inventory = ICP(COGS/365) $ 20,000 91.25 38.00 $8,329 = Receivables = $ 16,000 58.40 20.00 $5,479 DSO(Sales/365) = Payables = PDP(COGS/365) = $ 5,000 22.81 30.00 $6,575 New and old NWC $ 31,000 126.84 28.00 $7,233 Reduction in NWC = Old − New = $23,767 Interest rate = 8% Savings = Interest rate × Reduction in NWC = $1,901 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 46. Monar Inc.'s CFO would like to decrease its cash conversion cycle by 10 days (based on a 365 day year). The company carries average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its average collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. The CFO believes he can reduce the average inventory to $647,260 with no effect on sales.

By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of the cash conversion cycle?

Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management a. $123,630 b. $130,137 c. $136,986 d. $143,836 e. $151,027 ANSWER: RATIONALE:

c

Original New Inventory $750,000 $647,260 Annual sales $10,000,000 $10,000,000 Days/year 365 365 COGS/Sales 75.00% 75.00% Payables deferral period (PDP) 30.00 30.00 Avg. collection period (DSO) = 2 × ICP Cost of goods sold $7,500,000 $7,500,000 Inv. conv. period (ICP) 36.50 31.50 DSO (calculated) 73.00 68.00 Receivables (A/R) $2,000,000 $1,863,014 CCC = DSO + ICP − PDP = 79.50 69.50CHECK on CCC Decrease in CCC 10 New CCC 69.50 Reduction in A/R = Orig. A/R − New A/R = $136,986 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.03 - LO: 16-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 47. The overriding goal of inventory management is to ensure that the firm never suffers a stock-out, i.e., never runs out of an inventory item. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.04 - LO: 16-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Goal of inventory management Bloom’s: Knowledge 8/9/2018 11:06 AM 8/9/2018 11:06 AM

48. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.04 - LO: 16-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of inventory management KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 49. Which of the following statements is most consistent with efficient inventory management? The firm has a a. low incidence of production schedule disruptions. b. below average total assets turnover ratio. c. relatively high current ratio. d. relatively low DSO. e. below average inventory turnover ratio.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.04 - LO: 16-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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50. The average accounts receivable balance is a function of both the volume of credit sales and the days sales outstanding. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables balance KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 51. If a firm has a large percentage of accounts over 30 days old, this is proof positive that its receivables manager is not doing a good job. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables aging KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 52. The aging schedule is a commonly used method for monitoring receivables. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Monitoring receivables KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 53. The four primary elements in a firm's credit policy are (1) credit standards, (2) cash discounts offered, (3) credit period, and (4) collection policy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 54. Changes in a firm's collection policy can affect sales, working capital, and profits. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DATE MODIFIED:

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55. Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taking discounts KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 56. Suppose a firm changes its credit policy from 2/10 net 30 to 3/10 net 30. The change is meant to meet competition, so no increase in sales is expected. The average accounts receivable balance will probably decline as a result of this change. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Change in credit policy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 57. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables balance KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 58. Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future. Dimon's accounts receivable balance will remain constant at the current level, because the 10% cash sales can be used to support the 10% growth rate, other things held constant. a. True b. False ANSWER: False RATIONALE: Accounts receivable will increase by 10%. That percentage increase would occur regardless of the level of the cash sales. Even if cash sales were 90%, receivables would still increase by 10% under the assumptions in the question.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables and growth KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 59. For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Working capital management United States - OH - Default City - TBA Receivables and growth Bloom’s: Comprehension 8/9/2018 11:06 AM 8/9/2018 11:06 AM

60. A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 61. Because money has time value, a cash sale is always more profitable than a credit sale. a. True b. False ANSWER: False RATIONALE: Department stores, auto dealers, and many others sell on credit, using interest bearing notes payable. The interest rate on this credit can exceed the firm's cost of capital, making credit sales more profitable than cash sales.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash vs. credit sales KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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62. If a firm sells on terms of 2/10 net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past-due accounts. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO and past-due accounts KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 63. Which of the following is NOT commonly regarded as being a credit policy variable? a. Collection policy. b. Credit standards. c. Cash discounts. d. Payments deferral period. e. Credit period.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 64. Which of the following statements is CORRECT? a. In managing a firm's accounts receivable, it is possible to increase credit sales per day yet still keep accounts receivable fairly steady, provided the firm can shorten the length of its collection period (its DSO) sufficiently.

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Chapter 16: Supply Chains and Working Capital Management b. Because of the costs of granting credit, it is not possible for credit sales to be more profitable than cash sales. c. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. d. Other things held constant, if a firm can shorten its DSO, this will lead to a higher current ratio. e. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant rate of 10% annually.

Such a firm will be able to keep its accounts receivable at the current level, since the 10% cash sales can be used to finance the 10% growth rate.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 65. Which of the following statements is CORRECT? a. If a firm that sells on terms of net 30 changes its policy to 2/10 net 30, and if no change in sales volume occurs, then the firm's DSO will probably increase. b. If a firm sells on terms of 2/10 net 30, and its DSO is 30 days, then the firm probably has some past-due accounts. c. If a firm sells on terms of net 60, and if its sales are highly seasonal, with a sharp peak in December, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in January than in July. d. If a firm changed the credit terms offered to its customers from 2/10 net 30 to 2/10 net 60, then its sales should increase, and this should lead to an increase in sales per day, and that should lead to a decrease in the DSO. e. Other things held constant, the higher a firm's days sales outstanding (DSO), the better its credit department.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Days sales outstanding (DSO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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66. Which of the following statements is CORRECT? a. If cash inflows from collections occur in equal daily amounts but most payments must be made on the 10th of each month, then a regular monthly cash budget will be misleading. The problem can be corrected by using a daily cash budget. b. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. If a firm sells on terms of net 90, and if its sales are highly seasonal, with 80% of its sales in September, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in October than in August. e. Depreciation is included in the estimate of cash flows (Cash flow = Net income = Depreciation); hence depreciation is set forth on a separate line in the cash budget.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 67. Krackle Korn Inc. had credit sales of $3,500,000 last year and its days sales outstanding was DSO = 35 days. What was its average receivables balance, based on a 365-day year? a. $335,616 b. $352,397 c. $370,017 d. $388,518 e. $407,944 ANSWER: a RATIONALE: Sales $3,500,000 DSO 35 Receivables = (Sales per day)(DSO) = Sales/365 × DSO = $335,616 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts receivable balance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 68. Famous Farm's payables deferral period (PDP) is 50 days (on a 365-day basis), accounts payable are $100 million, and its balance sheet shows inventory of $125 million. What is the inventory turnover ratio? a. 4.73 b. 5.26 c. 5.84 d. 6.42 e. 7.07 ANSWER: c RATIONALE: PDP 50Days/year 365 Payables $100Inventory $125 Use PDP equation to find sales: PDP = Receivables/(COGS/365) COGS = 365(Payables)/DSO = $730 Inventory turnover = COGS/Inventory = 5.84 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.05 - LO: 16-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover and DSO KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 69. If a firm busy on terms of 2/10 net 30, it should pay as early as possible during the discount period. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 70. Trade credit can be separated into two components: free trade credit, which is credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 71. As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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72. If a firm's suppliers stop offering cash discounts, then its use of trade credit is more likely to increase than to decrease, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 73. When deciding whether or not to take a cash discount, the cost of borrowing from a bank or other source should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 74. The calculated cost of trade credit can be reduced by paying late. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 75. The calculated cost of trade credit for a firm that buys on terms of 2/10 net 30 is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 76. One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge Copyright Cengage Learning. Powered by Cognero.

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77. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 78. Accruals are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 79. Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms have little control over the level of these accounts. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 80. The facts (1) that no explicit interest is paid on accruals and (2) that the firm can control the level of these accounts at will makes them an attractive source of funding to meet working capital needs. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 81. If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit Copyright Cengage Learning. Powered by Cognero.

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82. If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 83. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 84. Which of the following statements is CORRECT? a. A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds. b. If a company receives trade credit under terms of 2/10 net 30, this implies that the company has 10 days of free trade credit.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management c. One cannot tell if a firm uses a current asset financing policy that matches maturities, is conservative, or is aggressive without an examination of its cash budget. d. If a firm has a relatively aggressive current asset financing policy vis-á-vis other firms in its industry, then its current ratio will probably be relatively high. e. Accruals are an expensive but commonly used way to finance working capital.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 85. Newsome Inc. buys on terms of 3/15, net 45. It does not take the discount, and it generally pays after 60 days. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 25.09% b. 27.59% c. 30.35% d. 33.39% e. 36.73% ANSWER: a RATIONALE: Discount % 3%Net days 45 Discount days 15Actual days to payment 60 Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) Nom. % cost = 3.09% × 8.11 = 25.09% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: nom. cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Copyright Cengage Learning. Powered by Cognero.

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86. Freeman Builders, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 60 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 10.86% b. 12.07% c. 13.41% d. 14.90% e. 16.55% ANSWER: e RATIONALE: Discount % 2%Net days 30 Discount days 15Actual days to payment 60 Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) Nom. % cost = 2.04% × 8.11 = 16.55% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: nom. cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 87. The company you just started has been offered credit terms of 4/30, net 90 days. What will be the nominal annual percentage cost of its non-free trade credit if it pays 120 days after the purchase? (Assume a 365-day year.) a. 16.05% b. 16.90% c. 17.74% d. 18.63% e. 19.56% ANSWER: b RATIONALE: Discount % 4%Net days 90 Discount days 30Actual days to payment 120 Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) = 16.90% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: nom. cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 88. Howes Inc. purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50. If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its non-free trade credit?

(Assume a 365-day year.) a. 20.11% b. 21.17% c. 22.28% d. 23.45% e. 24.63% ANSWER: d RATIONALE: Discount % 2%Net days 50 Discount days 15Actual days to payment 50 [365/(Actual days − Disc. Period)] EAR = [1 + Disc. %/(100 − Disc. %)] −1 = 23.45% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: EAR cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 89. Andrews Corporation buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays after 58 days.

What is the effective annual percentage cost of its non-free trade credit? (Use a 365-day year.) a. 14.34% b. 15.10% c. 15.89% d. 16.69% e. 17.52% Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: RATIONALE:

c Discount % 2%Net days Discount days 8Actual days to payment EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 15.89% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: EAR cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

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90. Safety Window and Door Co. buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $450,000 per year. On average, how much "free" trade credit does the firm receive during the year? (Assume a 365-day year, and note that purchases are net of discounts.) a. $18,493 b. $19,418 c. $20,389 d. $21,408 e. $22,479 ANSWER: a RATIONALE: Purchases $450,000Net days 60 Discount % 2%Days to payment 60 Discount days 15Days/Year 365 Purchases/day = $450,000/365 = $1,233 Free credit = Disc. days × Purchases/day = $18,493 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management 91. Taylor Textbooks Inc. buys on terms of 2/15, net 50 days. It does not take discounts, and it typically pays on time, 50 days after the invoice date. Net purchases amount to $450,000 per year. On average, what is the dollar amount of costly trade credit (total credit − free credit) the firm receives during the year? (Assume a 365-day year, and note that purchases are net of discounts.) a. $43,151 b. $45,308 c. $47,574 d. $49,952 e. $52,450 ANSWER: a RATIONALE: Purchases $450,000Net days 50 Discount % 2%Days to payment 50 Discount days 15Days/Year 365 Purchases/day = $450,000/365 = $1,233 Avg. trade credit = Average A/P = Days to payment × Net purchases/day = $61,644 Free trade credit = Discount days × Purchases/day = $18,493 Costly trade credit = Total credit − Free credit = $43,151 Alternatively, Costly TC = (Days to pmt. − Disc. days) × (Purchases/day) = $43,151 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costly trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 92. Fairweather Corporation purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $800,000 per year. What is the maximum dollar amount of costly trade credit the firm could get, assuming it abides by the supplier's credit terms? (Assume a 365-day year.) a. $53,699 b. $56,384 c. $59,203 d. $62,163 e. $65,271 ANSWER: a RATIONALE: Discount 2%Gross purchases $800,000 Discount days 15Days in year 365 Net days 40 Net purchases = Gross(1 − Disc. %) = $784,000 Net per day = Net/365 = $2,148 Total trade credit = Net days × Net per day = $85,918 Free credit = Net per day × Discount days = $32,219 Costly credit = Total credit − Free credit = $53,699 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costly trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 93. Hinkle Corporation buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $550,000 per year. On average, what is the dollar amount of total trade credit (costly + free) the firm receives during the year, i.e., what are its average accounts payable? (Assume a 365day year, and note that purchases are net of discounts.) a. $90,411 b. $94,932 c. $99,678 d. $104,662 e. $109,895 ANSWER: a RATIONALE: Purchases $550,000Net days 60 Discount % 2%Days to payment 60 Discount days 15Days/Year 365 Purchases/day = $550,000/365 = $1,507 Average trade credit = Average A/P = Days to payment × Net purchases/day = $90,411 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 94. Noddings Inc. needs to raise more capital because its business is booming. The company purchases supplies on terms of 1/10 net 20, and it currently takes the discount. One way of getting the needed funds would be to forgo the discount, Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management and the firm's owner believes she could delay payment to 40 days without adverse effects. What would be the effective annual percentage cost of funds raised by this action? (Assume a 365-day year.) a. 10.59% b. 11.15% c. 11.74% d. 12.36% e. 13.01% ANSWER: e RATIONALE: Discount % 1%Net days 20 Discount days 10Actual days to payment 40 [365/(Actual days − Disc. Period)] EAR = [1 + Disc. %/(100 − Disc. %)] − 1 = 13.01% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 95. Suppose the suppliers of your firm offered you credit terms of 2/10 net 30 days. Your firm is not taking discounts, but is paying after 25 days instead of waiting until Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%. But since your firm is neither taking discounts nor paying on the due date, what is the effective annual percentage cost (not the nominal cost) of its costly trade credit, using a 365-day year? a. 60.3% b. 63.5% c. 66.7% d. 70.0% e. 73.5% ANSWER: b RATIONALE: Discount % 2%Net days 30 Discount days 10Actual days to payment 25 [365/(Actual days − Disc. Period)] EAR = [1 + Disc. %/(100 − Disc. %)] − 1 = 63.49% POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Trade credit: EAR cost Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 8/9/2018 11:06 AM

96. Arnold Inc. purchases merchandise on terms of 2/10 net 30, and it always pays on the 30th day. The CFO calculates that the average amount of costly trade credit carried is $375,000. What is the firm's average accounts payable balance?

(Assume a 365-day year.) a. $458,160 b. $482,273 c. $507,656 d. $534,375 e. $562,500 ANSWER: e RATIONALE: Discount % 2%Net days 30 Discount days 10Actual days to payment 30 Costly trade credit $375,000Years/day 365 Costly trade credit= Purchases per day × (Days credit is outstanding − Discount period) $375,000= Purchases per day × 20 Purchases per day= $18,750 Free trade credit= Purchases per day × Discount period Free trade credit= $18,750 × 10 Free trade credit= $187,500 Total trade credit= Costly trade credit + Free trade credit Total trade credit= $375,000 + $187,500 Total trade credit= $562,500 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts payable balance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 97. Blueroot Inc. is considering a change in its financing policy. Currently, it uses maximum trade credit by not taking discounts on its purchases. The standard industry credit terms offered by all its suppliers are 2/10 net 30 days, and the firm Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management pays on time. The new CFO is considering borrowing from its bank, using short-term notes payable, and then taking discounts. The firm wants to determine the effect of this policy change on its net income. Its net purchases are $11,760 per day, using a 365-day year. The interest rate on the notes payable is 10%, and the tax rate is 25%. If the firm implements the plan, what is the expected change in net income? a. $41,202 b. $43,370 c. $45,657 d. $48,060 e. $50,463 ANSWER: d RATIONALE: Discount % 2%Net days 30 Discount days 10Actual days to payment 30 Net purchases/day $11,760Days/year 365 Annual interest rate 10.00%Tax rate 25% A/PNo disc. = Net purchases/day × Actual days to payment A/PNo disc. = $11,760 × 30 = $352,800 A/PDisc. = Net purchases/day × Discount days A/PDisc. = $11,760 × 10 = $117,600 Amount needed to be financed = A/PNo disc. − A/PDisc. Amount needed to be financed = $352,800 − $117,600 = $235,200 Additional interest cost = Amount needed to be financed × Annual interest rate Additional interest cost = $235,200 × 10.00% = $23,520 Gross purchases = (Net purchases/day × 365)/(1 − Disc. %) Gross purchases = $11,760 × 365/98.00% = $4,380,000 Discounts lost = Gross purchases × Discount % Discounts lost = $4,380,000 × 2.00% = $87,600 Pre-tax savings = Discounts lost − Additional interest Pre-tax savings = $87,600 − $23,520 = $64,080 After-tax savings = Pre-tax savings × (1 − T) After-tax savings = $64,080 × 75.00% = $48,060 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fin. stmts. and trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 1/27/2019 10:16 PM 98. During the coming year, Gold & Gold wants to increase its free cash flow by $180 million, which should result in a higher stock price. The CFO has made these projections for the upcoming year: ∙ EBIT is projected to equal $852 million.

Gross capital expenditures are expected to total to $360 million versus depreciation of $120 ∙ million, so its net capital expenditures should total $240 million. ∙ The tax rate is 25%.

There will be no changes in cash or marketable securities, nor will there be any changes in ∙ notes payable or accruals.

What increase in net working capital (in millions of dollars) would enable the firm to meet its target increase in FCF? Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management a. $175 b. $219 c. $263 d. $316 e. $379 ANSWER: RATIONALE:

b EBIT $850 Gross capital expenditures $360 Depreciation $120 Tax rate 25% Target increase in FCF $180 FCF= EBIT(1 − T) + Deprec. − Capex. −ΔNWC $180= $639 + $120 − $360 − ΔNWC $180= $399 − ΔNWC −$219= − ΔNWC ΔNWC= $219 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.06 - LO: 16-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital, FCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 1/27/2019 10:19 PM 99. Shorter-term cash budgets⎯say a daily cash budget for the next month⎯are generally used for actual cash control while longer-term cash budgets⎯say monthly cash budgets for the next year⎯are generally used for planning purposes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Knowledge Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DATE CREATED: DATE MODIFIED:

8/9/2018 11:06 AM 8/9/2018 11:06 AM

100. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 101. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality receipts are concentrated at the beginning of each month. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 102. The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash and capital budgets KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 103. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget and depreciation KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 104. Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket? a. Depreciation. b. Cumulative cash. c. Repurchases of common stock. d. Payment for plant construction. e. Payments lags.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Working capital management United States - OH - Default City - TBA Cash budget Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:06 AM 8/9/2018 11:06 AM

105. Which of the following statements concerning the cash budget is CORRECT? a. Cash budgets do not include financial items such as interest and dividend payments. b. Cash budgets do not include cash inflows from long-term sources such as the issuance of bonds. c. Changes that affect the DSO do not affect the cash budget. d. Capital budgeting decisions have no effect on the cash budget until projects go into operation and start producing revenues. e. Depreciation expense is not explicitly included, but depreciation's effects are reflected in the estimated tax payments.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 106. Which of the following items should a company report directly in its monthly cash budget? a. Cash proceeds from selling one of its divisions. b. Accrued interest on zero coupon bonds that it issued. c. New shares issued in a stock split. d. New shares issued in a stock dividend. e. Its monthly depreciation expense.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Working capital management United States - OH - Default City - TBA Cash budget Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:06 AM 8/9/2018 11:06 AM

107. Which of the following statements is CORRECT? a. The cash budget and the capital budget are developed separately, and although they are both important to the firm, one does not affect the other. b. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. c. The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations. d. The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash.

These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts. e. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 108. Baltimore Baking is preparing its cash budget and expects to have sales of $30,000 in January, $35,000 in February, and $35,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March? a. $24,057 b. $26,730 c. $29,700 d. $33,000 e. $36,300 ANSWER: d RATIONALE: Payments: Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management Cash Pay 2nd month Pay 3rd month

20% 40% 40% Collections Sales for Mos. $30,000 35,000 35,000

January $6,000

January February March _____ Total collections for $6,000 month: POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

February $12,000 7,000 ______

March $12,000 14,000 7,000

$19,000

$33,000

109. Tierney Enterprises is constructing its cash budget. Its budgeted monthly sales are $5,000, and they are constant from month to month. 40% of its customers pay in the first month and take the 2% discount, while the remaining 60% pay in the month following the sale and do not receive a discount. The firm has no bad debts. Purchases for next month's sales are constant at 50% of projected sales for the next month. "Other payments," which include wages, rent, and taxes, are 25% of sales for the current month. Construct a cash budget for a typical month and calculate the average net cash flow during the month. a. $1,092 b. $1,150 c. $1,210 d. $1,271 e. $1,334 ANSWER: c RATIONALE: Monthly sales $5,000 Monthly purchase % 50% Other payments: 25% Sales Month Next Month Payment pattern: 40% 60% Discount: 2% Last Current Next Cash budget: Month Month Month Sales $5,000 $5,000 $5,000 Collections, same month's sales (% of Sales)(Sales)(1 − Discount) Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management Collections (last month's sales) Total collections Purchases payments Other payments Total payments Net cash flow POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.07 - LO: 16-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

3,000 $4,960 2,500 1,250 $3,750 $1,210

110. Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary for conducting a firm's normal business activities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.08 - LO: 16-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of cash management KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 111. Firms hold cash balances in order to complete transactions (both routine and precautionary) that are necessary in business operations and as compensation to banks for providing loans and services. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.08 - LO: 16-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Motives for holding cash KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 112. For a firm that makes heavy use of net float, being able to forecast collections and disbursement check clearings is essential. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Float KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 113. Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DATE MODIFIED:

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114. Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow synchronization KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 115. On average, a firm collects checks totaling $250,000 per day. It takes the firm approximately 4 days from the day the checks were mailed until they result in usable cash for the firm. Assume that (1) a lockbox system could be employed which would reduce the cash conversion procedure to 2 1/2 days and (2) the firm could invest any additional cash generated at 6% after taxes. The lockbox system would be a good buy if it costs $25,000 annually. a. True b. False ANSWER: False RATIONALE: Funds generated = Days saved × Checks per day = $375,000 Return on funds generated = Funds generated × Rate of return = $22,500 < $25,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 116. A lockbox plan is a. used to identify inventory safety stocks. b. used to slow down the collection of checks our firm writes.

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Chapter 16: Supply Chains and Working Capital Management c. used to speed up the collection of checks received. d. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks. e. used to protect cash, i.e., to keep it from being stolen.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 117. A lockbox plan is most beneficial to firms that a. have widely dispersed manufacturing facilities. b. have a large marketable securities portfolio and cash to protect. c. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks. d. have customers who operate in many different parts of the country. e. have suppliers who operate in many different parts of the country.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 118. Carter & Carter is considering setting up a regional lockbox system to speed up collections. The company sells to customers all over the U.S., and all receipts come in to its headquarters in San Francisco. The firm's average accounts receivable balance is $2.5 million, and they are financed by a bank loan at an 11% annual interest rate. The firm believes this new lockbox system would reduce receivables by 20%. If the annual cost of the system is $15,000, what pre-tax net Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management annual savings would be realized? a. $29,160 b. $32,400 c. $36,000 d. $40,000 e. $44,000 ANSWER: d RATIONALE: Average accounts receivable balance $2,500,000 Annual interest rate to finance A/R 11.00% % Reduction in A/R 20.00% Annual lockbox cost $15,000 Reduction in A/R = % Reduction in A/R × Avg. A/R balance Reduction in A/R = 20.00% × $2,500,000 Reduction in A/R = $500,000 Annual int. savings Annual int. savings Annual int. savings

= Reduction in A/R × Annual interest rate = $500,000 × 11.00% = $55,000

Pre-tax net annual savings = Annual interest savings − Annual lockbox cost Pre-tax net annual savings = $55,000 − $15,000 Pre-tax net annual savings = $40,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.09 - LO: 16-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 119. Which of the following statement completions is CORRECT? If the yield curve is upward sloping, then the marketable securities held in a firm's portfolio, assumed to be held for emergencies, should a. consist mainly of short-term securities because they pay higher rates. b. consist mainly of U.S. Treasury securities to minimize interest rate risk. c. consist mainly of short-term securities to minimize interest rate risk. d. be balanced between long- and short-term securities to minimize the adverse effects of either an upward or a downward trend in interest rates. e. consist mainly of long-term securities because they pay higher rates.

ANSWER: c POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.10 - LO: 16-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Marketable securities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 120. Which of the following statements is NOT CORRECT? a. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected. b. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. Managing working capital is important because it influences financing decisions and the firm's profitability. e. A company may hold a relatively large amount of cash and marketable securities if it is uncertain about its volume of sales, profits, and cash flows during the coming year.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.10 - LO: 16-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 121. An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and thus is a more reliable source of funds for the borrower. a. True b. False ANSWER: False POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bank loans KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 122. The maturity of most bank loans is short term. Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature. However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bank loans KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 123. Loans from commercial banks generally appear on balance sheets as notes payable. A bank's importance is actually greater than it appears from the dollar amounts shown on balance sheets because banks provide nonspontaneous funds to firms. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management Copyright Cengage Learning. Powered by Cognero.

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United States - OH - Default City - TBA Bank loans Bloom’s: Knowledge 8/9/2018 11:06 AM 8/9/2018 11:06 AM

124. A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Promissory note KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 125. A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower during some future period, assuming the borrower maintains its financial strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Line of credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 126. If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit.

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Chapter 16: Supply Chains and Working Capital Management a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Revolving credit KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 127. A revolving credit agreement is a formal line of credit. The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Revolving credit KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 128. Which of the following statements is CORRECT? a. Conservative firms generally use no short-term debt and thus have zero current liabilities. b. A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt. c. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10 net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. d. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance. e. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk.

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Chapter 16: Supply Chains and Working Capital Management ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 129. Sanders Enterprises arranged a revolving credit agreement of $9,000,000 with a group of banks. The firm paid an annual commitment fee of 0.5% of the unused balance of the loan commitment. On the used portion of the revolver, it paid 1.5% above prime for the funds actually borrowed on a simple interest basis. The prime rate was 3.25% during the year. If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar annual cost of the revolver? a. $285,000 b. $300,000 c. $315,000 d. $330,750 e. $347,288 ANSWER: b RATIONALE: Total commitment $9,000,000 Fee on unused balance 0.50% Prime rate 3.25% Premium over prime 1.50% Amount borrowed $6,000,000 Interest rate on borrowed funds = Prime + Premium = 4.75% Cost of used portion = Amount borrowed × Rate = $285,000 Cost of unused portion: Unused balance × Fee = $15,000 Total annual cost of loan agreement = $300,000 Alternative solution: Rate per day = 4.75%/365 = Interest per day = (Rate per day)(Amount borrowed) = Interest per year = (Interest per day)(365) = Cost of unused portion: Unused balance × Fee = Total annual cost of loan agreement = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.12 - LO: 16-12 Copyright Cengage Learning. Powered by Cognero.

0.0130137% $781 $285,000 $15,000 $300,000

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Chapter 16: Supply Chains and Working Capital Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Analytic United States - AK - DISC: Working capital management United States - OH - Default City - TBA Revolving credit agreement Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 8/9/2018 11:06 AM

130. Which of the following statements is CORRECT? a. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies. b. Short-term debt is favored by firms because, while it is generally more expensive than long-term debt, it exposes the borrowing firm to less risk than long-term debt. c. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. d. Commercial paper is typically offered at a long-term maturity of at least five years. e. Trade credit is provided only to relatively large, strong firms.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.13 - LO: 16-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 131. Which of the following statements is NOT CORRECT? a. Accruals are "free" in the sense that no explicit interest is paid on these funds. b. A conservative approach to working capital management will result in most, if not all, permanent current operating assets being financed with long-term capital. c. The risk to a firm that borrows with short-term credit is usually greater than if it borrowed using long-term debt. This added risk stems from the greater variability of interest costs on short-term debt and possible difficulties with rolling over short-term debt. d. Bank loans generally carry a higher interest rate than commercial paper. e. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 16: Supply Chains and Working Capital Management QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.16.13 - LO: 16-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

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Chapter 17: Multinational Financial Management 1. Multinational financial management requires that financial analysts consider the effects of changing currency values. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.02 - LO: 17-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multinational financial management KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 2. Legal and economic differences among countries, although important, do NOT pose significant problems for most multinational corporations when they coordinate and control worldwide operations of subsidiaries. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.02 - LO: 17-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multinational financial management KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 3. Exchange rate quotations consist solely of direct quotations. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exchange rates KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 4. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a third currency as a base. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cross rates KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 5. When the value of the U.S. dollar appreciates against another country's currency, we may purchase more of the foreign currency with a dollar. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Currency appreciation Bloom's: Knowledge 8/9/2018 11:07 AM 11/16/2018 9:33 AM

6. If it takes $0.71 U.S. dollars to purchase one Swiss franc, how many Swiss francs can one U.S. dollar buy? a. 0.50 b. 0.71 c. 1.00 d. 1.41 e. 2.81 ANSWER: d RATIONALE: Dollars should sell for 1/0.71, or 1.41 Swiss francs per dollar.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exchange rates KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 7. If 1.64 Canadian dollars can purchase one U.S. dollar, how many U.S. dollars can you purchase for one Canadian dollar? a. 0.37 b. 0.61 c. 1.00 d. 1.64 e. 3.28 ANSWER: b RATIONALE: You can get 1/1.64, or 0.61 U.S. dollars for one Canadian dollar.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

management United States - OH - Default City - TBA Exchange rates Bloom's: Application TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 11/16/2018 9:33 AM

8. Suppose the exchange rate between U.S. dollars and Swiss francs is SF 1.41 = $1.00, and the exchange rate between the U.S. dollar and the euro is $1.00 = 1.64 euros. What is the cross-rate of Swiss francs to euros? a. 0.43 b. 0.86 c. 1.41 d. 1.64 e. 2.27 ANSWER: b RATIONALE: SF/euro = (1.41/1) × (1/1.64) = 1.41/1.64 = 0.86 SF/euro.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cross rates KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 9. Suppose that 1 British pound currently equals 1.62 U.S. dollars and 1 U.S. dollar equals 1.62 Swiss francs. What is the cross exchange rate between the pound and the franc? a. 1 British pound equals 3.2400 Swiss francs b. 1 British pound equals 2.6244 Swiss francs c. 1 British pound equals 1.8588 Swiss francs d. 1 British pound equals 1.0000 Swiss francs e. 1 British pound equals 0.3810 Swiss francs ANSWER: b RATIONALE: 1 British pound can be exchanged for 1.62 U.S. dollars. 1.62 U.S. dollars can then be exchanged for 2.6244[(1.62)(1.62)] Swiss francs. It follows that 1 pound is worth 2.6244 francs.

POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cross rates?nonalgorithmic KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 10. If the spot rate of the Israeli shekel is 5.51 shekels per dollar and the 180-day forward rate is 5.97 shekels per dollar, then the forward rate for the Israeli shekel is selling at a ____ to the spot rate. a. premium of 8% b. premium of 18% c. discount of 18% d. discount of 8% e. premium of 16% ANSWER: d RATIONALE: (5.97 − 5.51)/5.51 = 0.083 ≈ 8%. Because one can obtain more Israel shekels for a dollar in the forward market, the forward currency is selling at an 8% discount to the spot rate.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forward exchange rates?nonalgorithmic KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 11. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold for the same amount of yen today but the current exchange rate is 144 yen per dollar, what would the car be selling for today in U.S. dollars? a. $5.964 b. $8,200 c. $10,250 Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management d. $12,628 e. $13,525 ANSWER: RATIONALE:

c Exchange rate in 1985 = 1,476,000/$8,200 = 180 yen per dollar. Today's exchange rate = 144 yen per dollar; 144/180 = 0.80. Today's price = $8,200/0.8 = $10,250. Alternatively, 1,476,000/144 = $10,250.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exchange rates and asset value KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 12. If the United States is running a deficit trade balance with China, then in a free market we would expect the value of the Chinese yuan to depreciate against the U.S. dollar. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade deficit and depreciation KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 13. Suppose one U.S. dollar can purchase 144 yen today in the foreign exchange market. If the yen depreciates by 8.0% tomorrow, how many yen could one U.S. dollar buy tomorrow? a. 155.5 yen b. 144.0 yen c. 133.5 yen Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management d. 78.0 yen e. 72.0 yen ANSWER: RATIONALE:

a If the yen depreciates by 8% we would get more yen per dollar. One U.S. dollar will equal 144 × 1.08 = 155.5 yen.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Currency appreciation KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 14. The United States and most other major industrialized nations currently operate under a system of floating exchange rates. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating exchange rates KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 15. Exchange rate risk is the risk that the cash flows from a foreign project, when converted to the parent company's currency, will be worth less than was originally projected because of exchange rate changes. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exchange rate risk KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 16. Individuals and corporations can buy or sell forward currencies to hedge their exchange rate exposure. Essentially, the process involves simultaneously selling the currency expected to appreciate in value and buying the currency expected to depreciate. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.08 - LO: 17-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forward market hedging transactions KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 17. If the inflation rate in the United States is greater than the inflation rate in Britain, other things held constant, the British pound will a. Depreciate against the U.S. dollar. b. Remain unchanged against the U.S. dollar. c. Appreciate against other major currencies. d. Appreciate against the dollar and other major currencies. e. Appreciate against the U.S. dollar.

ANSWER: e POINTS: 1 DIFFICULTY: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.09 - LO: 17-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Currency depreciation KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 18. Suppose it takes 1.82 U.S. dollars today to purchase one British pound in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 12.0% against the pound over the next 30 days. How many dollars will a pound buy in 30 days? a. 1.12 b. 1.63 c. 1.82 d. 2.04 e. 3.64 ANSWER: d RATIONALE: The British pound will appreciate against the dollar by 12%. 1£ = 1.82 US$ × 1.12 = 2.04 US$.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Currency depreciation KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 19. A Eurodollar is a U.S. dollar deposited in a bank outside the United States. a. True b. False ANSWER: True POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.12 - LO: 17-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Eurodollars KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 20. The Eurodollar market is essentially a long-term market; most loans and deposits in this market have maturities longer than one year. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.12 - LO: 17-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Eurodollar market KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 21. LIBOR is an acronym for London Interbank Offer Rate, which is an average of interest rates offered by London banks to smaller U.S. corporations. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.12 - LO: 17-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

management United States - OH - Default City - TBA LIBOR Bloom's: Knowledge 8/9/2018 11:07 AM 11/16/2018 9:33 AM

22. The interest rate paid on Eurodollar deposits depends on the particular bank's lending rate and on rates available on U.S. money market instruments. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.12 - LO: 17-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Eurodollar interest rates KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 23. Which of the following is NOT a reason why companies move into international operations? a. To develop new markets for the firm's products. b. To better serve their primary customers. c. Because important raw materials are located abroad. d. To increase their inventory levels. e. To take advantage of lower production costs in regions where labor costs are relatively low.

ANSWER: d POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.01 - LO: 17-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Motivation for going global KEYWORDS: Bloom's: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:07 AM 11/16/2018 9:33 AM

24. Which of the following statements is NOT CORRECT? a. Foreign bonds and Eurobonds are two important types of international bonds. b. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. c. The term Eurobond applies only to foreign bonds denominated in U.S. currency. d. A foreign bond might pay a higher nominal interest rate than a U.S. bond. e. Any bond sold outside the country of the borrower is called an international bond.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.12 - LO: 17-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: International bond markets KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 25. Suppose a foreign investor who holds tax-exempt Eurobonds paying 9% is considering investing in an equivalent-risk domestic bond in a country with a 28% withholding tax on interest paid to foreigners. If 9% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return? a. 9.00% b. 10.20% c. 11.28% d. 12.50% e. 13.57% ANSWER: d RATIONALE: Gross up the interest rate on the domestic bond: rd(pretax) = 0.09/(1 − 0.28) = 12.5%. Solution check: After-tax return: 12.5% − 0.28(12.5%) = 12.5% − 3.5% = 9.0%.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.01 - LO: 17-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: International financial ma - DISC: International financial management United States - OH - Default City - TBA Eurobonds versus domestic bonds Bloom's: Application TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 11/16/2018 9:33 AM

26. A U.S.-based company, Stewart, Inc., arranged a 2-year, $1,000,000 loan to fund a project in Mexico. The loan is denominated in Mexican pesos, carries a 10.0% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.10 pesos per dollar before the first payment came due.

The loan was not hedged in the foreign exchange market. Thus, Stewart must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective interest rate will Stewart end up paying on the loan? a. 10.36% b. 11.50% c. 17.44% d. 20.00% e. 21.79% ANSWER: e RATIONALE:

Financial calculator solution: Calculate the required payments in Mexican pesos: Inputs: N = 4; I/YR = 5; PV = −5,750,000; FV = 0. Output: PMT = 1,621,568 MP. 1,621,568 Mexican pesos are needed on each payment date. At the initial exchange rate of 5.75 pesos/US$, the payments are approximately US $282,012. Payment in U.S. dollars after conversion = 1,621,568 pesos/(5.75 FF/US$) = $282,011.83. However, at an exchange rate of 5.10 pesos/US$, the cost to the firm in US$ increases to 1,621,568/5.10 = $317,954.51 ≈ $317,955. Calculate nominal annual interest rate on loan: Inputs: N = 4; PV = −1,000,000; PMT = 317,955; FV = 0. Output: I/YR = 10.36% semiannual rate. Annual nominal rate = 10.36(2) = 20.72%. Calculate effective annual rate: Inputs: P/YR = 2; NOM% = 20.72.

Output: EFF% = 21.79%.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.03 - LO: 17-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EAR on foreign debt KEYWORDS: Bloom's: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 11/16/2018 9:33 AM

27. Because political risk is seldom negotiable, it cannot be explicitly addressed in multinational corporate financial analysis. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Political risk KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 28. The cash flows relevant for a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company plus the cash flows that must remain in the foreign country. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant investment cash flows KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 29. The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Foreign project's cost of capital KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 30. When considering the risk of a foreign investment, a higher risk might arise from exchange rate risk and political risk while lower risk might result from international diversification. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and international investment KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 31. Tashakori Trucking, a U.S.-based company, is considering expanding its operations into a foreign country. The required investment at Time = 0 is $10 million. The firm forecasts total cash inflows of $4 million per year for 2 years, $6 million for the next 2 years, and then a possible terminal value of $8 million. In addition, due to political risk factors, Tashakori believes that there is a 50% chance that the gross terminal value will be only $2 million and a 50% chance that it will be $8 million. However, the government of the host country will block 20% of all cash flows. Thus, cash flows that can be repatriated are 80% of those projected. Tashakori's cost of capital is 15%, but it adds one percentage point to all foreign projects to account for exchange rate risk. Under these conditions, what is the project's NPV? a. $1.01 million b. $2.77 million Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management c. $3.09 million d. $5.96 million e. $7.39 million ANSWER: RATIONALE:

b Time line: (In millions)

*Calculate the expected terminal value cash flow: Expected terminal cash flow (CF5) = 0.5(8) + 0.5(2) = 4 + 1 = 5. Calculate the unrestricted cash flows that can be repatriated to the parent firm: Unrestricted cash flows = Projected cash inflows × 0.80. Tabular solution (In millions): Unrestricted Projected Percent Repatriable Year Cash Flow Unrestricted Cash Flows 1 $4 0.80 $3.2 2 4 0.80 3.2 3 6 0.80 4.8 4 6 0.80 4.8 5 5 0.80 4.0 2 3 4 NPV= $3.2/1.16 + $3.2/1.16 + $4.8/1.16 + $4.8/1.16 + $4.0/1.165 − $10.0 = $3.2(0.8621) + $3.2(0.7432) + $4.8(0.6407) + $4.8(0.5523) + $4.0(0.4761) − $10.0 = $2.759 + $2.378 + $3.075 + $2.651 + $1.904 − $10.0 = $2.768 ≈ $2.77 million.

Financial calculator solution (In millions): Inputs: CF0 = −10.0; CF1 = 3.2; Nj = 2; CF2 = 4.8; Nj = 2; CF3 = 4.0; I/YR = 16. Output: NPV = $2.767 ≈ $2.77 million.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.13 - LO: 17-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Foreign investment cash flows KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 32. Credit policy for multinational firms is generally more risky due in part to the additional consideration of exchange rates and also due to uncertainty regarding the credit worthiness of many foreign customers. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: International credit management KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 33. Due to advanced communications technology and the standardization of general procedures, working capital management for multinational firms is no more complex than it is for large domestic firms. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: International working capital management KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 34. Exchange rates influence a multinational firm's inventory policy because changing currency values can affect the value of inventory. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Multinational inventory management KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 35. The threat of expropriation creates an incentive for the multinational firm to minimize inventory holdings in certain countries and to bring in goods only as needed. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expropriation and inventory KEYWORDS: Bloom's: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 36. Suppose Yates Inc., a U.S. exporter, sold a consignment of antique American muscle-cars to a Japanese customer at a price of 143.5 million yen, when the exchange rate was 140 yen per dollar. In order to close the sale, Yates agreed to make the bill payable in yen, thus agreeing to take some exchange rate risk for the transaction. The terms were net 6 months. If the yen fell against the dollar such that one dollar would buy 154.4 yen when the invoice was paid, what dollar amount would Yates actually receive after it exchanged yen for U.S. dollars? a. $1,075,958 b. $1,025,000 c. $1,000,000 d. $975,610 e. $929,404 ANSWER: e RATIONALE: Time line:

Calculate the amount received in U.S. dollars after the 143,500,000 yen are exchanged for Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management dollars at the spot rate of 154.4 yen, when the invoice is paid. 143,500,000/154.4 = $929,404.15 ≈ $929,404.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit and exchange rate risk KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 37. Suppose Stackpool Inc. had inventory in Britain valued at 240,000 pounds one year ago. The exchange rate for dollars to pounds was 1£ = 2 U.S. dollars. This year the exchange rate is 1£ = 1.82 U.S. dollars. The inventory in Britain is still valued at 240,000 pounds. What is the gain or loss in inventory value in U.S. dollars as a result of the change in exchange rates? a. −$240,000 b. −$43,200 c. $0 d. $43,200 e. $47,473 ANSWER: b RATIONALE: Inventory, this year = 240,000£ × $1.82 = $436,800 Inventory, last year = 240,000£ × $2.00 = 480,000 Loss = ($ 43,200) POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory value and exchange rates KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management 38. Suppose a U.S. firm buys $200,000 worth of stereo speaker wire from a Mexican manufacturer for delivery in 60 days with payment to be made in 90 days (30 days after the goods are received). The rising U.S. deficit has caused the dollar to depreciate against the peso recently. The current exchange rate is 5.50 pesos per U.S. dollar. The 90-day forward rate is 5.45 pesos/dollar. The firm goes into the forward market today and buys enough Mexican pesos at the 90-day forward rate to completely cover its trade obligation. Assume the spot rate in 90 days is 5.30 Mexican pesos per U.S. dollar. How much in U.S. dollars did the firm save by eliminating its foreign exchange currency risk with its forward market hedge? a. $0 b. $1,834.86 c. $4,517.26 d. $5,712.31 e. $7,547.17 ANSWER: d RATIONALE: Obligation is for 200,000 × 5.50 = 1,100,000 pesos. 1,100,000/5.45 = cost of forward contract = $201,834.86. Spot rate in 90 days = 5.30 pesos per U.S. dollar. 1,100,000/5.30 = cost of spot rate in 90 days = $207,547.17. Spot cost − forward cost = $207,547.17 − $201,834.86 = $5,712.31.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.15 - LO: 17-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forward market hedge KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 39. If an investor can obtain more of a foreign currency for a dollar in the forward market than in the spot market, then the forward currency is said to be selling at a discount to the spot rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Discount on forward rate Bloom's: Comprehension 8/9/2018 11:07 AM 11/16/2018 9:33 AM

40. If a dollar will buy fewer units of a foreign currency in the forward market than in the spot market, then the forward currency is said to be selling at a premium to the spot rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Premium on forward rate KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 41. A U.S.-based importer, Zarb Inc., makes a purchase of crystal glassware from a firm in Switzerland for 39,960 Swiss francs, or $24,000, at the spot rate of 1.665 francs per dollar. The terms of the purchase are net 90 days, and the U.S. firm wants to cover this trade payable with a forward market hedge to eliminate its exchange rate risk. Suppose the firm completes a forward hedge at the 90-day forward rate of 1.682 francs. If the spot rate in 90 days is actually 1.638 francs, how much will the U.S. firm have saved or lost in U.S. dollars by hedging its exchange rate exposure? a. −$396 b. −$243 c. $0 d. $243 e. $638 ANSWER: e RATIONALE: Time line:

POINTS: DIFFICULTY:

Calculate the cost of the forward contract at the forward rate: 39,960 SFr/(1.682 SFr/US$) = $23,757.43. Calculate the cost of purchasing exchange currency at the spot rate in 90 days to satisfy the payable: 39,960 SFr/1.638 SFr/US$ = $24,395.60. Calculate the savings from the forward market hedge: $24,395.60 − $23,757.43 = $638.17 ≈ $638.

1 Moderate

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Chapter 17: Multinational Financial Management QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.05 - LO: 17-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forward market hedge KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 42. A foreign currency will, on average, depreciate against the U.S. dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of the United States. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.08 - LO: 17-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Currency value and inflation KEYWORDS: Bloom's: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 43. Suppose 6 months ago a Swiss investor bought a 6-month U.S. Treasury bill at a price of $9,708.74, with a maturity value of $10,000. The exchange rate at that time was 1.420 Swiss francs per dollar. Today, at maturity, the exchange rate is 1.324 Swiss francs per dollar. What is the annualized rate of return to the Swiss investor? a. −7.92% b. −4.13% c. 6.00% d. 8.25% e. 12.00% ANSWER: a RATIONALE: Time line:

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Financial calculator solution: Calculate the 6-month return to the Swiss investor after she has exchanged US$ for Swiss francs. Inputs: N = 1; PV = −13,786.41; FV = 13,240. Output: I/YR = −3.96%. Annualized nominal rate of return = −3.96(2) = −7.92%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.08 - LO: 17-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exchange fluctuations and T-bills KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 44. In Japan, 90-day securities have a 4% annualized return and 180-day securities have a 5% annualized return. In the United States, 90-day securities have a 4% annualized return and 180-day securities have an annualized return of 4.5%.

All securities are of equal risk, and Japanese securities are denominated in terms of the Japanese yen. Assuming that interest rate parity holds in all markets, which of the following statements is most CORRECT? a. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 180-day forward market. b. The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market. c. The spot rate equals the 90-day forward rate. d. The spot rate equals the 180-day forward rate. e. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.09 - LO: 17-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate parity KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management DATE CREATED: DATE MODIFIED:

8/9/2018 11:07 AM 11/16/2018 9:33 AM

45. Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return. In the U.S., 90-day investments of similar risk have a 4% annualized return and a 1% quarterly (90-day) return. In the 90-day forward market, 1 British pound equals $1.65. If interest rate parity holds, what is the spot exchange rate? a. 1 pound = $1.8000 b. 1 pound = $1.6582 c. 1 pound = $1.0000 d. 1 pound = $0.8500 e. 1 pound = $0.6031 ANSWER: b RATIONALE: From the interest rate parity formula it follows that e0 = (ft)(1 + rf)/(1 + rh) = (1.65 dollars/pound)(1.015)/(1.01) = 1.6582 dollars/pound. Another way to think of this is $1 invested today in the United States yields $1.01 90 days from now. Alternatively, investors could put their money in British securities. In this case, the investor would exchange today $1 for (1/1.6582) or 0.6031 pounds in the spot market. This money could be invested in Britain and after 90 days this investment would be worth 0.6031(1.015) = 0.6121 pounds. Given the forward exchange rate, 0.6121 pounds is worth $1.01 90 days from now (0.6121 × 1.65 = $1.01).

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.09 - LO: 17-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate parity KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 46. Suppose 1 U.S. dollar equals 1.60 Canadian dollars in the spot market. 6-month Canadian securities have an annualized return of 6% (and thus a 6-month periodic return of 3%). 6-month U.S. securities have an annualized return of 6.5% and a periodic return of 3.25%. If interest rate parity holds, what is the U.S. dollar-Canadian dollar exchange rate in the 180-day forward market? a. 1 U.S. dollar = 0.6235 Canadian dollars b. 1 U.S. dollar = 0.6265 Canadian dollars c. 1 U.S. dollar = 1.0000 Canadian dollars d. 1 U.S. dollar = 1.5961 Canadian dollars e. 1 U.S. dollar = 1.6039 Canadian dollars ANSWER: d RATIONALE: From the interest rate parity formula it follows that Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management ft

= (eo)(1 + rh)/(1 + rf) = (0.6250 U.S. dollars/Canadian dollar)(1.0325)/(1.03) = 0.6265 U.S. dollars/Canadian dollar, or 1.5961 Canadian dollars per U.S. dollar.

Another way to think of this is $1 invested today in the United States yields $1.0325 six months from now. Alternatively, investors could put their money in Canadian securities. In this case, the investor would exchange $1 today for 1.6 Canadian dollars. This money could be invested in Canada and after 6 months this investment would be worth 1.6480 Canadian dollars[(1.6)(1.03)]. At a forward exchange rate of 1 U.S. dollar equals 1.5961 Canadian dollars, 1.6480 Canadian dollars would be worth $1.0325 in the U.S. Since the 2 investments produce the same return, interest rate parity holds.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.09 - LO: 17-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate parity KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 47. A product sells for $750 in the United States. The exchange rate is $1 to 1.65 Swiss francs. If purchasing power parity (PPP) holds, what is the price of the product in Switzerland? a. 123.75 Swiss francs b. 454.55 Swiss francs c. 750.00 Swiss francs d. 1,237.50 Swiss francs e. 1,650.00 Swiss francs ANSWER: d RATIONALE: $750 equals 1,237.50 [(750)(1.65)] Swiss francs. If PPP holds, the product should cost the same in both markets.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.10 - LO: 17-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Purchasing power parity KEYWORDS: Bloom's: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 11/16/2018 9:33 AM

48. Suppose a carton of hockey pucks sell in Canada for 105 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S. dollars. If purchasing power parity (PPP) holds, what is the price of hockey pucks in the United States? a. $14.79 b. $63.00 c. $74.55 d. $85.88 e. $147.88 ANSWER: c RATIONALE: 105 Canadian dollars equals 74.55 [(105)(0.71)] U.S. dollars. If PPP holds, the pucks should cost the same in both markets.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.10 - LO: 17-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Purchasing power parity KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM 49. A box of chocolate candy costs 28.80 Swiss francs in Switzerland and $20 in the United States. Assuming that purchasing power parity (PPP) holds, what is the current exchange rate? a. 1 U.S. dollar equals 0.69 Swiss francs b. 1 U.S. dollar equals 0.85 Swiss francs c. 1 U.S. dollar equals 1.21 Swiss francs d. 1 U.S. dollar equals 1.29 Swiss francs e. 1 U.S. dollar equals 1.44 Swiss francs ANSWER: e RATIONALE: If PPP holds, the chocolate should cost the same in each country, so that 28.80 Swiss francs equal 20 U.S. dollars. This relationship implies that 1 U.S. dollar equals 1.44 Swiss francs (28.80 SF/20).

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.17.10 - LO: 17-10 Copyright Cengage Learning. Powered by Cognero.

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Chapter 17: Multinational Financial Management NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: International financial ma - DISC: International financial management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Purchasing power parity?nonalgorithmic KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:33 AM

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks 1. Going public establishes a market value for the firm's stock, and it also ensures that a liquid market will continue to exist for the firm's shares. This is especially true for small firms that are not widely followed by security analysts. a. True b. False ANSWER: False RATIONALE: False. Going public does establish the firm's market value, but it does not ensure that a liquid market will continue to exist, and this is especially true for small firms that are not widely followed.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.02 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Going public KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 2. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.02 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Disadvantages of going public KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 3. Which of the following is generally NOT true and an advantage of going public? a. Increases the liquidity of the firm's stock. b. Makes it easier to obtain new equity capital.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks c. Establishes a market value for the firm. d. Makes it easier for owner-managers to engage in profitable self-dealings. e. Facilitates stockholder diversification.

ANSWER: d RATIONALE: Publicly owned firms are regulated by the SEC, and this limits the sort of deals that the owner/managers of private companies can make with themselves.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.02 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Going public KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 4. Which of the following statements about listing on a stock exchange is most CORRECT? a. Any firm can be listed on the NYSE as long as it pays the listing fee. b. Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business. c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC. d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE. e. Listing is a decision of more significance to a firm than going public.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.02 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Listing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks 5. The term "leaving money on the table" refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm's new stock offering. The banker is, in effect, "buying the job" with the low bid and thus not getting all the money his firm would normally earn on the job. a. True b. False ANSWER: False RATIONALE: False. Leaving money on the table occurs when a security issue is underpriced.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.03 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IPOs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 6. Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.03 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 7. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common Copyright Cengage Learning. Powered by Cognero.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker's required return on such arrangements is 15%, and ignore taxes. a. $1,235,925 b. $1,300,973 c. $1,369,446 d. $1,441,522 e. $1,517,391 ANSWER: e RATIONALE: Gross funds: $5,000,000 Current price: $5.00 Small fee: 6% Expected price: $6.50 Normal fee: 10% Possible price: $12.00 Option shares: 200,000 Required return: 15% Fee received now = 6% × $5,000,000 = $300,000 Additional fee: Option profit if the stock price is $12 in 1 year = ($12 − $5) × 200,000 = $1,400,000 PV of total compensation if $12 price = $300,000 + $1,400,000/(1.15)1 = $1,517,391 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.03 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment bankers' compensation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 8. The term "equity carve-out" refers to the situation where a firm's managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it "carves out" some of their value. a. True b. False ANSWER: False RATIONALE: False. An equity carve-out occurs when there is only a partial public offering. In other words, the public is sold equity in a wholly owned subsidiary but the parent retains full control of the subsidiary by retaining the majority of the subsidiary's common stock.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.04 - LO: 18-4 Copyright Cengage Learning. Powered by Cognero.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity carve-outs KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 9. If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement. a. True b. False ANSWER: False RATIONALE: False. In a private placement, securities are sold to one or a few investors, generally institutional investors. Private placements are most common with bonds, but they also occur with stocks.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.05 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Private placements KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 10. Which of the following statements is most CORRECT? a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement. b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs. c. The SEC requires that all private placements be handled by a registered investment banker. d. Private placements can generally bring in funds faster than is the case with public offerings. e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.05 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing United States - OH - Default City - TBA Private placements Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:05 AM 11/16/2018 9:39 AM

11. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT? a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market. b. Listing a large firm's stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm. c. Stockholders have the right to elect the firm's directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management's performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer. d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called "market pressure," and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue. e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.05 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking process KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 12. Which of the following statements is NOT CORRECT? a. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC. c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public," and the market for such stock is called the new issue market. d. It is possible for a firm to go public and yet not raise any additional new capital.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks e. When a corporation's shares are owned by a few individuals who own most of the stock or are part of the firm's management, we say that the firm is "closely, or privately, held."

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.05 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking process KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/16/2018 9:39 AM 13. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues? a. $79,425 b. $83,606 c. $88,006 d. $92,406 e. $97,027 ANSWER: c RATIONALE: Flotation%, 3 issues: 3.0% Flotation %, 1 issue: 1.6% Total funds needed = 3 × $5,000,000 = $15,000,000 Total debt needed = 40% × $15,000,000 = $6,000,000 Debt/year if use 3 separate issues = Total debt/3 = $2,000,000 Grossed-up debt if use a single issue = Net debt needed/(1 − F) = $6,000,000/(1 − 0.016) = $6,097,561 Flotation cost for single issue: Gross debt − Proceeds to company = $97,561 Gross debt with 3 issues: Net debt needed/(1 − F) = $6,000,000/(1 − 0.03) = $6,185,567 Flotation cost for yearly issues: Gross debt − Proceeds to company = $185,567 Difference = Additional cost of 3 issues: $185,567 − $97,561 = $88,006 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.18.05 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing Copyright Cengage Learning. Powered by Cognero.

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Chapter 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Flotation costs Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:05 AM 11/16/2018 9:39 AM

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Chapter 19: Lease Financing 1. Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases." a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of leases KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 2. A sale and leaseback arrangement is a type of financial, or capital, lease. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of leases KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 3. Operating leases help to shift the risk of obsolescence from the user to the lessor. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating lease KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sale and leaseback KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 5. Operating leases often have terms that include a. full amortization over the life of the lease. b. very high penalties if the lease is canceled. c. restrictions on how much the leased property can be used. d. much longer lease periods than for most financial leases. e. maintenance of the equipment by the lessor.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Operating lease Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:05 AM 8/9/2018 11:05 AM

6. Which of the following statements is most CORRECT? a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation. b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan. c. Capital, or financial, leases generally provide for maintenance by the lessor. d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. e. Finance leases usually have a cancelation feature.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.01 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leasing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/14/2018 10:25 AM 7. A company must capitalize any lease lasting more than a year by reporting it on the balance sheets as a

liability and as an asset. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.02 - LO: 19-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Off-balance sheet leasing Bloom’s: Knowledge 8/9/2018 11:05 AM 11/14/2018 10:27 AM

8. Almost all leases lasting more than a year must be included in the balance sheet by reporting the a. residual value as a liability. b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability. c. undiscounted sum of future lease payments as an asset and as an offsetting liability. d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability. e. residual value as a fixed asset.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.02 - LO: 19-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capitalizing leases KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/14/2018 10:28 AM 9. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.03 - LO: 19-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Lease payments Bloom’s: Knowledge 8/9/2018 11:05 AM 8/9/2018 11:05 AM

10. After a project has been accepted, the decision to lease or buy is determined by the present value of the lease's cash flows when discounted at the project's risk-adjusted cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.04 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease financing KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 12/4/2018 11:25 AM 11. A lessee should calculate the present value of a lease by discounting its cash flows at the same rate used to determine the present value of its a. proposed projects. b. debt. c. pension fund. d. sales. e. dividends.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.04 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease cash flows KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing DATE CREATED: DATE MODIFIED:

8/9/2018 11:05 AM 12/4/2018 11:14 AM

12. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased a. is financed with long-term debt. b. is financed with debt whose maturity matches the term of the lease. c. is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the WACC. d. is financed with retained earnings. e. is financed with short-term debt.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.04 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease analysis discount rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 13. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 endof-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment. a. $177,169 b. $196,854 c. $207,215 d. $217,576 e. $228,455 ANSWER: c RATIONALE: Years: 5 Loan amount: $6,000,000 Interest rate: 10.0% Lease Pmt: $1,790,000 0 1 2 3 4 5 Loan: −$6,000,000 PMT PMT PMT PMT PMT Find the loan payment: Financial calculator solution: Inputs: N = 5; I/YR = 10; PV = −6,000,000; FV = 0. Output = PMT = $1,582,785. Difference in payments = $1,790,000 − $1,582,785 = $207,215.

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Chapter 19: Lease Financing POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.05 - LO: 19-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Difference in payments KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 14. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 25%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) a. $119 b. $132 c. $139 d. $146 e. $153 ANSWER: b RATIONALE: Years: 3Tax rate: 25% Loan amount = equipment cost: $4,800Maintenance costs: $240 Interest rate: 10.0%Salvage value: $0 Lease Pmt: $2,100 After tax cost of debt = Rate × (1 − T) = 7.5% Depreciation per year = Cost/3 = $1,600 Tax saving from deprn = Deprn × T = $400 0 1 2 3 Cost of owning: Interest −480 −480 −480 Interest tax saving 120 120 120 Maintenance −240 −240 −240 Maintenance tax saving 60 60 60 Deprn tax saving 400 400 400 Repayment of loan −4,800 Net cash loan costs −140 −140 −4,940 PV cost of owning (6%): −4,228 Cost of leasing: Lease payment Tax savings from lease Copyright Cengage Learning. Powered by Cognero.

−2,100 525

−2,100 525

−2,100 525 Page 7

Chapter 19: Lease Financing Net cash lease costs PV cost of leasing (6%):

−1,575

−1,575

−1,575

−4,096

NAL = PV Cost of Owning − PV Cost of $132 Leasing = POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.05 - LO: 19-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net advantage to leasing (NAL) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 1/27/2019 10:29 PM 15. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck's 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC's tax rate is 25%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.) a. $1,020 b. $1,075 c. $1,134 d. $1,197 e. $1,257 ANSWER: d RATIONALE: Life of equipment: 4Tax rate: 25% Loan amount = equipment cost: $40,000Maintenance costs: $1,000 Interest rate: 10.0%Salvage value: $10,000 Lease Pmt: $10,000 Loan amortization for cash payment and interest expense: Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = −$12,618.83 Year Beg. Bal. PMT Interest Principal Ending Bal. 1 40,000 12,619 4,000 8,619 31,381 2 31,381 12,619 3,138 9,481 21,900 3 21,900 12,619 2,190 10,429 11,472 4 11,472 12,619 1,147 11,472 0 Loan Analysis: 0 1 2 3 4 MACRS factor 0.3333 0.4445 0.1481 0.0741 Depreciation 13,332 17,780 5,924 2,964 Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing Loan Pmt Int tax saving (Int. from table × T) Maintenance Maint. tax saving (Maint. × T) Depr'n tax saving (Deprn × T) Net operating CF Salvage value Tax on residual Net residual val Total Net CF PV cost of buying at I(1 − T) = 7.5%

−28,201

Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I (1 − T)

0 −10,000 2,500 −7,500 −27,004

−12,619 1,000 −1,000 250 3,300 −9,069

−12,619 785 −1,000 250 4,500 −8,084

−12,619 548 −1,000 250 1,500 −11,321

−9,069

−8,084

−11,321

−12,619 287 −1,000 250 700 −12,382 10,000 −2,500 7,500 −4,882

1 −10,000 2,500 −7,500

2 −10,000 2,500 −7,500

3 −10,000 2,500 −7,500

4 0 0 0

NAL = $1,197 POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.05 - LO: 19-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lessee's analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 1/27/2019 11:35 PM 16. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. Due to special circumstances, the firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.) a. $5,734 b. $6,023 Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing c. $6,324 d. $6,640 e. $6,972 ANSWER: RATIONALE:

a Life of equipment: Loan amount = equipment cost: Interest rate, simple: Lease Pmt: Loan Analysis: MACRS factor Depreciation

3Tax rate: $100,000Maintenance costs: 10.0%Salvage value: $29,000 0

1 0.3333 33,330

2 0.4445 44,550

−10,000 2,000 −3,000 600 6,666 −3,734

−10,000 2,000 −3,000 600 8,890 −1,490

Loan repayment Interest Int tax saving (Interest × T) Maintenance Maint. tax saving (Maint. × T) Depr'n tax saving (Deprn × T) Net operating CF Salvage value before taxes Book value (Cost − Total dep'rn) Taxable salvage value Tax on salvage value Salvage value after taxes Total Net CF PV cost at I(1 − T) = 8.00%

−2,400 −70,306

−3,734

−1,510

Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 − T)

0 −29,000 5,800 −23,200 −64,572

1 −29,000 5,800 −23,200

2 −29,000 5,800 −23,200

−3,000 600 −2,400

20% $3,000 $30,000 3 0.1418 14,180

Totals 0.9196 91,960

−100,000 −10,000 2,000

2,836 −105,164 30,000 8,040 21,960 −4,392 25,608 −79,556

3 0 0

NAL = $5,734

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.05 - LO: 19-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lessee's analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/14/2018 10:33 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing 17. A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.06 - LO: 19-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leveraged lease KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 18. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.08 - LO: 19-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synthetic leases KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 19. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset.

The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company's books. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.08 - LO: 19-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synthetic leases KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 20. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.08 - LO: 19-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual value and lease rates KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 21. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee's viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.08 - LO: 19-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of Copyright Cengage Learning. Powered by Cognero.

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Chapter 19: Lease Financing LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

capital United States - OH - Default City - TBA Residual value and lease rates Bloom’s: Comprehension 8/9/2018 11:05 AM 8/9/2018 11:05 AM

22. In the lease versus buy decision, leasing is often preferable a. because, generally, no down payment is required, and there are no indirect interest costs. b. because lease obligations do not affect the firm's risk as seen by investors. c. because the lessee owns the property at the end of the least term. d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset. e. because it has no effect on the firm's ability to borrow to make other investments.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.19.09 - LO: 19-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM

Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles 1. The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 3. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 4. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 5. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

financing United States - OH - Default City - TBA Preferred stock Bloom’s: Comprehension 8/9/2018 11:06 AM 8/9/2018 11:06 AM

6. Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 7. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 50% tax exemption on preferred dividends received. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating-rate preferred stock KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles DATE MODIFIED:

11/14/2018 10:40 AM

8. Which of the following statements is most CORRECT? a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm's common stock. b. From the issuer's point of view, preferred stock is less risky than bonds. c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less. d. Unlike bonds, preferred stock cannot have a convertible feature. e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 9. Mariano Manufacturing can issue a 25-year, 8.8% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 25% tax bracket.

The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par? a. 8.27% b. 8.69% c. 9.12% d. 9.58% e. 10.05% ANSWER: a RATIONALE: Maturity: 25Pfd. exclusion: 50% Coupon rate: 8.80%Tax rate: 25.00% Risk premium 1.00% Bond yield AT = = Target Preferred yield AT= = AT pfd yield = AT pfd yield = Copyright Cengage Learning. Powered by Cognero.

BT yield(1 – T) 6.60% AT bond yield + RP 7.60% BTpfd yield – BT pfd yield(1 – Exclusion)(Tax rate) BTpfd yield(1 - (1-Exclusion)T) Page 4

Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles BT Pref yield = (AT pfd yield)/[1-(1-Exclusion)T] = 7.6%/[1-(1 - 0.5)(0.25] = 8.69% Check: base case AT pfd yield AT pfd yield = BTpfd yield – BT pfd yield(1 – Exclusion)(Tax rate) = 8.69% – 8.69%(1 – 0.5)(0.25) = 7.600% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.01 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock vs. bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 12/5/2018 6:11 PM 10. A warrant is an option, and as such it cannot be used as a "sweetener." a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 11. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 12. The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 13. A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued.

Most traded warrants are originally attached to bonds or preferred stocks. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing United States - OH - Default City - TBA Detachable warrant Bloom’s: Knowledge 8/9/2018 11:06 AM 8/9/2018 11:06 AM

14. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par? a. 7.83% b. 8.24% c. 8.65% d. 9.08% e. 9.54% ANSWER: b RATIONALE: Stock price: $42.00Bond par value: $1,000 Exercise price: $47.00Bond maturity: 20 No. of warrants: 75Straight-debt yield: 10.0% Value of warrants: $2.00 Total value = Straight-debt value + Warrant value = $1,000 = Bond value + $150 VB = $1,000 − $150 = $850 Now set N = 20, I/YR = 10, PV = −850, FV = 1000 and solve for PMT: $82.38 To get this payment on a $1,000 bond, the coupon rate must be: 8.24% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 15. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straightdebt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000? a. 6.75% Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles b. 7.11% c. 7.48% d. 7.88% e. 8.27% ANSWER: RATIONALE:

d Bond par value: $1,000No. of warrants: 20 Bond maturity: 30Value of warrants: $10.00 Straight-debt yield: 10.0% Total value = Straight-debt value (VB) + Warrant value = $1,000 VB = $1,000 − $200.00 = $800.00 Set N = 30, I/YR = 10, PV = −800, and FV = 1000. Then solve for PMT: $78.78 To get this payment on a $1,000 bond, the coupon rate must be: 7.88% POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 16. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant? a. $3.76 b. $3.94 c. $4.14 d. $4.35 e. $4.56 ANSWER: a RATIONALE: Bond par value: $1,000No. of warrants: 50 Bond maturity: 20Convertible coupon: 12.0% Straight-debt yield: 15.0% Find the straight-debt value: N = 20, I/YR = 15, PMT = −120, and FV = −1000. PV = $812.22 Total value = Straight-debt value + Warrant value. $1,000 = Straight-debt value + 50(Warrant value) Warrant value = ($1,000 − Straight-debt value)/50 = $3.76 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles LEARNING OBJECTIVES: FMTP.EHRH.20.20.02 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 17. The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 18. A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles DATE CREATED: DATE MODIFIED:

8/9/2018 11:06 AM 8/9/2018 11:06 AM

19. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 20. Firms generally do not call their convertibles unless the conversion value is greater than the call price. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 21. Which of the following statements about convertibles is most CORRECT? a. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted. b. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles c. At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price. d. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock. e. The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt.

ANSWER: d RATIONALE: Response d is correct. From an investor's standpoint, convertibles are normally more risky than straight debt but less risky than common stock, hence the expected return on the convertible lies between that on the stock and that on the straight bond.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 22. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond? a. $707.33 b. $744.56 c. $783.75 d. $825.00 e. $866.25 ANSWER: d RATIONALE: Stock price: $33.00Coupon rate: 8.00% Bond price: $850.00Par value: $1,000.00 Conversion ratio: 25.00 Conversion value = Conversion ratio × Stock price = $825 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

financing United States - OH - Default City - TBA Convertible features: straight-debt value Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 8/9/2018 11:06 AM

23. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc? a. $40.00 b. $42.00 c. $44.10 d. $46.31 e. $48.62 ANSWER: a RATIONALE: Par value: $1,000.00 Conversion ratio: 25.00 Conversion price = Par value/Conversion ratio = $40.00 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conversion price KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 24. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of the convertible at the end of Year 3? a. $794.01 b. $835.81 c. $879.80 d. $926.10 e. $972.41 Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles ANSWER: RATIONALE:

d Bond par value: $1,000Conversion ratio (Shares): 20 Bond maturity: 10Convertible coupon: 8.0% Evaluation year: 3Stock price: $40.00 Straight-debt yield: 10.0%Growth rate: 5.0% Dividend per share: $2.00 Find the straight-debt value at N = 10 − 3 = 7: N = 7, I/YR = 10, PMT = −80, and FV = −1000. PV = VB = $902.63 Conversion value at t = 3: CV = (Shares) × (Stock price) × (1 + g)3 = $926.10 The floor value is the higher of the bond value or the conversion value, so it is $926.10.

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: Maturity: Par value: Annual coupon:

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

25. Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's conversion ratio? a. 27.14 b. 28.57 c. 30.00 d. 31.50 e. 33.08 ANSWER: b RATIONALE: Years to maturity: 10Stock price: Par value: $1,000.00Conversion price: Annual coupon: 5.00%Straight-debt yield: Conversion ratio = Par/Conversion price = $1,000/$35 = 28.57 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

$30.00 $35.00 8.00%

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles PREFACE NAME: Neuman Corporation Convertible Bonds LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: conversion ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Problems with this preface (Neuman Corporation Convertible Bonds) MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 26. Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's conversion value? a. $698.15 b. $734.89 c. $773.57 d. $814.29 e. $857.14 ANSWER: e RATIONALE: Conversion value = Conversion ratio × Market price of stock = $857.14 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Neuman Corporation Convertible Bonds LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: conversion value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Problems with this preface (Neuman Corporation Convertible Bonds) MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 27. Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's straight-debt value? a. $684.78 b. $720.82 c. $758.76 Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles d. $798.70 e. $838.63 ANSWER: d RATIONALE: Inputs to find the straight-debt value: N = 10; I/YR = 8; PMT = 50; FV = 1,000. $798.70 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Neuman Corporation Convertible Bonds LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: straight-debt value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: Problems with this preface (Neuman Corporation Convertible Bonds) MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 28. Refer to the data for the Neuman Corporation's convertible bonds. What is the minimum price (or "floor" price) at which the Neuman's bonds should sell? a. $698.15 b. $734.89 c. $773.57 d. $814.29 e. $857.14 ANSWER: e RATIONALE: The floor price is the higher of the bond's conversion value or straight debt value. Those values are as follows: Conversion value: $857.14 Straight-debt value: $798.70 Max of the two = minimum price = floor = $857.14 POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Neuman Corporation Convertible Bonds LEARNING OBJECTIVES: FMTP.EHRH.20.20.03 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Convertible features: floor price Bloom’s: Analysis TYPE: Multiple Choice: Multi-part Problems with this preface (Neuman Corporation Convertible Bonds) MUST be kept together.

8/9/2018 11:06 AM 8/9/2018 11:06 AM

29. Which of the following statements concerning warrants is correct? a. Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops. b. Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen. c. A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders. d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital. e. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants were used but remains the same if it used convertibles.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.04 - LO: 20-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants and convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM 30. Which of the following statements is most CORRECT? a. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds. b. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt. c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant. d. Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual. e. Warrants have an option feature but convertibles do not.

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Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles ANSWER: RATIONALE:

b Answer b is correct; convertibles do normally have a relatively low coupon because the opportunity for capital gains provides part of their expected total return. The other responses are all incorrect. Statement c is incorrect because like other options, the value of the warrant is increased by price volatility in the underlying asset.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.20.04 - LO: 20-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants and convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 8/9/2018 11:06 AM

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Chapter 21: Dynamic Capital Structures and Corporate Valuation 1. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.01 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital structure: Unlevered value KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 2. In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.02 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taxes and capital structure KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 3. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.02 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taxes and capital structure KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 4. MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.02 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM models KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 5. MM showed that in a world without taxes, a firm's value is not affected by its capital structure. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.02 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM models KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is 25%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

6. Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto's unlevered value? a. $1,782,000 b. $1,980,000 c. $2,200,000 d. $2,420,000 e. $2,662,000 ANSWER: c RATIONALE: FCF = NOPAT − Net investment in operating assets = EBIT(1 − T) − EBIT(0.20) = $200,000(0.75) − $200,000(0.20) = $150,000 − $40,000 = $110,000 VU

= FCF/(rsU − g) = $110,000/(0.11 − 0.06) = $2,200,000

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Kitto Electronics Data LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM extension with growth KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for the data for Kitto Electronics MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 1/27/2019 11:38 PM 7. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: discount rate KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 8. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: discount rate KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 9. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. b. The horizon value is calculated by discounting the expected earnings at the WACC. c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. d. The horizon value must always be more than 20 years in the future. e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - ak - DISC: Capital structure United States - OH - Default City - TBA Merger analysis Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:05 AM 8/9/2018 11:05 AM

10. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Discount rate KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 11. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity. b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity. d. The CAPV approach stands for the accounting pre-valuation approach. e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Merger analysis Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:05 AM 8/9/2018 11:05 AM

12. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash flows and post-horizon expected future tax shields at the weighted average cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie's beta is 2.0, and its tax rate is 25%. The risk-free rate is 6%, and the market risk premium is 5%.

13. Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings? a. 12.0% b. 13.9% c. 14.4% d. 16.0% e. 16.9% ANSWER: c RATIONALE: rsL = 6% + 2.0(5%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.

POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES:

1 Difficulty: Easy Multiple Choice False

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Chapter 21: Dynamic Capital Structures and Corporate Valuation PREFACE NAME: Sallie's Sandwiches LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Discount rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: All questions referring to the preface Sallie's Sandwiches MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/14/2018 11:00 AM 14. Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions)? a. $72.37 b. $73.99 c. $74.49 d. $75.81 e. $76.45 ANSWER: e RATIONALE: rsL = 6% + 2.0(5%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.

Year 0 Combined FCF and TS (including horizon values of FCF and TS) 14.40% rsU = NPV @ rsU =

1

2

3

4

2

4

5

117

$76.45

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Sallie's Sandwiches LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Discount rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: All questions referring to the preface Sallie's Sandwiches MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM Copyright Cengage Learning. Powered by Cognero.

Page 7

Chapter 21: Dynamic Capital Structures and Corporate Valuation DATE MODIFIED:

11/14/2018 11:01 AM

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock. Glassmaker's beta is 1.5. Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years. (Its tax rate will remain unchanged.)

Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4. Glass maker will increase its debt to $140 million in the recapitalization. This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

15. Refer to data for Glassmaker Corporation. What is Glassmaker's current levered cost of equity based on its current capital structure? a. 11.00% b. 11.50% c. 12.00% d. 12.50% e. 13.00% ANSWER: c RATIONALE: w_d = D/(D + S) = $100/($100 + $300) w_d = w_s = w_s = r_sL = r_sL =

25.00% 1 - w _d = 1 - 0.25 75.00% r_RF + beta(RP_M) 12.00%

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Glassmaker Corporation LEARNING OBJECTIVES: FMTP.EHRH.20.21.06 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: current WACC of company KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to preface for Glassmaker Corporation MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 1/27/2019 11:50 PM Copyright Cengage Learning. Powered by Cognero.

Page 8

Chapter 21: Dynamic Capital Structures and Corporate Valuation 16. Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker's free cash flows and interest tax savings? a. 10.00% b. 11.00% c. 11.25% d. 12.03% e. 13.11% ANSWER: c RATIONALE: w_d = D/(D + S) = $100/($100 + $300) w_d =

25.00%

w_s =

1 - w_d = 1 - 0.25

w_s =

75.00%

r_sL =

r_RF + beta(RP_M) = 6% + 1.5(4%)

r_sL =

12.00%

r_d =

9.0%

r_sU = r_sU =

wd rd + wsr sL = 0.25(9%) + 0.75(12%) 11.250%

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Glassmaker Corporation LEARNING OBJECFMTP.EHRH.20.21.06 - LO: 21-6 TIVES: NATIONAL STAND United States - BUSPROG: Analytic ARDS: STATE STANDARDUnited States - ak - DISC: Capital structure S: LOCAL STANDAR United States - OH - Default City - TBA DS: TOPICS: Compressed APV: discount rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the preface Glassmaker Corporation MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 2:25 PM

17. Refer to data for Glassmaker Corporation. Using the compressed adjusted present value model, how much will Copyright Cengage Learning. Powered by Cognero.

Page 9

Chapter 21: Dynamic Capital Structures and Corporate Valuation Glassmaker's equity be worth after completing the recapitalization? (Round your answer to the closest thousand dollars.) a. $316 b. $340 c. $348 d. $366 e. $380 ANSWER: b RATIONALE: D = $100 S = $300 w_d = D/(D + S) = $5/($5 + $10) = 25% w_s = 1 - w_d = 1 - 0.3333333 = 75.00% r_sL = r_RF + beta(RP_M) = 6% + 1.36(4%) = 12.00% r_d = 9.0% r_sU = wdrd + wsrsL = 0.333(11%) + 0.667(11.44%) = 11.25% Year FCF HV FCF TS HV TS Total

1 $31,000

2 $31,000

3 $31,000

$3,200

$3,200

$3,200

$34,200

$34,200

$34,200

4 $31,000 $521,000 $3,200 $53,000 $608,200

Financial calculator inputs: CF0 = 0; CF1 = 34.2; Nj = 3; CF2 = 608.2; 1/YR = 11.25 Output: PV Inflows = V ops. $480.26 million Debt after recap = $140 million Stock = $340.26 million POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Glassmaker Corporation LEARNING OBJECTIVES: FMTP.EHRH.20.21.06 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV model: Value of equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to preface for Glassmaker Corporation MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 5:27 PM Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation 18. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity using the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC in the compressed APV model is less than the WACC under MM's original (with tax) assumptions. d. The total value of the firm increases with the amount of debt. e. The tax shields should be discounted at the unlevered cost of equity.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Discount rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 19. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity is greater in the compressed APV model than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC is greater in the compressed APV model than the WACC under MM's original (with tax) assumptions. d. The total value of the firm increases with the amount of debt. e. The tax shields should be discounted at the cost of debt.

ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MM extension with growth KEYWORDS: Bloom’s: Analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Conceptual 8/9/2018 11:05 AM 8/9/2018 11:05 AM

20. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions. d. The total value of the firm is independent of the amount of debt it uses. e. The tax shields should be discounted at the unlevered cost of equity.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: General concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 21. The market value of Rudyard Incorporated's debt is $200,000 and its yield is 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 12%. Using the compressed adjusted present value model, what is Rudyard's cost of equity? a. 11.4% b. 12.0% c. 12.6% d. 13.3% e. 14.0% ANSWER: e RATIONALE: Debt: $200,000 Equity: $300,000 rd: 9% rsU : 12% T: 25% g: 5% rsL = rsU + (rsU − rd)(D/S) = 12% + (12% − 9%)($200,000/$300,000) = 14.0% POINTS: DIFFICULTY: QUESTION TYPE:

1 Difficulty: Moderate Multiple Choice

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Chapter 21: Dynamic Capital Structures and Corporate Valuation HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.06 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Discount rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 11/14/2018 11:26 AM 22. The market value of DeLoach Photography’s debt is $200,000 and its yield is 8%. The firm's equity has a market value of $800,000, its free cash flows are growing at a 4% rate, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 12%. Using the compressed adjusted present value (CAPV) model, what would its total value be if it had no debt? a. $878,750 b. $925,000 c. $950,000 d. $997,500 e. $1,050,000 ANSWER: c RATIONALE: Debt: $200,000 Equity: $800,000 rd: 8% rsU : 12% T: 25% g: 4% Firm L has a total value of $200,000 + $800,000 = $1,000,000. A similar firm with no debt should have a smaller value. Here is the calculation: VTotal = VU + VTS, so VU = VTotal − VTS = D + S − VTS. Value tax shelter = VTS = rdTD/(rsU − g) = 0.08(0.25)($200,000)/(0.12 − 0.04) = $50,000 VU = $200,000 + $800,000 − $50,000 = $950,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 2:33 PM 23. Angelou Corporation has debt worth $150,000, with a yield of 8%, and equity worth $350,000. It is growing at a 5% rate, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 13%. Using the compressed adjusted present value model, what is the value of the firm's tax shield, i.e., how much value does the use of debt add?

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Chapter 21: Dynamic Capital Structures and Corporate Valuation a. $33,750 b. $37,500 c. $41,250 d. $45,375 e. $49,913 ANSWER: RATIONALE:

b Debt: $150,000 Equity: $350,000 rd: 8% rsU: 13% T: 25% g: 5% VTotal = VU + VTS Value tax shelter = VTS = rdTD/(rsU − g) = 0.08(0.25)($150,000)/(0.13 − 0.05) = $37,500

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.05 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 2:43 PM Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is 25%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

24. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is the value of Kitto's tax shield? a. $97,741 b. $102,885 c. $108,300 d. $114,000 e. $120,000 ANSWER: e RATIONALE: EBIT: $200,000 rsU: 11% Debt: $300,000 T: 25% EBIT retained: 20% rd: 8% g: 6% VTS = rdTD/(rsU − g) = 0.08(0.25)($300,000)/(0.11 − 0.06) = $120,000 POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

Page 14

Chapter 21: Dynamic Capital Structures and Corporate Valuation DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Kitto Electronics Data LEARNING OBJECTIVES: FMTP.EHRH.20.21.06 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to preface for Kitto Electronics Data MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 2:47 PM 25. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is Kitto's value of equity? a. $2,020,000 b. $2,070,500 c. $2,122,263 d. $2,175,319 e. $2,229,702 ANSWER: a RATIONALE: VEquity = VTotal − Debt. VTotal = VU + VTS so, VEquity = VU + VTS − Debt. VTS = $120,000 (from previous parts of Kitto analysis). VU = $1,600,000 (from previous parts of Kitto analysis). VEquity = $2,200,000 + $120,000 − $300,000 = $2,020,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Kitto Electronics Data LEARNING OBJECTIVES: FMTP.EHRH.20.21.06 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compressed APV: Value of equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to preface for Kitto Electronics Data MUST be kept together.

DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 2:52 PM 26. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

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Page 15

Chapter 21: Dynamic Capital Structures and Corporate Valuation a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discount rate in a merger analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM 27. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP).

Raymond's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values: Year 1 2 3 4 Free cash flow $20.00 $25.00 $30.00 $35.00 Unlevered horizon value $366.00 Tax shield $2.10 $2.20 $2.30 $2.40 Horizon value of tax shield $25.00 Assume that all cash flows occur at the end of the year. SGP is currently financed with 25% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current debt and issue enough new debt to continue at the 25% target level. The interest rate would remain the same. SGP's pre-merger beta is 2.0, and its post-merger tax rate would be 25%. The risk-free rate is 8% and the market risk premium is 4%. Using the compressed adjusted present value approach, what is the value of SGP to Raymond? (Show your answer in millions of dollars.) a. $210 b. $233 c. $256 d. $282 e. $310 ANSWER: b RATIONALE: Inputs: SGP current w_d = 25% SGP current r_d = 10% SGP pre-merger beta = 2 Tax rate = 25% Risk-free rate = 8% Market risk premium = 4% Solution: rsL = rRF + b(RPM) = 8% + 2.0(4%) = 16%.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation rsU = wdrd + wsrs = 0.30(10%) + 0.70(16%) = 14.50%.

Because all of the cash flows are to be discounted at the same rate, we don't need to separately calculate the values of the tax shield and unlevered value of operations. We can simply add the tax shields and free cash flows together each year to input in the financial calculator: Time line: (In millions) Year Total CF + HV = NPV of Total at r_sU = V op = - Debt = S=

1 $22.10

2 $27.20

3 $32.30

4 $428.40

$310.81 $77.70 $233.11

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 2/3/2019 3:12 PM 28. Volunteer Enterprises has the following information for the current year. Calculate its free cash flow to equity.

FCF $1,000 Interest expense $40 Principal payments $200 New debt $300 Tax rate 25% a. $1,070 b. $1,177 c. $1,295 d. $1,424 e. $1,567 ANSWER: RATIONALE:

a FCF Less after-tax interest expense Less principal payments

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1,000 30 Interest expense x (1 - T) 200 Page 17

Chapter 21: Dynamic Capital Structures and Corporate Valuation Plus new debt = FCFE

300 1,070

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.04 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 12/5/2018 6:47 PM 29. Gators Incorporated has the following information for the current year and projected for next year. Calculate its projected free cash flow to equity. (Assume new debt is added at the beginning of the year.)

Current year Projected FCF NA $1,000 Total debt $400 $600 Interest rate on debt 6% 6% Tax rate 25% 25%

a. $1,066 b. $1,173 c. $1,290 d. $1,419 e. $1,561 ANSWER: RATIONALE:

b FCF Interest expense after-tax interest expense Net new debt FCFE

1,000 36 Interest rate x debt 27 Interest expense x (1 - T) 200 Increase in debt.

1,173 FCF - after-tax interest expense + increase in debt

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

Page 18

Chapter 21: Dynamic Capital Structures and Corporate Valuation HAS VARIABLES: False LEARNING OBJE FMTP.EHRH.20.21.04 - LO: 21-4 CTIVES: NATIONAL STAN United States - BUSPROG: Analytic DARDS: STATE STANDAR United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis DS: LOCAL STANDAR United States - OH - Default City - TBA DS: TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED:12/5/2018 6:47 PM

30. Gamma Pharmaceuticals has the following financial information for the current year and projected for next year.

Calculate Gamma's projected free cash flow to equity.

Current year Projected NOPAT NA $1,000 Total operating capital $2,000 $2,200 Total debt $900 $800 Interest rate on debt 6% 6% Tax rate 25% 25%

a. $549 b. $604 c. $664 d. $730 e. $803 ANSWER: RATIONALE:

c NOPAT Less investment in TOC = FCF Less After-tax interest expense Plus Increase in debt FCFE

POINTS: DIFFICULTY:

1,000 200 Change in TOC 800 36 = Debt x interest rate x (1 - T) -100 Change in debt 664 = FCF - after-tax interest expense + increase in debt

1 Difficulty: Moderate

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Page 19

Chapter 21: Dynamic Capital Structures and Corporate Valuation QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJEC FMTP.EHRH.20.21.04 - LO: 21-4 TIVES: NATIONAL STAND United States - BUSPROG: Analytic ARDS: STATE STANDARD United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis S: LOCAL STANDARD United States - OH - Default City - TBA S: TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 12/5/2018 6:48 PM 31. Alpha Manufacturing has the following financial information for the current year and projected for next year.

Calculate its projected free cash flow to equity.

Current year Projected EBIT $1,500 $1,800 Operating assets $3,000 $3,400 Operating liabilities $200 $220 Total debt $1,500 $1,800 Interest rate on debt 6% 6% Tax rate 25% 25% a. $893 b. $983 c. $1,081 d. $1,189 e. $1,308 ANSWER: d RATIONA LE:

Calculati ons

Curre nt Year

Projected

NOPAT

1,350

TOC 2,800 Investment in TOC FCF

3,180

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380 970

= EBI Tx(1 - T) = Operating assets - Operating liabilities = Increase in TOC = NOPAT Page 20

Chapter 21: Dynamic Capital Structures and Corporate Valuation Less After-tax interest expense Plus Increase in debt FCFE

Increase in TOC = Debt x interest 81 rate x (1 - T) = Change in 300 debt 1,189 = FCF - after-tax interest expense + increase in debt

POINTS: 1 DIFFICU Difficulty: Moderate LTY: QUESTIO Multiple Choice N TYPE: HAS VARI False ABLES: LEARNIN FMTP.EHRH.20.21.04 - LO: 21-4 G OBJEC TIVES: NATIONA United States - BUSPROG: Analytic L STANDA RDS: STATE ST United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis ANDARDS : LOCAL ST United States - OH - Default City - TBA ANDARDS : TOPICS: Value of an acquisition KEYWOR Bloom’s: Analysis DS: OTHER: TYPE: Multiple Choice: Problem DATE CR 8/9/2018 11:05 AM EATED: DATE MO 12/5/2018 6:51 PM DIFIED: 32. Eta Edibles had free cash flow to equity, required return, and long-term growth rate as indicated below. Eta has no non-operating assets. Calculate Eta's intrinsic value of equity using the FCFE model.

Most recent FCFE $1000 Required return on equity 9% Long-term growth rate 4%

a. $18,909 b. $20,800 c. $22,880 d. $25,168 Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation e. $27,685 ANSWER: RATIONALE:

b Calculations HVFCFE

20,800

= Constant growth formula = FCFE x (1 + g)/(r - g)

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE Multiple Choice : HAS VARIABLES: False LEARNING OBJE FMTP.EHRH.20.21.04 - LO: 21-4 CTIVES: NATIONAL STAN United States - BUSPROG: Analytic DARDS: STATE STANDAR United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis DS: LOCAL STANDAR United States - OH - Default City - TBA DS: TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED 12/5/2018 6:53 PM : 33. Epsilon Consultants has the following projected free cash flows to equity and other information. It has no nonoperating assets. Calculate Epsilon's intrinsic value of equity using the FCFE model.

Year 1 Year 2 Year 3 FCFE $1,000 $1,200 $1,260 Long-term FCFE growth 5% Required return on equity 9% a. $28,440 b. $31,284 c. $34,413 d. $37,854 e. $41,640 ANSWER: a RATIONAL E: HV3 Timel ine

33,075

=FCFE3 x (1 + g)/(r - g)

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Chapter 21: Dynamic Capital Structures and Corporate Valuation 0

1 1,000

2 1,200

3 34,335 = FCFE3 + HV3

$28,4 40 = VFCFE = PV of timeline entries discounted at required return on equity POINTS: 1 DIFFICUL Difficulty: Moderate TY: QUESTION Multiple Choice TYPE: HAS VARIA False BLES: LEARNING FMTP.EHRH.20.21.05 - LO: 21-5 OBJECTIV ES: NATIONAL United States - BUSPROG: Analytic STANDARD S: STATE STA United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis NDARDS: LOCAL ST United States - OH - Default City - TBA ANDARDS: TOPICS: Value of an acquisition KEYWORD Bloom’s: Analysis S: OTHER: TYPE: Multiple Choice: Problem DATE CRE 8/9/2018 11:05 AM ATED: DATE MO 12/5/2018 6:56 PM DIFIED: 34. Zeta Technologies has the following projections. It has no non-operating assets. Calculate Zeta's intrinsic value of equity using the FCFE model.

Current year Year 1 Year 1 Year 3 FCF NA $1,000 $1,200 $1,248 Total debt $3,000 $3,900 $4,290 $4,462 Interest rate on debt 6% 6% 6% 6% Tax rate 25% 25% 25% 25% Long-term growth rate 4% Required return on equity 9%

a. $21,165 b. $23,282 Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation c. $25,610 d. $28,171 e. $30,988 ANSWER: b RATIONALE : FCF Aftertax interest expense Increase in debt FCFE HVFCF E VFCFE

Year 1 1,000

Year 1 1,200

Year 3 1,248

175.5

193.05

200.79 = Debt x interest rate x (1 - T)

900 1,725

390 1,397

172 = Change in debt 1,219 = FCF - a-t interest + increase in debt

25,360 = FCFE3x(1+g)/(r-g) $23,2 82 = PV of FCFE and HVFCFE at required return on equity

POINTS: 1 DIFFICULT Difficulty: Moderate Y: QUESTION Multiple Choice TYPE: HAS VARIA False BLES: LEARNING FMTP.EHRH.20.21.05 - LO: 21-5 OBJECTIVE S: NATIONAL United States - BUSPROG: Analytic STANDARD S: STATE STANUnited States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis DARDS: LOCAL STA United States - OH - Default City - TBA NDARDS: TOPICS: Value of an acquisition KEYWORDS Bloom’s: Analysis : OTHER: TYPE: Multiple Choice: Problem DATE CREA 8/9/2018 11:05 AM TED: DATE MODI 12/5/2018 6:58 PM FIED: 35. Theta Therapeutics has the following information and projections. Use the FCFE model to calculate the intrinsic value of Theta's equity.

Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation

EBIT (operating profit) Operating assets Operating liabilities Total Debt Tax rate Interest rate on debt long-term growth rate Required return on equity a. $14,156 b. $15,572 c. $17,129 d. $18,842 e. $20,726 ANSWER: RATIONALE:

Current year NA $1,200 $300 $1,000 NA NA 4% 9%

Year 1 $1,000 $1,300 $300 $900 25% 6%

Year 2 $1,100 $1,500 $400 $1,100 25% 6%

Year 3 $1,200 $1,600 $500 $1,200 25% 6%

c Current year

Year 1 750.0

Year 2 825.0

1,000.0 100.0

1,100.0 100.0

FCF

650.0

725.0

After-tax interest Change in debt

40.5 (100.0)

49.5 200.0

FCFE

509.5

875.5

NOPAT TOC Investment in TOC

900.0

HVFCFE

VFCFE

17,128.9

Year 3 900.0 = EBITx(1 - T) = Operating assets 1,100.0 operating liabilities - = Change in TOC = NOPAT 900.0 investment in TOC = Debt x interest rate 54.0 x (1 - T) 100.0 = increase in debt = FCF - a-t interest 946.0 + increase in debt = FCFE3x(1+g)/(r 19,676.8 g) = PV of FCFE and HVFCFE at required return on equity

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTI FMTP.EHRH.20.21.05 - LO: 21-5 VES: NATIONAL STANDA United States - BUSPROG: Analytic RDS: STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 21: Dynamic Capital Structures and Corporate Valuation LOCAL STANDARDS United States - OH - Default City - TBA : TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 12/5/2018 7:00 PM 36. Holland Auto Parts is considering a merger with Workman Car Parts. Workman's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. Using the Compressed APV Model, what will Workman's required rate of return on equity be after it is acquired? a. 7.4% b. 8.9% c. 9.3% d. 9.6% e. 9.7% ANSWER: e RATIONALE: Calculate the current required return to Workman's equity: rK = rRF + b(RPM) = 6% + (0.9)4% = 9.6%. Calculate Workman's unlevered cost of equity: rsU = wdrd + wsrs = 0.20(8%) + 0.80(9.6%) = 9.28%. Calculate Workman's levered cost of equity at the new capital structure with the new cost of debt: rsL = rsU + (rsU − rd)(D/S) = 9.28% + (9.28% − 9%)/(0.6/0.4) = 9.7%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.21.03 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Post-merger return on equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:05 AM DATE MODIFIED: 8/9/2018 11:05 AM

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Chapter 22: Mergers and Corporate Control 1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synergistic merger KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 2. Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sources of synergy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 3. A spin-off is a type of divestiture in which the assets of a division are sold to another firm. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.12 - LO: 22-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spin-off KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 4. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 5. The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Comprehension Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control DATE CREATED: DATE MODIFIED:

8/9/2018 11:07 AM 8/9/2018 11:07 AM

6. Since managers' central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm's stockholders. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Managerial control KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 7. Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s? a. A profitable firm acquires a firm with large accumulated tax losses that may be carried forward. b. Attempts to stabilize earnings by diversifying. c. Purchase of assets below their replacement costs. d. Reduction in competition resulting from mergers. e. Synergistic benefits arising from mergers.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mergers KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control 8. Which of the following statements is most CORRECT? a. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed. b. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger. c. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm. d. Operating economies are never a motive for mergers. e. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 9. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.02 - LO: 22-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conglomerate merger KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control 10. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: International mergers KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 11. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.02 - LO: 22-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Vertical merger KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 12. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.02 - LO: 22-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Congeneric merger KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 13. A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can't be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent's marginal tax rate is 25% and if the exclusion on intercompany dividends is 50%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received? a. 12.5%; $2,187,500 b. 12.5%; $2,135,000 c. 23.8%; $1,905,000 d. 12.5%; $1,750,000 e. 25.0%; $1,650,000 ANSWER: a RATIONALE: Effective tax rate = (1 − Exclusion)(Tax rate) = (1 − 0.50)(0.25) = 12.5%.

Net dividends

Alternate method: Effective tax rate

= Gross dividends − Tax = $2,500,000 − $2,500,000(1 − 0.50)(0.25) = $2,500,000 − $312,500 = $2,187,500.

= Tax amount/Gross dividends. = $312,500/$2,500,000 = 12.5%.

POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.11 - LO: 22-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Intercompany dividends KEYWORDS: Bloom’s: Application Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 12/5/2018 7:54 PM

14. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.03 - LO: 22-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mergers and interest rates KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 15. Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.04 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defensive mergers KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 16. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in agreeing on the terms of a merger. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger terms KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 17. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defensive tactics KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 18. Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Managerial opposition KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 19. Firms use defensive tactics to fight off undesired mergers. These tactics do not include a. getting a white squire to purchase stock in the firm. b. getting white knights to bid for the firm. c. repurchasing their own stock. d. changing the bylaws to eliminate supermajority voting requirements. e. raising antitrust issues.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.04 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Hostile mergers KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 20. Which of the following statements is most CORRECT? a. A defensive merger is one where the firm's managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover. b. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition. c. Cash payments are used in takeovers but never in mergers. d. Managers often are fired in takeovers, but never in mergers. e. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.04 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous merger concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 21. Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 22. Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22. - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Merger analysis Bloom’s: Comprehension 8/9/2018 11:07 AM 8/9/2018 11:07 AM

23. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.06 - LO: 22-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger cash flows KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 24. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant merger cash flows KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 25. Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control could be described as primarily a financial merger. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial merger KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 26. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 27. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Challenging Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 28. Which of the following statements is most CORRECT? a. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm's capital structure, it will not affect its overall required rate of return. b. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis. c. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms. d. The primary rationale for most operating mergers is synergy. e. The acquiring firm's required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 29. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. b. The horizon value is calculated by discounting the expected earnings at the WACC. c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control d. The horizon value must always be more than 20 years in the future. e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 30. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity. b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity. d. The CAPV approach stands for the accounting pre-valuation approach. e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.07 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control 31. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers has determined that Fast Fruit's current cost of equity is 17.5%; Fast Fruit currently has no debt outstanding. In Year 1, Juicers expects Fast Fruit to generate $9 million in NOPAT and invest $50 million in total net operating capital. Fast Fruit will borrow to finance this expansion, with the first interest payment ($5 million) due at Year 2. (There will be no interest due at Year 1.) In Year 2, Fast Fruit will generate $25 million in NOPAT and invest $10 million in total net operating capital. Fast Fruit's marginal tax rate is 25%.

After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%. Assume that all cash flows occur at the end of the year. If Juicers must pay $90 million to acquire Fast Fruit, what is the NPV of the proposed acquisition? (Report your answer in millions of dollars.) a. $16.75 million b. $17.63 million c. $18.56 million d. $19.53 million e. $20.56 million ANSWER: c RATIONALE: Year 1 2 NOPAT $12.00 $30.00 Inv. in Op Cap $40.00 $10.00 FCF ($28.00) $20.00 Interest tax shield $0.00 $1.00 Total CF ($28.00) $21.00 HV of total CF $161.78 Total + HV ($28.00) $182.78 Vops = −$28/(1.175) + $182.78/(1.175)2 = $108.56

V_Equity = Vops − Debt = $108.56 28 − $0 = $108.56 (Fast Fruits has no debt at the time o NPV of acquisition = Vops − Acquisition price = $108.56 − $90 =$18.56

POINTS: 1 DIFFICULTY: Difficulty: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJEC FMTP.EHRH.20.22.07 - LO: 22-7 TIVES: NATIONAL STAND United States - BUSPROG: Analytic ARDS: STATE STANDARD United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis S: LOCAL STANDARD United States - OH - Default City - TBA S: TOPICS: Merger NPV Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 12/5/2018 8:11 PM 32. A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Two-tier offer KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 33. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synergistic gain KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 34. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control chain. Arthouse's analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Craftworks is 16%. Craftworks has 4 million shares outstanding and no debt. Craftworks' current price is $16.25. What is the maximum price per share that Arthouse should offer? a. $16.25 b. $16.97 c. $17.42 d. $18.13 e. $19.00 ANSWER: d RATIONALE: Price per share = POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.08 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum price per share KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 35. Currently (2018), mergers can be accounted for using either the purchase method or the pooling method. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.13 - LO: 22-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control 36. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.13 - LO: 22-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 37. Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.13 - LO: 22-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 38. Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge "golden parachutes" that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as "poison pills." a. True b. False ANSWER: True POINTS: 1 Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.04 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Poison pills KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 39. Which of the following statements is most CORRECT? a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm. b. Defensive mergers are designed to make a company less vulnerable to a takeover. c. Hostile mergers always create value for the acquiring firm. d. In a tender offer, the target firm's management always remain after the merger is completed. e. A conglomerate merger is one where a firm combines with another firm in the same industry.

ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.04 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous merger concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 40. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control LEARNING OBJECTIVES: FMTP.EHRH.20.22.11 - LO: 22-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Joint ventures KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 41. The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary's stock. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.11 - LO: 22-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Holding companies KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 8/9/2018 11:07 AM 42. The three main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.22.11 - LO: 22-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Holding company advantages Copyright Cengage Learning. Powered by Cognero.

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Chapter 22: Mergers and Corporate Control KEYWORDS: DATE CREATED: DATE MODIFIED:

Bloom’s: Comprehension 8/9/2018 11:07 AM 8/9/2018 11:07 AM

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Chapter 23: Enterprise Risk Management 1. One objective of risk management can be to reduce the volatility of a firm's cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.01 - LO: 23-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk management KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 2. Which of the following are NOT ways risk management can be used to increase the value of a firm? a. Risk management can help a firm maintain its optimal capital budget. b. Risk management can reduce the expected costs of financial distress. c. Risk management can help firms minimize taxes. d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments. e. Risk management can increase debt capacity.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.01 - LO: 23-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 3. Which of the following statements about interest rate and reinvestment rate risk is CORRECT? a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested. b. Interest rate price risk can be eliminated by holding zero coupon bonds. c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.

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Chapter 23: Enterprise Risk Management d. Interest rate risk can never be reduced. e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.01 - LO: 23-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate and reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 4. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Swaps KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 5. In theory, reducing the volatility of its cash flows will always increase a company's value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Reflective Thinking United States - AK - DISC: Derivatives United States - OH - Default City - TBA Risk management Bloom’s: Knowledge 8/9/2018 11:07 AM 11/16/2018 9:52 AM

6. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Futures market hedging KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 7. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT? a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds. b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties. c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market. d. A company can swap fixed interest payments for floating interest payments. e. A swap involves the exchange of cash payment obligations.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Swaps Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:07 AM 11/16/2018 9:52 AM

8. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates? a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates. b. Purchase principal only (PO) strips that decline in value whenever interest rates rise. c. Enter into a short hedge where the bank agrees to sell interest rate futures. d. Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans. e. Buying inverse floaters.

ANSWER: c RATIONALE: Given its interest rate exposure, the bank needs a strategy which is profitable whenever interest rates rise. If designed correctly, the profits from this strategy can partially, or in some cases, completely offset the losses the bank realizes from its basic operations whenever rates rise. Of the 5 strategies, only the short hedge is profitable when rates rise⎯all the other strategies would make sense if the bank were looking for extra profits when rates dropped.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Hedging KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 9. Company A can issue floating-rate debt at LIBOR + 1% and can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5% and can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B? a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%. b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%. c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%. d. A pays a fixed rate of 7.95%, B pays LIBOR. e. None of the above answers is correct.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management RATIONALE:

A pays LIBOR + 1% to its lenders, receives LIBOR from B, and pays B 7.95%, for a net fixed payment of 8.95%. B pays 9.4% to its lenders, pays LIBOR to A, and receives 7.95% from A, for a net payment of LIBOR + 1.45%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Swaps–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 10. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89'09. What is the implied annual interest rate inherent in this futures contract? a. 6.32% b. 6.65% c. 7.00% d. 7.35% e. 7.72% ANSWER: c RATIONALE: Quote: 89'09 0.89 0.09 N: 40 PV = (0.89 + .09/32) × $1,000 = −$892.8125 FV = $1,000 PMT = $30 I/YR = 3.50% Annual rate: I/YR × 2 = 7.00% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Treasury bond futures contracts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 11. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80'07. What is the implied annual interest rate inherent in the futures contract? a. 6.86% Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management b. 7.22% c. 7.60% d. 8.00% e. 8.40% ANSWER: RATIONALE:

d Quote: 80'07 0.80 0.07 N: 40 PV = (0.80 + 0.07/32) × $1,000 = −$802.1875 FV = $1,000 PMT = $30 I/YR = 4.00% Annual rate: I/YR × 2 = 8.00% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Treasury bond futures contracts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 12. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80'07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the nearest whole dollar.) a. −$78.00 b. −$82.00 c. −$86.00 d. −$90.00 e. −$95.00 ANSWER: a RATIONALE: Quote: 80'07 0.80 0.07 Increase in annual rate: 0.01000 Par value: $1,000 N: 40 PMT: $30 Price = PV = (0.80 + 0.07/32) × $1,000 = −$802.1875 Enter data to get rate = I/YR 2 = 7.9986% New rate = (Old rate + 1.0%)/2 = 4.4993% New price = −$724.08 Change in price = loss = −$78 POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.07 - LO: 23-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Treasury bond futures contracts Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:07 AM 11/16/2018 9:52 AM

13. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.04 - LO: 23-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Speculative versus pure risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM 14. Which of the following statements is most CORRECT? a. Futures contracts generally trade on an organized exchange and are marked to market daily. b. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts. c. There are futures contracts for currencies but no forward contracts for currencies. d. Futures contracts don't have any margin requirements but forward contracts do. e. One advantage of forward contracts is that they are default free.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.23.05 - LO: 23-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forwards vs. futures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:52 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 23: Enterprise Risk Management

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Chapter 24: Bankruptcy, Reorganization, and Liquidation 1. A central question that must be addressed in bankruptcy proceedings is whether the firm's inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.02 - LO: 24-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy issues KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 2. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm's income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.04 - LO: 24-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy claimants KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 3. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

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Chapter 24: Bankruptcy, Reorganization, and Liquidation POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.05 - LO: 24-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Doctrine of fairness KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 4. The primary test of feasibility in a reorganization is whether the firm's fixed charges after reorganization can be covered by its projected cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.05 - LO: 24-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard of feasibility KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 5. Even if a firm's cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.05 - LO: 24-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Copyright Cengage Learning. Powered by Cognero.

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Chapter 24: Bankruptcy, Reorganization, and Liquidation STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Bankruptcy proceedings Bloom’s: Comprehension 8/9/2018 11:07 AM 11/16/2018 9:58 AM

6. One of the actions that can be taken in bankruptcy under the standard of feasibility is to replace existing management with a new team if the quality of management is judged to have been substandard. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.05 - LO: 24-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Replacing management KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 7. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.08 - LO: 24-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Social issues and bankruptcy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 24: Bankruptcy, Reorganization, and Liquidation DATE MODIFIED:

11/16/2018 9:58 AM

8. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.08 - LO: 24-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Social issues and bankruptcy KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 9. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) (2) (3)

Trustees' costs to administer and operate the firm.

Common stockholders.

General, or unsecured, creditors.

Secured creditors, who have a claim to the proceeds from the sale of specific property (4) pledged to secure a loan.

(5) Taxes due to federal and state governments. a. 5, 4, 1, 3, 2 b. 4, 1, 5, 3, 2 c. 5, 1, 4, 2, 3 d. 1, 5, 4, 3, 2 e. 1, 4, 3, 5, 2 ANSWER: b POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.08 - LO: 24-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 24: Bankruptcy, Reorganization, and Liquidation TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Priority of claims Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:07 AM 11/16/2018 9:58 AM

10. Chapter 7 of the Bankruptcy Act is designed to do which of the following? a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments. b. Ensure that the firm is viable after emerging from bankruptcy. c. Allow the firm to negotiate with each creditor individually. d. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt. e. Protect shareholders against creditors.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.06 - LO: 24-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidation procedures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 11. Which of the following statements is most CORRECT? a. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws. b. All bankruptcy petitions are filed by creditors seeking to protect their claims against firms in financial distress.

Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm's management. c. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act. d. "Restructuring" a firm's debt can involve forgiving a certain portion of the debt, but it cannot call for changing the debt's maturity or its contractual interest rate. e. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 24: Bankruptcy, Reorganization, and Liquidation QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.06 - LO: 24-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy law KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM 12. Which of the following statements is most CORRECT? a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan. b. The basic doctrine of fairness states that all debtholders must be treated equally. c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the "public interest" is not a relevant concern. d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely. e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its assets if they are sold off individually.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.24.06 - LO: 24-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy issues KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 9:58 AM

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Chapter 25: Portfolio Theory and Asset Pricing Models True / False 1. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 2. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck's stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 3. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions. a. True b. False ANSWER: False RATIONALE: Managers can influence the firm's beta coefficient by changing such things as the capital structure (more debt will increase beta) and changing the type of assets held by the firm Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models (riskier assets will tend to increase beta). However, managers cannot control the risk-free rate or the return on the market.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 4. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 5. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Beta coefficients Bloom’s: Knowledge 8/9/2018 11:00 AM 11/16/2018 10:04 AM

6. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 7. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 8. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data. a. True Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 9. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 10. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.02 - LO: 25-2 Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models NATIONAL STANDARDS: STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

United States - BUSPROG: Reflective Thinking United States - AK - DISC: Risk and return United States - OH - Default City - TBA Risk aversion Bloom’s: Comprehension 8/9/2018 11:00 AM 11/16/2018 10:04 AM

11. The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.03 - LO: 25-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.07 - LO: 25-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Arbitrage pricing theory KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models Multiple Choice 13. Which of the following statements is CORRECT? a. The slope of the CML is ( M − rRF)/bM. b. All portfolios that lie on the CML to the right of σM are inefficient. c. All portfolios that lie on the CML to the left of σM are inefficient. d. The slope of the CML is ( M − rRF)/σM. e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 14. You have the following data on three stocks: Stock A B C

Standard Deviation 0.15 0.25 0.20

Beta 0.79 0.61 1.29

As a risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; B. b. B; C. c. C; A. d. C; B. e. A; A. ANSWER: a POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Risk aversion Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 10:04 AM

15. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Standard deviation; correlation coefficient. b. Beta; variance. c. Coefficient of variation; beta. d. Beta; beta. e. Variance; correlation coefficient.

ANSWER: c POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk measures KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 16. Which of the following is NOT a potential problem with beta and its estimation? a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta. b. The beta of "the market," can change over time, sometimes drastically. c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. d. There is a wide confidence interval around a typical stock's estimated beta. e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

ANSWER: b POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Beta coefficients Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 10:04 AM

17. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities?

(Assume market equilibrium.) a. Stock B must be a more desirable addition to a portfolio than Stock A. b. Stock A must be a more desirable addition to a portfolio than Stock B. c. The expected return on Stock A should be greater than that on Stock B. d. The expected return on Stock B should be greater than that on Stock A. e. When held in isolation, Stock A has greater risk than Stock B. ANSWER: c POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 18. In a portfolio of three different stocks, which of the following could NOT be true? a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. b. The beta of the portfolio is less than the betas of each of the individual stocks. c. The beta of the portfolio is greater than the beta of one or two of the individual stocks' betas. d. The beta of the portfolio cannot be equal to 1. e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Portfolio risk and return Bloom’s: Analysis TYPE: Multiple Choice: Conceptual 8/9/2018 11:00 AM 11/16/2018 10:04 AM

19. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? Years Market 1 0.03 2 −0.05 3 0.01 4 −0.10 5 0.06 a. bA > +1; bB = 0.

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

b. bA = 0; bB = −1. c. bA < 0; bB = 0. d. bA < −1; bB = 1. e. bA > 0; bB = 1.

ANSWER: RATIONALE:

c B's returns are independent of the market, hence its beta is zero. If you plot A's returns against those of the market, you see a negative slope, hence B's beta is negative. Therefore, d is the correct answer.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 20. Which of the following statements is CORRECT? a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6. b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94. c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94. d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

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Chapter 25: Portfolio Theory and Asset Pricing Models e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta calculation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 21. Which of the following statements is CORRECT? a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry. b. The slope of the characteristic line is the stock's standard deviation. c. The distance of the plot points from the characteristic line is a measure of the stock's market risk. d. The distance of the plot points from the characteristic line is a measure of the stock's diversifiable risk. e. "Characteristic line" is another name for the Security Market Line.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Characteristic line KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 22. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio? a. 1.1139 b. 1.1700 c. 1.2311 Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models d. 1.2927 e. 1.3573 ANSWER: RATIONALE:

b % lead stock: Coal beta: Mineral beta: Old beta:

5% 1.00 2.00 1.12 =0.95X + 0.05(1.00) where X is the portfolio's average beta w/o Mineral.

X =1.12/0.95 − 0.05 = 1.1263 New beta = 0.95X + 0.05(2.00) = 0.95 × 1.1263 + 0.05 × 2.00 = 1.1700 POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 23. Your mother's well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock? rp bp a. 11.69%; 1.22 b. 12.30%; 1.28 c. 12.92%; 1.34 d. 13.56%; 1.41 e. 14.24%; 1.48 ANSWER: RATIONALE:

POINTS: DIFFICULTY: QUESTION TYPE:

b Old portfolio return 12.0% Old portfolio beta 1.20 New stock return 15.0% New stock beta 2.00 Percent of portfolio in new stock: 10% New expected portfolio return = rp = 0.1 × 15% + 0.9 × 12% = 12.30% New expected portfolio beta = bp = 0.1 × 2.00 + 0.9 × 1.20 = 1.28 1 Easy Multiple Choice

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Chapter 25: Portfolio Theory and Asset Pricing Models HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 24. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.'s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc. a. 10.29% b. 10.83% c. 11.40% d. 12.00% e. 12.60% ANSWER: d RATIONALE: IP: 4.00% Real rate: 3.00% 5.00% RPM: Beta: 1.00 Required return = 3% + 4% + 1.0(5%) = 12.00% POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 25. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event? a. 36.10% b. 38.00% Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models c. 40.00% d. 42.00% e. 44.10% ANSWER: RATIONALE:

c Beta: 2.00 Required return on stock: 15.0% Required return on market: 10.0% Increase in required market return: 30.0% Find risk-free rate: rs = rRF + b(rM − rRF) = rRF + b(rM) − b(rRF); rRF = b(rM) − rs rRF = b(rM) − rs = 2.0(10%) − 15% = Find new return on average stock = 10.0%(1.3) Find new market risk premium = 13% − 5% = New req. return on our stock = rs = rRF + b(rM − rRF) = 5% + 2(8%) = % increase in stock's req. return = (21% − 15%)/15% = POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM

5.00% 13.00% 8.00% 21.00% 40.00%

26. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market's required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund's assets are as follows: Stock Investment A $ 200,000 B 300,000 C 500,000 D 1,000,000 a. 10.67% b. 11.23% c. 11.82% d. 12.45% e. 13.10% ANSWER: RATIONALE:

Beta 1.50 −0.50 1.25 0.75

e 15.0% rM: 7.0% rRF: Find portfolio beta:

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Weight

Beta

Product Page 13

Chapter 25: Portfolio Theory and Asset Pricing Models $200,000 0.100 1.50 0.1500 $300,000 0.150 −0.50 −0.0750 $500,000 0.250 1.25 0.3125 $1,000,000 0.500 0.75 0.3750 $2,000,000 1.000 0.7625 Find RPM = rM − rRF = 8.00% rs = rRF + b(RPM) = 13.10% POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 27. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the indicated percentage. What is the firm's new required rate of return?

Beta: 1.50 10.20% Required return (rs) 6.00% RPM: Percentage increase in beta: 20% a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02% ANSWER: a RATIONALE: Old beta: 1.50 10.20% Old rs = rRF + b(RPM) 6.00% RPM Percentage increase in beta: 20% Find new beta after increase = 1.80 Old rs = rRF + b(RPM): 10.2% = rRF + 1.5(6.0%): rRF = 10.2% − 9.0% = Find old rRF: 1.20% Find new rRF: Old rRF + 2.0% increase in inflation = 3.20% Find new rs = new rRF + new beta(RPM) = 14.00% POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 28. Assume that the market is in equilibrium and that stock betas can be estimated with historical data. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required return on the United Fund are shown below.

Based on this information, what is the required return on the market, rM? Year 2011 2012 2013 2014 2015 rRF: 7.00%; a. 10.57% b. 11.13% c. 11.72% d. 12.33% e. 12.95% ANSWER: RATIONALE:

Market −9% 11% 15% 5% −1%

UF −14% 16% 22% 7% −2%

rUnited: 15.00%

d The following graph shows that United's returns are perfectly correlated with the market.

rRF: rUnited:

7.00% 15.00%

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Chapter 25: Portfolio Theory and Asset Pricing Models 1.

Find beta: We found beta using Excel, but it could be found with a calculator or using the rise-over-run method as shown below:

2.

Now find RPM : rs = 15% = 7% + 1.5(RPM) RPM = (15 − 7)/1.5 = 5.33%

3.

Find rM: rM = rRF + RPM = 12.33%

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 29. You are given the following returns on "the market" and Stock F during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what's the value of beta 2 − beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator's regression function.)

Year Market 1 6.10% 2 12.90% 3 16.20% a. 7.89 b. 8.30 c. 8.74 d. 9.20 e. 9.66 ANSWER: RATIONALE:

Stock F 6.50% −3.70% 21.71%

d Year Market Stock F 1 6.10% 6.50% 2 12.90% −3.70% 3 16.20% 21.71% Years 1 and 2, beta 1 = Rise/Run = (−3.7 − 6.5)/(12.9 − 6.1) = −1.50 Years 2 and 3, beta 2 = Rise/Run = (21.71 − −3.7)/(16.2 − 12.9) = 7.70 Difference: Beta 2 − Beta 1 = 9.20 You would get the same result using a calculator to find the two betas.

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Chapter 25: Portfolio Theory and Asset Pricing Models POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.05 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta's sensitivity to the base year KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 30. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels), a. The past realized rate of return must be equal to the expected rate of return; that is, . b. The required rate of return must equal the realized rate of return; that is, r = . c. All companies must pay dividends. d. No companies can be in danger of declaring bankruptcy. e. The expected rate of return must be equal to the required rate of return; that is, = r.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.02 - LO: 25-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 31. Assume an economy in which there are three securities: Stock A with rA = 10% and σA = 10%; Stock B with rB = 15% and σB = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT? a. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%. b. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%. c. The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models in the range of 7% to 10%. d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%. e. The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

ANSWER: b RATIONALE:

Percent A 100 75 50 25 0

Percent B 0 25 50 75 100

rp 10.00% 11.25 12.50 13.75 15.00

rp = xrA + (1 − x)rB.

σp 10.00% 9.01 11.18 15.20 20.00 . But ρAB = 0, so,

. For our investor, rp = 14.75% and σp = 14.25%.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.02 - LO: 25-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolios and risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 32. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct. b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM. c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable. d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller. e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.25.06 - LO: 25-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Tests of the CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM Subjective Short Answer 33. Stock A has an expected return rA = 10% and σA = 10%. Stock B has rB = 14% and σB = 15%. rAB = 0. The rate of return on riskless assets is 6%.

Construct a graph that shows the feasible and efficient sets, giving consideration to the a. existence of the riskless asset.

Explain what would happen to the CML if the two stocks had (a) a positive correlation b. coefficient or (b) a negative correlation coefficient.

Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone's indifference curves were such that they were tangent to the CML to the right of c. the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

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Chapter 25: Portfolio Theory and Asset Pricing Models ANSWER:

ABCDE = feasible set.

BCDE = efficient set of risky assets. rRFD = efficient set including riskless asset.

The table below shows the returns and standard deviations for various portfolios of Securities A and B.

a.

Percent of Portfolio in Security A (x) 100 75 50 25 0

Percent of Portfolio Expected Portfolio Standard Deviation of Portfolio in Security B Return Return (1 − x) 0 25 50 75 100

σp (%) 10.00 8.39 9.01 11.52 15.00

rr (%) 10.0 11.0 12.0 13.0 14.0

Calculations: rp = xrA + (1 − x)rB. . rA = 10%; σA = 10%; rB = 14%; σB = 15%; rAB = 0%.

For x = 0.5: rp = 0.5(10%) + 0.5(14%) = 0.05 + 0.07 = 0.12 = 12%.

rp and σp for other combinations of Securities A and B in the portfolio were similarly calculated. b.

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If the correlation coefficient were positive, then the CML would have a less steep slope. The riskiness of the portfolio would increase. If the correlation Page 20

Chapter 25: Portfolio Theory and Asset Pricing Models coefficient were negative, then the CML would be steeper.

c.

This would not represent a stable equilibrium, because no one would want to hold the riskless asset. In a stable equilibrium, all securities must be priced so that they will be held in portfolios. Therefore, the price of the riskless asset will fall, and its rate of return, rRF, will rise. This will produce a new tangency point and cause a new CML to be created.

However, at the new tangency point we have a new market portfolio. This will probably lead to a repricing of stocks, hence to a change in the efficient set.

The final results will include (1) a higher rRF, (2) a CML that is less steep than the present one, (3) some change in the efficient set, (4) a rebalancing of portfolios, with some investors (those who are most risk averse) holding portfolios that contain some of the riskless asset and some of the market portfolio, and (5) an equilibrium situation in which all securities were held in portfolios and there was no general desire to change portfolio compositions.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Subjective Short Answer HAS VARIABLES: False STUDENT ENTRY MODE: Basic LEARNING OBJECTIVES: FMTP.EHRH.20.25.04 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Efficient portfolios–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Short Answer: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM 34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and σX = 5%. The expected return for Y is 12% and σY = 6%. The correlation coefficient, rXY, is 0.75. a. Calculate rp and σp for 100%, 75%, 50%, 25%, and 0% in Stock X. Use the values you calculated for rp and σp to graph the attainable set of portfolios. Which part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves b. to show how an investor might select a portfolio comprised of Stocks X and Y. Let an indifference curve be tangent to the efficient set at the point where rp = 11%.

Now suppose we add a riskless asset to the investment possibilities. What effects will this c. have on the construction of portfolios?

Suppose rM = 12%, σM = 4%, and rRF = 6%. What would be the required and expected d. return on a portfolio with σP = 10%?

Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this e. information, along with data given previously, to determine Stock X's and Stock Y's beta coefficients.

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Chapter 25: Portfolio Theory and Asset Pricing Models What is the required rate of return on Stocks X and Y? Do these stocks appear to be in equilibrium? If not, what would happen to bring about an equilibrium?

ANSWER: f.

rp = X(rX) + (1 − X)(rY)

a.

X 1.00 0.75 0.50 0.25 0.00

×

+ rX 10% 10 10 10 10

(1 − X) 0.00 0.25 0.50 0.75 1.00

×

rY 12% 12 12 12 12

=

rp 10.0% 10.5 11.0 11.5 12.0

covXY = rXYσXσY = (0.75)(0.05)(0.06) = 0.00225.

At 100% Stock X: .

At 75% Stock X:

At 50% Stock X:

At 25% Stock X:

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Chapter 25: Portfolio Theory and Asset Pricing Models At 0% Stock X:

b Portfoli Percen Percen . o t in X t in Y rp A B C D E

100% 0% 75 50 25 0

25 50 75 100

10.0 % 10.5 11.0 11.5 12.0

σp 5.00% 4.98 5.15 5.50 6.00 The segment BCDE is efficient. The segment BAE is not efficient.

c.

With the addition of a riskless asset, a new portfolio can be created which combines risk-free and risky assets. Now investors will choose combinations of the market portfolio and the riskless asset. If borrowing is permitted, then less risk-averse investors will move out the CML beyond P.

d.

e.

f.

rX = rRF + (rM − rRF)bX = 6% + (11% − 6%)1.0 = 11%. rY = 6% + (11% − 6%)1.35 = 12.75%.

Since the expected return on X, X = 10% < 11%, and Y = 12% < 12.75%, both stocks are out of equilibrium. They are both overvalued. Their prices would decline, and their expected returns would rise, until an equilibrium was restored.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Subjective Short Answer HAS VARIABLES: False STUDENT ENTRY MOD Basic E: LEARNING OBJECTIVE FMTP.EHRH.20.25.05 - LO: 25-5 S: NATIONAL STANDARDS United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 25: Portfolio Theory and Asset Pricing Models : STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Portfolios and risk–nonalgorithmic Bloom’s: Analysis TYPE: Short Answer: Problem 8/9/2018 11:00 AM 11/16/2018 10:04 AM

35. Security A has an expected return of 12.4% with a standard deviation of 15%, and a correlation with the market of 0.85. Security B has an expected return of −0.73% with a standard deviation of 20%, and a correlation with the market of −0.67. The standard deviation of rM is 12%.

To someone who acts in accordance with the CAPM, which security is more risky, A or B? a.

Why? (Hint: No calculations are necessary to answer this question; it is easy.) b. What are the beta coefficients of A and B? Calculations are necessary. c. If the risk-free rate is 6%, what is the value of rM? ANSWER: The very fact that rA > rB indicates that Security A is regarded by investors as the more risky one. This occurs because Security B has a negative covariance with the a. market⎯holding B in a diversified portfolio lowers the riskiness of the portfolio.

Although it is not necessary for answering the question, one could use the data to calculate covariances for A and B: Cov(rA, rM) = ρA,M σAσM, where ρA,M = Correlation of A's return with the market return = 0.85. σA,M = Standard deviations of returns of A and the market, respectively.

Cov(rA, rM) = 0.85(0.15)(0.12) = 0.0153.

Cov(rB, rM) = ρB,MσBσM = −0.67(0.20)(0.12) = −0.01608.

Security A's contribution to the portfolio risk is, therefore, higher than that of B. In a single-asset portfolio, the security's risk is measured by the variance of its returns.

VarianceA = = (0.15)2 = 0.0225, and VarianceB = = (0.20)2 = 0.04.

Thus, in a single-asset portfolio, B is riskier than A, but in a diversified (CAPM) portfolio, A is riskier. b.

Beta coefficients of A and B are calculated as follows: .

.

c.

The value of rM is calculated from the CAPM equation: rsA = rRF + (rM − rRF)bA. 12.4% = 6% + (rM − 6%)1.0625.

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Chapter 25: Portfolio Theory and Asset Pricing Models Therefore, 1.0625rM = 12.4% − 6% + 6.375% = 12.775%. rM = 12.775%/1.0625 = 12.02%.

A similar solution could be obtained by applying the CAPM equation to Security B. POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Subjective Short Answer HAS VARIABLES: False STUDENT ENTRY MODE: Basic LEARNING OBJECTIVES: FMTP.EHRH.20.25.02 - LO: 25-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolios and risk–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Short Answer: Problem DATE CREATED: 8/9/2018 11:00 AM DATE MODIFIED: 11/16/2018 10:04 AM

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Chapter 26: Real Options True / False 1. Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project's cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.01 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 2. Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.01 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 3. The option to abandon a project is a real option, but a call option on a stock is not a real option. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.01 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 4. Real options are most valuable when the underlying source of risk is very low. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.02 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 5. Real options affect the size, but not the risk, of a project's expected cash flows. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.02 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options Multiple Choice 6. Which of the following is NOT a real option? a. The option to buy shares of stock if its price goes up. b. The option to expand into a new geographic region. c. The option to abandon a project. d. The option to switch the type of fuel used in an industrial furnace. e. The option to expand production if the product is successful.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.01 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 7. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option? a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today. b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year. c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV. d. Waiting would probably reduce the project's risk. e. The investment timing option does not affect the cash flows and will therefore have no impact on the project's risk.

ANSWER: d RATIONALE: By having the ability to wait and see you reduce the risk of the project. Therefore, statement e is false. The greater the uncertainty, the more value there is in waiting for additional information before going on with a project. Therefore, statement a is false. Statements b and c are not necessarily true. By waiting to do a project you may lose strategic advantages associated with being the first competitor to enter a new line of business, which may alter the cash flows. Since statements a, b, c, and e are false, the correct choice is statement d.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.02 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment timing option KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 8. Which of the following will NOT increase the value of a real option? a. An increase in the volatility of the underlying source of risk. b. An increase in the risk-free rate. c. An increase in the cost of obtaining the real option. d. A decrease in the probability that a competitor will enter the market of the project in question. e. Lengthening the time in which a real option must be exercised.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.02 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 9. Which of the following is most CORRECT? a. Real options change the risk, but not the size, of projects' expected cash flows. b. Real options are likely to reduce the cost of capital that should be used to discount a project's expected cash flows. c. Very few projects actually have real options. d. Real options are less valuable when there is a lot of uncertainty about the true values future sales and costs. e. Real options change the size, but not the risk, of projects' expected cash flows.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options LEARNING OBJECTIVES: FMTP.EHRH.20.26.02 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 10. Which one of the following is an example of a "flexibility" option? a. A company has an option to close down an operation if it turns out to be unprofitable. b. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change. c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date. d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial. e. A company has an option to invest in a project today or to wait a year.

ANSWER: b RATIONALE: Statements a, b, c, and e are all examples of different types of real options. A flexibility option permits the firm to alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs, or both, can be changed.. Statement a is an example of an abandonment option. Statement b is an example of a flexibility option and statement c is an example of a growth option. Statement d is not really a real option at all.

Statement e is an example of an investment timing option. Therefore, statement b is the correct choice.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.04 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 11. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation? a. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.

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Chapter 26: Real Options b. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget. c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget. d. Real options should not have any effect on the size of the optimal capital budget. e. Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account.

ANSWER: e RATIONALE: By failing to consider real options, the firm's capital budget would probably be too small. The firm might well reject projects that would be seen to have positive expected NPVs if real options had been considered. Therefore, the correct choice is statement e.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.26.04 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM Drilling Experts, Inc. Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. t = 0.

A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project.

t = 1.

If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells. The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t = 2.

If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.

t = 3.

If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less

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Chapter 26: Real Options oil and then only receiving a $10,000 inflow.

12. Refer to the data for Drilling Experts, Incorporated. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project's expected NPV, in thousands of dollars? a. $336.15 b. $373.50 c. $415.00 d. $461.11 e. $507.22 ANSWER: d RATIONALE: Cost of capital: 20%

*Here are the cash flows of the four potential outcomes. Find the potential outcomes' NPVs as the PV of these cash flows, discounted at the 20% cost of capital: 0 1 2 3 NPV NPV-1 = −$400 −$1,000 −$10,000 $25,000 $6,289.81 NPV-2 = −$400 −$1,000 −$10,000 $10,000 −$2,390.74 NPV-3 = −$400 −$1,000 $0 $0 −$1,233.33 NPV-4 = −$400 $0 $0 $0 −$400.00 **Joint probabilities: Probs 1 and 2 = 0.8 × 0.6 × 0.5 = 0.24; Prob 3 = 0.8 × 0.4 = 0.32; Prob 4 = 0.2.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Drilling Experts, Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

United States - ak - DISC: Capital structure United States - OH - Default City - TBA Decision tree: expected NPV Bloom’s: Analysis TYPE: Multiple Choice: Problem The problems referring to Drilling Experts, Inc., MUST be kept together.

8/9/2018 11:04 AM 11/16/2018 10:08 AM

13. Refer to the data for Drilling Experts. Calculate the project's coefficient of variation. (Hint: Use the expected NPV.) Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options a. 5.87 b. 6.52 c. 7.25 d. 7.97 e. 8.77 ANSWER: RATIONALE:

c The CV = SD/Expected NPV. Prob.

0.24 0.24 0.32 0.20 1.00

NPV NPVi − E(NPV) $6,289.81 $5,829 −$2,390.74 −$2,852 −$1,233.33 −$1,694 −$ 400.00 −$861 $ 461.11

Squared deviation $33,973,787 $8,133,059 $2,871,142 $741,512 Variance Standard deviation CV

Squared dev. times probability $ 8,153,709 $ 1,951,934 $ 918,765 $ 148,302 $11,172,711 $3,342.56 7.25

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Drilling Experts, Inc. LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Decision tree: SD and CV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: The problems referring to the preface for Drilling Experts MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM Nationwide Pharmaceutical Corporation A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC).

(All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7).

NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7).

14. Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Assuming that all cash flows are discounted at Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project's expected NPV in today's dollars (i.e., at t = 0), relative to the NPV if it proceeds today? a. $77.23 b. $85.81 c. $95.34 d. $105.94 e. $116.53 ANSWER: d RATIONALE: Cost of capital: 10% Invest immediately:

Delay, then invest in period 1 if the outlook is good:

*

The NPV number under the delay option occurs one year later, so it must be discounted back to t = 0 at the cost of capital to make NPVs comparable. The figure shown in the delay tree is after discounting.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Nationwide Pharmaceutical Corporation LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment timing option, decision trees KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: The problems referring to Preface for Nationwide Pharmaceutical Corporation MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 15. Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Calculate the effect of waiting on the project's risk, using the same data. By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV.) a. 2.23 Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options b. 2.46 c. 2.70 d. 2.97 e. 3.27 ANSWER: RATIONALE:

a The CV = SD / Expected NPV. Invest immediately: Prob.

0.75 0.25 1.00

NPVi − E(NPV) $578 −$1,734

Squared deviation $334,228 $3,008,054 Variance Standard deviation CV Delay, then invest in period 1 if the outlook is good: Prob.

0.75 0.25 1.00

NPV $934.21 −$1,378.29 $ 356.08

NPV $616.03 $ 0.00 $462.02

Squared dev. times probability $ 250,671 $ 752,013 $1,002,685 $ 1,001.34 2.81

Squared dev.

NPVi − E(NPV) Squared deviation times probability $154 $23,718 $17,789 −$462 $213,463 $53,366 Variance $71,154 Standard $266.75 deviation CV 0.58

Reduction in the CV due to 2.23 waiting Note that the problem implicitly assumes that the project is riskless if it is delayed. This is, of course, unrealistic. Note also that a lower cost of capital should be used to find the NPV of the Go Now decision than the Wait decision. The appropriate cost of capital is often lowered by the existence of real options.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Nationwide Pharmaceutical Corporation LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Timing option, effect of delay on CV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: The problems referring to Preface for Nationwide Pharmaceutical Corporation. MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM Garner-Wagner Incorporated The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to Copyright Cengage Learning. Powered by Cognero.

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Chapter 26: Real Options produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.

16. Refer to the data for Garner-Wagner Incorporated. Based on the above data, what is the project's net present value? a. −$1,312,456 b. −$1,104,607 c. −$875,203 d. $105,999 e. $321,788 ANSWER: b RATIONALE: Find the project's NPV using a financial calculator and entering the following data inputs: CF0 = −3,000,000; CF1−5 = 500,000; I/YR = 10; and then solve for NPV = −$1,104,607.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Garner-Wagner Incorporated LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for Garner-Wagner Incorporated MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 17. Refer to the data for Garner-Wagner Incorporated. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity? a. −$1,104,607 b. −$875,203 c. $199,328 d. $561,947 e. $898,205 ANSWER: c

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Chapter 26: Real Options RATIONALE:

Step 1:

Find the NPV at t = 0 of the first project: Enter the following data inputs in the financial calculator: CF0 = −3,000,000; CF1−5 = 500,000; I/YR = 10; and then solve for NPV = −$1,104,607.

Step 2:

Find the NPV at t = 0 of the new projects: If at t = 5 the firm's technology is not successful, the firm will choose not to do the additional projects (since their NPV is −$6,000,000). Therefore, the NPV at t = 5 is calculated as 0.35($6,000,000) + 0.65($0) = $2,100,000.

However, this is the NPV at t = 5, so we need to discount this NPV to find the NPV of the additional projects today. Enter the following data inputs in the financial calculator: N = 5; I/YR = 10; PMT = 0; FV = 2,100,000; and then solve for PV = $1,303,935.

Step 3:

Find the NPV of the entire project considering its future opportunities: −$1,104,607 + $1,303,935 = $199,328.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Garner-Wagner Incorporated LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growth option–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to the Preface for Garner-Wagner Incorporated MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM Steppingstone Incorporated The Z−90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z−45, becomes an industry standard.

There is a 50% chance that the Z−45 will become the industry standard, in which case the Z−90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Z−45 will not become the industry standard, in which case the Z−90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

18. Refer to data for Steppingstone Incorporated. Based on the above information, what is the Z−90's expected net present value?

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Chapter 26: Real Options a. −$6,678 b. −$3,251 c. $15,303 d. $20,004 e. $45,965 ANSWER: RATIONALE:

a Step 1:

Step 2:

Find the project's expected cash flows in Years 1 through 5: (0.5)($110,000) + (0.5)($25,000) = $67,500.

Find the project's NPV by entering the following data inputs in the financial calculator: CF0 = −250,000; CF1−5 = 67,500; I/YR = 12; and then solve for NPV = −$6,678.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Steppingstone Incorporated LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Project NPV–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Preface for Steppingstone Incorporated MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM 19. Refer to data for Steppingstone Incorporated (SI). Now assume that one year from now SI will know if the Z−45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option? a. $0 b. $2,075 c. $4,067 d. $8,945 e. $10,745 ANSWER: e RATIONALE: No abandonment:

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Chapter 26: Real Options

Abandonment:

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Steppingstone Incorporated LEARNING OBJECTIVES: FMTP.EHRH.20.26.03 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - ak - DISC: Capital structure LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Abandonment option–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Preface for Steppingstone Incorporated MUST be kept together.

DATE CREATED: 8/9/2018 11:04 AM DATE MODIFIED: 11/16/2018 10:08 AM

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Chapter 27: Providing and Obtaining Credit True / False 1. The credit period is the amount of time it takes to do a credit search on a potential customer. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.01 - LO: 27-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit period KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 2. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.01 - LO: 27-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit standards KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.03 - LO: 27-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.03 - LO: 27-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 5. Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.04 - LO: 27-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

Cash discounts Bloom’s: Comprehension 8/9/2018 11:06 AM 11/16/2018 10:13 AM

6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.04 - LO: 27-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash discounts KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.06 - LO: 27-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

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Chapter 27: Providing and Obtaining Credit a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.06 - LO: 27-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.07 - LO: 27-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month's sales. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Uncollected balances schedule KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM Multiple Choice 12. Which of the following is not correct? a. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales. b. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased. c. Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account. d. A lax collection policy will frequently lead to an increase in accounts receivable. e. Collection policy is how a firm goes about collecting past-due accounts.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit LEARNING OBJECTIVES: FMTP.EHRH.20.27.03 - LO: 27-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 13. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days? a. The quarterly uncollected balances schedule will be the same in each quarter. b. The level of accounts receivable will be constant from month to month. c. The ratio of accounts receivable to sales will vary from month to month. d. The level of accounts receivable at the end of each quarter will be the same. e. DSO will vary from month to month.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.06 - LO: 27-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 14. A firm's credit policy consists of which of the following items? a. Credit period, cash discounts, credit standards, collection policy. b. Credit period, cash discounts, receivables monitoring, collection policy. c. Cash discounts, credit standards, receivables monitoring, collection policy. d. Credit period, receivables monitoring, credit standards, collection policy. e. Credit period, cash discounts, credit standards, receivables monitoring.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 15. Which of the following statements is most correct? a. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially "weak" firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts. b. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity. c. Firms use seasonal dating primarily to decrease their DSO. d. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st. e. If credit sales as a percentage of a firm's total sales increases, and the volume of credit sales also increases, then the firm's accounts receivable will automatically increase.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy and seasonal dating KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM Exhibit Reese Brothers Reese Brothers Publishers Inc (RBP) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since RBP wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days.

Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit the cost of capital is 15 percent.

16. Refer to Exhibit Reese Brothers. What would be the incremental bad losses if the change were made? a. $315,000 b. $260,500 c. −$260,500 (bad debt losses would decline) d. −$315,000 (Bad debt losses would decline) e. $0 (no change would occur) ANSWER: d RATIONALE: Bad debt losses old: (.05)($15,000,000) = $750,000.

Bad debt losses new: (.03)($14,500,000) = $435,000.

Change in bad debt losses = $435,000 − $750,000 = −$315,000.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Reese Brothers LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bad debt losses KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 17. Refer to Exhibit Reese Brothers. What would be the incremental cost of carrying receivables if this change were made? a. $108,750 b. −$116,250 (carrying costs would decline) c. $157,900 d. −$225,000 (carrying costs would decline) e. $260,500 ANSWER: b RATIONALE: DSO0 = 60 days; DSON = 30 days. No discounts. Calculate cost of carrying receivables at current and new sales levels: Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.

Sales at $14,500,000: 30($14,500,000/360)(0.6)(0.15) = $108,750.

Change = $108,750 − $225,000 = −$116,250.

POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Reese Brothers LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of carrying receivables KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 18. Refer to Exhibit Reese Brothers. What are the incremental pre-tax profits from this proposal? a. $181,250 b. $271,750 c. $256,250 d. $206,500 e. $231,250 ANSWER: e RATIONALE: Analysis of policy change: Current Effect of Credit New Projections Policy Change Projections Net sales $15,000,000 −$500,000 $14,500,000 Production costs 9,000,000 + 300,000 8,700,000 Profit before credit costs $ 6,000,000 −$200,000 $ 5,800,000 Cost of carrying receivables 225,000 + 116,250 108,750 Bad debt losses 750,000 + 315,000 435,000 Pre-tax profits $ 5,025,000 +$231,250 $ 5,256,250 Change in incremental pre-tax profits = $231,250.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Reese Brothers LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Incremental profits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit NOTES: DATE CREATED: DATE MODIFIED:

The problems referring to Exhibit 27.2 MUST be kept together.

8/9/2018 11:06 AM 11/16/2018 10:13 AM

Exhibit Van Doren Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren’s cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.

19. Refer to Exhibit Van Doren. What would be the cost to Van Doren of the discounts taken? a. $116,750 b. −$108,750 c. $155,000 d. $225,000 e. $260,500 ANSWER: c RATIONALE: No discounts with old policy; 2% discount with new policy (2/10, net 30). Discount = $15,500,000(0.5)(0.02) = $155,000.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Van Doren LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash discounts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.3 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 20. Refer to Exhibit Van Doren. What would be the incremental bad debt losses if the change were made? a. $130,000 b. $250,000 c. −$250,000 (bad debt losses would decline) d. −$130,000 (bad debt losses would decline) e. $620,000 ANSWER: d RATIONALE: Bad debt losses old: (0.05)($15,000,000) = $750,000.

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Chapter 27: Providing and Obtaining Credit Bad debt losses new: (0.04)($15,500,000) = $620,000.

Changes in bad debt losses = $620,000 − $750,000 = −$130,000.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Van Doren LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bad debt losses KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.3 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 21. Refer to Exhibit Van Doren. What would be the incremental cost of carrying receivables if the change were made? a. −$108,750 (carrying costs would decline) b. $116,250 c. $157,900 d. −$225,000 (carrying costs would decline) e. $260,000 ANSWER: a RATIONALE: DSO0 = 60 days; DSON = 30 days.

Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.

Sales at $15,500,000: 30($15,500,000/360)(0.6)(0.15) = $116,250.

Change = $116,250 − $225,000 = −$108,750.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Van Doren LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of carrying receivables KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit NOTES: DATE CREATED: DATE MODIFIED:

The problems referring to Exhibit 27.3 MUST be kept together.

8/9/2018 11:06 AM 11/16/2018 10:13 AM

22. Refer to Exhibit Van Doren. What are the incremental pre-tax profits from this proposal? a. $283,750 b. $250,500 c. $303,250 d. $493,750 e. $288,250 ANSWER: a RATIONALE: Analysis of policy change: Current Effect of Credit New Projections Policy Change Projections Sales $15,000,000 +$500,000 $15,500,000 Discounts 0 − 155,000 155,000 Net sales $15,000,000 +$345,000 $15,345,000 Production costs 9,000,000 − 300,000 9,300,000 Profit before credit costs $ 6,000,000 +$ 45,000 $ 6,045,000 Cost of carrying receivables 225,000 + 108,750 116,250 Bad debt losses 750,000 + 130,000 620,000 Pre-tax profits $ 5,025,000 +$283,750 $ 5,308,750 Change in incremental pre-tax profits = +$283,750.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Van Doren LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Incremental profits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.3 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 23. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its credit period? a. −$20,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit b. −$10,000 c. $0 d. $10,000 e. $20,000 ANSWER: RATIONALE:

e

DSO0 = 30 days; DSON = 50 days; no discounts. Calculate cost of carrying receivables at current and new sales levels: Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Sales at $1,000,000: 30($1,000,000/360)(0.8)(0.15) = $10,000.

Sales at $1,200,000: 50($1,200,000/360)(0.8)(0.15) = $20,000.

Analysis of policy changes: Current Effect of Credit New Projections Policy Change Projections Net sales $1,000,000 +$200,000 $1,200,000 Production costs 800,000 − 160,000 960,000 Profit before credit costs $ 200,000 +$ 40,000 $ 240,000 Cost of carrying receivables 10,000 − 10,000 20,000 Bad debt losses* 20,000 − 10,000 30,000 Pre-tax profits $ 710,000 +$ 20,000 $ 190,000 * Bad debt losses old: $1,000,000(0.02) = $20,000.

Bad debt losses new: $1,000,000(0.02) + $200,000(0.05) = $30,000.

The annual incremental pre-tax profit with the change in policy is $20,000.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.08 - LO: 27-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Change in credit policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 24. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a. Competitive cost of services provided. b. Size of the bank's deposits. c. Experience of personnel. d. Loyalty and willingness to assume lending risks. e. Convenience of location.

ANSWER: d POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.10 - LO: 27-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Choosing a bank KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM Exhibit Brother's Loan Your brother has just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires him to maintain a compensating balance equal to 15 percent of the initial face amount of the loan. He currently has $20,000 in his checking account, and he plans to maintain this balance. The loan is an add-on installment loan which he will repay in 12 equal monthly installments, beginning at the end of the first month.

25. Refer to Exhibit Brother's Loan. How large are your brother's monthly payments? a. $6,250 b. $7,000 c. $7,500 d. $5,250 e. $6,875 ANSWER: e RATIONALE: The monthly payments would be: POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Brother's Loan LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Loan payments KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.1 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit 26. Refer to Exhibit Brother's Loan. What is the nominal annual add-on interest rate on this loan? a. 10.00% b. 16.47% c. 18.83% d. 20.00% e. 24.00% ANSWER: d RATIONALE: POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Brother's Loan LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Add-on installment loan KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 27.1 MUST be kept together.

DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 27. Suppose that you're planning a vacation and borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged? a. 14.00% b. 8.57% c. 16.28% d. 21.21% e. 28.00% ANSWER: d RATIONALE: Will receive $2,000. Face amount of loan = $2,000/(1 − 0.14 − 0.20) = $3,030.30. Discount interest = 0.14($3,030.30) = $424.24. Compensating balance = 0.20($3,030.30) = $606.06.

With

POINTS:

a financial calculator, enter N = 1, PV = 2,000, PMT = 0, FV = and solve for I/YR = 21.21%.

1

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Chapter 27: Providing and Obtaining Credit DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EAR discount/compensating balance loan KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 28. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans? a. 11.00% b. 15.94% c. 11.46% d. 13.75% e. 12.72% ANSWER: b RATIONALE: Assume firm needs $10,000. Face amount of loan = $10,000/(1 − 0.11 − 0.20) = $14,492.75.

Discount interest = 0.11($14,492.75) = $1,594.20. Compensating balance = 0.20($14,492.75) = $2,898.55.

With

a financial calculator, enter N = 1, PV = 10,000, PMT = 0, FV = −11,594.20, and solve for I/YR = 15.94%.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EAR discount/compensating balance loan KEYWORDS: Bloom’s: Application Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit OTHER: DATE CREATED: DATE MODIFIED:

TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 11/16/2018 10:13 AM

29. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent "add-on", one-year installment loan, payable in four equal quarterly payments. What is the effective annual rate of interest? a. 9.50% b. 10.19% c. 15.99% d. 16.98% e. 20.38% ANSWER: d RATIONALE: First, calculate the amount of "add-on" interest. Interest = 0.1019($12,000) = $1,222.80. The total amount to be repaid is $1,222.80 + $12,000 = $13,222.80. The quarterly payments are $13,222.80/4 = $3,305.70. Find the periodic rate, where N = 4, PV = 12,000, PMT = −3,305.70, FV = 0, so the quarterly rate = 3.9977%. Finally, enter the nominal rate into your calculator, 4 × 3.9977% = 15.99% = NOM%. Enter P/YR = 4. Now, solve for EFF% = 16.98%.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 30. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan? a. 16.22% b. 17.97% c. 17.48% d. 18.67% e. 18.00% ANSWER: c RATIONALE: Interest is 9%($200,000) = $18,000. Thus, the face value of the loan is $200,000 + $18,000 = $218,000. Monthly payments are $218,000/12 = $18,166.67. Calculate the periodic rate as follows: N = 12, PV = 200,000, FV = 0, PMT = −18,166.67, I/YR = ? = 1.3514%. Convert this to an annual rate: 1.3514% × 12 = 16.2168%. Applying the EAR formula, solve for EAR = (1 + 0.162168/12)12 − 1 = 17.48%.

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Chapter 27: Providing and Obtaining Credit POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 31. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request for a $75,000, 1year loan.

Alternative 1: Alternative 2:

7 percent discount interest, with a 10 percent compensating balance.

8 percent simple interest, with interest paid monthly.

What is the effective annual rate on the cheaper loan? a. 8.00% b. 7.23% c. 7.67% d. 8.43% e. 8.30% ANSWER: e RATIONALE: Alternative 1: Face amount of loan = $75,000/(1 − 0.07 − 0.10) = $90,361.45 ≈ $90,361.

To solve

for the loan's effective rate enter N = 1, PV = 75,000, PMT = 0, FV = −81,325, and solve for I/YR = 8.43%. Alternative 2: EAR = (1 + 0.08/12)12 − 1 = 8.30%.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

Effective annual rate–nonalgorithmic Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 11/16/2018 10:13 AM

32. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discounted loan? a. 10.7% b. 12.0% c. 12.5% d. 13.6% e. 14.1% ANSWER: d RATIONALE: Will receive $12,000. Face amount of loan = $12,000/(1 − 0.12) = $13,636.36. Discount interest = 0.12($13,636.36) = $1,636.36.

With a financial calculator, enter N = 1, PV = 12,000, PMT = 0, FV = −13,636.36, and solve for I/YR = 13.64% ≈ 13.6%.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EAR discounted loan KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 33. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11 percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note? a. $111,000 b. $100,000 c. $112,360 d. $89,000 Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit e. $108,840 ANSWER: RATIONALE:

c

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discount interest face value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 34. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm's rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note? a. $61,856 b. $67,531 c. $60,000 d. $68,182 e. $67,423 ANSWER: a RATIONALE: Convert the annual rate to a periodic rate (quarterly) in the denominator of the face value

formula:

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - OH - Default City - TBA Discount interest face value Bloom’s: Application TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 11/16/2018 10:13 AM

35. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments.

What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan? a. 5.10% b. 10.19% c. 12.00% d. 20.38% e. 30.57% ANSWER: d RATIONALE: Total to be repaid= $12,000(1.1019) = $13,222.80.

Interest= $13,222.80 − $12,000 = $1,222.80.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Add-on interest loan KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 36. Darren's Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Darren already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Darren would otherwise keep in the account. Which of the following statements is most correct? a. The cost of using additional trade credit is approximately 36 percent. b. Considering only the explicit costs, Darren should finance the expansion with the bank loan. c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan.

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Chapter 27: Providing and Obtaining Credit However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan. d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Darren would hold a cash balance of one-half the compensating balance amount even if the loan were not taken. e. If Darren had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

ANSWER: d RATIONALE: Bank loan: With account: 12%/(1 − 0.12 − 0.10) = 15.38%.

Without account: 12%/(1 − 0.12 − 0.20) = 17.65%.

Trade credit: Approximately: (1%/99%)[360/(40 − 10)] = 12.12%.

Effective rate: (1.0101)12 − 1.0 = 12.82%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of short-term financing–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 37. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates? a. 1.12% b. 2.48% c. 3.60% d. 4.25% e. 5.00% ANSWER: c RATIONALE: Simple interest: EAR = 15%. Nominal interest, daily compounding: 9% add-on, 12 mos. payments: a. b.

Total amount to be repaid is $25,000 principal, plus 0.09($25,000) = $2,250 of interest, or $27,250.

The monthly payment = $27,250/12 = $2,270.83.

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Chapter 27: Providing and Obtaining Credit c.

With a financial calculator, enter N = 12; PV = 25,000; PMT = −2,270.83; and FV = 0 to solve for I = 1.3514%. However, this is a monthly rate. d. EARAdd-on = (1.013514)12 − 1 = 17.48%.

The difference between the highest and lowest EAR is 17.48% − 13.88% = 3.60%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of short-term financing–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM 38. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan? a. 9.50% b. 10.19% c. 15.22% d. 16.99% e. 22.05% ANSWER: d RATIONALE: Calculate total to be repaid and quarterly payments Total to be repaid = $12,000(1.1019) = $13,222.80.

Quarterly payment = $13,222.80/4 = $3,305.70.

Tabular solution: PV= $12,000 = $3,305.70(PVIFAi,4) (PVIFAi,4)= 3.6301 I≈ 4.0%.

EAR = 1.0(FVIF4%,4) −1.0 = 1.1699 − 1.0 = 0.1699 = 16.99%. Financial calculator solution: Calculate the nominal interest rate per period Inputs: N = 4; PV = −12,000; PMT = 3,305.71; FV = 0. Output: I = 4.0%. Calculate EAR using periodic rate and interest rate conversion feature Nominal annual rate = NOM% = 4 × 4.0% = 16.0%. Inputs: NOM% = 16; P/YR = 4. Output: EFF% = 16.99%.

POINTS: 1 DIFFICULTY: Challenging QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 27: Providing and Obtaining Credit HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.27.09 - LO: 27-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective interest rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:13 AM

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Chapter 28: Advanced Issues in Cash Management and Inventory Control 1. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Target cash balance–nonalgorithmic KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 2. The easier a firm's access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Precautionary balance–nonalgorithmic KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 3. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash balances–nonalgorithmic KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 4. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*. a. If the total amount of cash needed during the year increases by 20%, then C* will increase by 20%. b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%. c. If the average cash balance increases by 20% the total transactions costs will increase by 20%. d. The optimal transfer amount is the same for all companies. e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 5. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model? a. $7,483 b. $187 c. $3,741 d. $374 e. $748 Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control ANSWER: RATIONALE:

d

TC= (r)(C*/2) + (T/C*)(F) = 0.05($3,741.50) + ($700,000/$7,483)($2.00) = $374.17 ≈ $374.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 6. Humphrey's Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now? a. $200 b. $333 c. $414 d. $500 e. $666 ANSWER: b RATIONALE: C*OLD= $500(2) = $1,000. $1,000= 2FT= 0.04($1,000)2 = 0.04($1,000,000) 2FT= $40,000.

C*New=

= $666.67.

C*/2= $333.33 ≈ $333.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Baumol model Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:06 AM 11/16/2018 10:17 AM

7. Gemini Inc.'s optimal cash transfer amount, using the Baumol model, is $60,000. The firm's fixed cost per cash transfer of marketable securities to cash is $180, and the total cash needed for transactions annually is $960,000. On what opportunity cost of holding cash was this analysis based? a. 19.2% b. 10.4% c. 6.3% d. 12.1% e. 9.6% ANSWER: e RATIONALE: Use the Baumol model and solve for r, the opportunity cost of holding cash.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opportunity cost: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control DATE MODIFIED:

11/16/2018 10:17 AM

8. Gemini Inc.'s optimal cash transfer amount, using the Baumol model, is $60,000. The firm's fixed cost per cash transfer of marketable securities to cash is $180. In addition, the total estimated cash costs (transfers and carrying cost) for the firm, based on 16 transactions per year, are $5,760. On what opportunity cost of holding cash was this analysis based? a. 19.2% b. 10.4% c. 6.3% d. 12.1% e. 9.6% ANSWER: e RATIONALE: Method 1: Use the total cost formula to solve for the opportunity cost, r. Note that transactions costs and holding costs are equal when C*/2 is the optimal average cash balance.

Method 2: Divide the total cost (TC) into the optimal cash

transfer, C*, to yield the opportunity cost. Note that the holding costs equal transactions at C*. Thus, total costs are twice holding or transactions costs, and C* is twice the average cash balance held. r = TC/C* = $5,760/$60,000 = 0.096 = 9.6%. or r = Holding costs/(C*/2) = $2,880/$30,000 = 0.096 = 9.6%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opportunity cost: Baumol model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:06 AM DATE MODIFIED: 11/16/2018 10:17 AM 9. Suppose Stanley's Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.) a. $1,000 loss Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control b. $1,000 benefit c. $500 loss d. $500 benefit e. $0 (The change would not affect profits.)

ANSWER: d RATIONALE: Total cost of ordering and carrying EOQ

Total cost of ordering and carrying

(5,000)

10,000

Cost of increase = $500. Savings from discount = $0.02(50,000) = $1,000. Net benefit = $1,000 − $500 = $500.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quantity discounts–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM Exhibit Duckett Group The Duckett Group is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is $50, and the firm earns 10 percent on its marketable securities investments.

10. Refer to Exhibit Duckett Group. According to the Baumol model, what is the optimal transaction size for transfers from marketable securities to cash? a. $7,071 b. $38,357 c. $70,711 d. $102,956 e. $87,000 ANSWER: c RATIONALE: POINTS:

1

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Chapter 28: Advanced Issues in Cash Management and Inventory Control DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Duckett Group LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Optimal transfer size KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.1 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 11. Refer to Exhibit Duckett Group. According to the Baumol model, what should be Duckett's average cash balance? a. $35,356 b. $3,536 c. $22,157 d. $70,711 e. $42,918 ANSWER: a RATIONALE:

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Duckett Group LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average cash balance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.1 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control 12. Refer to Exhibit Duckett Group. What will be the total cost to Duckett of maintaining the optimal average cash balance, as determined by the Baumol model? a. $35,356 b. $7,071 c. $18,493 d. $70,711 e. $53,190 ANSWER: b RATIONALE:

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Duckett Group LEARNING OBJECTIVES: FMTP.EHRH.20.28.02 - LO: 28-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.1 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 13. A just-in-time system is designed to stretch accounts payable as long as possible. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control LOCAL STANDARDS: TOPICS: KEYWORDS: DATE CREATED: DATE MODIFIED:

forecasting, and cash flows United States - OH - Default City - TBA Inventory systems–nonalgorithmic Bloom’s: Comprehension 8/9/2018 11:07 AM 11/16/2018 10:17 AM

14. If a company increases its safety stock, then its EOQ will go up. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ Extension–nonalgorithmic KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 15. If a company increases its safety stock, then its average inventory will go up. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ Extension–nonalgorithmic KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 16. Which of the following would cause average inventory holdings to decrease, other things held constant?

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Chapter 28: Advanced Issues in Cash Management and Inventory Control a. The purchase price of inventory items decreases by 50 percent. b. The carrying price of an item decreases (as a percent of purchase price). c. The sales forecast is revised downward by 10 percent. d. Interest rates fall. e. Fixed order costs double.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average inventory–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 17. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ. a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%. b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%. c. If the average inventory increases by 20% the total order costs will increase by 20%. d. The EOC is the same for all companies. e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 18. Each year, Holly's Best Salad Dressing, Inc. (HBSD) purchases 50,000 gallons of extra virgin olive oil. Ordering costs Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control are $100 per order, and the carrying cost, as a percentage of inventory value, is 80 percent. The purchase price to HBSD is $0.50 per gallon. Management currently orders the EOQ each time an order is placed. No safety stock is carried. The supplier is now offering a quantity discount of $0.03 per gallon if HBSD orders 10,000 gallons at a time. Should HBSD take the discount? a. From a cost standpoint, HBSD is indifferent. b. No, the cost exceeds the benefit by $500. c. No, the cost exceeds the benefit by $1,000. d. Yes, the benefit exceeds the cost by $500. e. Yes, the benefit exceeds the cost by $1,120.

ANSWER: e RATIONALE: TC= (50,000/5,000)($100) + (10,000/2)($0.50)(0.80) = $1,000 + $1,000 = $2,000.

If the firm orders 10,000 gallons at a time, TC= (50,000/10,000)($100) + (10,000/2)($0.47)(0.80) = $500 + $1,880 = $2,380.

Therefore, costs increase by $2,380 − $2,000 = $380. The benefit is ($0.03)(50,000) = $1,500. Thus, the benefit exceeds the cost by $1,120.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quantity discounts–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 19. New England Charm, Inc. specializes in selling scented candles. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered New England's inventory problem from the EOQ model viewpoint. If the following constitute the relevant data, how does the current policy compare with the optimal policy?

Ordering cost = $10 per order Carrying cost = 20% of purchase price Purchase price = $10 per unit Total sales for year = 1,000 units Safety stock =0 a. Total costs will be the same, since the current policy is optimal. b. Total costs under the current policy will be less than total costs under the EOQ by $10. c. Total costs under the current policy exceed those under the EOQ by $3.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control d. Total costs under the current policy exceed those under the EOQ by $10. e. Cannot be determined due to insufficient information.

ANSWER: c RATIONALE: Units per order under current policy: Thus, Total costCurrent policy − Total costEOQ = $203 − $200 = $3. Total costs of current policy exceed total costs of EOQ by $3.00.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

20. Refer to Exhibit Cartwright Computing. What is the economic ordering quantity for chips? a. 12,088 b. 3,175 c. 6,243 d. 13,675 e. 8,124 ANSWER: b RATIONALE:

POINTS: DIFFICULTY: QUESTION TYPE: HAS VARIABLES:

1 Easy Multiple Choice False

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Chapter 28: Advanced Issues in Cash Management and Inventory Control PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 21. Refer to Exhibit Cartwright Computing. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is its average inventory level? a. 12,088 b. 3,175 c. 15,750 d. 13,675 e. 8,124 ANSWER: a RATIONALE:

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 22. Refer to Exhibit Cartwright Computing. Assume that Cartwright holds a safety stock equal to a 30-day supply of chips. What is the maximum amount of inventory that will have on hand at any time, that is, what will be the inventory level right after a delivery is made?

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Chapter 28: Advanced Issues in Cash Management and Inventory Control a. 9,216 b. 3,175 c. 6,243 d. 13,675 e. 8,124 ANSWER: d RATIONALE: Maximum inventory level = EOQ + Safety stock = 3,175 + 10,500 = 13,675.

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 23. Refer to Exhibit Cartwright Computing. How many orders should Cartwright place during the year? a. 12 b. 25 c. 30 d. 40 e. 60 ANSWER: d RATIONALE: POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control TOPICS: KEYWORDS: OTHER: NOTES: DATE CREATED: DATE MODIFIED:

Orders per year Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to Exhibit 28.2 MUST be kept together.

8/9/2018 11:07 AM 11/16/2018 10:17 AM

24. Refer to Exhibit Cartwright Computing. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30-day supply of chips, then at what inventory level should an order be placed? a. 15,570 b. 3,175 c. 12,250 d. 13,675 e. 8,124 ANSWER: c RATIONALE: POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Ordering inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 25. Refer to Exhibit Cartwright Computing. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is Cartwright's minimum cost of ordering and carrying inventory? a. $28,500 b. $15,950 c. $68,440 d. $34,220 e. $47,693 ANSWER: c RATIONALE: Average inventory is rounded to 12,088 = EOQ/2 + (126,000/360)(30). Number of orders is rounded to 40 = 126,000/3,175. Total cost = 40($200) + ($12,088)($25)(0.20) = $68,440.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Cartwright Computing LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.2 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM Exhibit Palmer Pens Assume that Palmer Executive Pens uses 1,440,000 gallons of ink each year. Further, assume that Palmer can order the ink at a cost of $2 per gallon plus fixed ordering costs of $100 per order. The firm's carrying cost is 20 percent of the inventory value, at cost.

26. Refer to Exhibit Palmer Pens. What is the firm's EOQ? a. 26,833 b. 30,040 c. 43,987 d. 13,563 e. 21,456 ANSWER: a RATIONALE:

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Palmer Pens LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control NOTES: DATE CREATED: DATE MODIFIED:

The problems referring to Exhibit 28.3 MUST be kept together.

8/9/2018 11:07 AM 11/16/2018 10:17 AM

27. Refer to Exhibit Palmer Pens. What is Palmer's minimum costs of ordering and holding inventory? a. $6,254 b. $10,733 c. $11,560 d. $13,563 e. $19,825 ANSWER: b RATIONALE:

POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Palmer Pens LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.3 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 28. Refer to Exhibit Palmer Pens. Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a least 40,000 gallons. Should Palmer increase its ordering quantity to take the discount? a. Yes; it will save $827 if it takes the discount. b. No; it will lose $827 if it takes the discount. c. Yes; it will save $14,400 if it takes the discount. d. Yes; it will save $13,573 if it takes the discount. e. No; it will lose $13,573 if it takes the discount.

ANSWER: d

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Chapter 28: Advanced Issues in Cash Management and Inventory Control RATIONALE: Total inventory cost with discount Incremental costs = $11,560 − $10,733 = $827. Savings from discount = ($2)(0.005)(1,440,000) = $14,400. Net savings = $14,400 − $827 = $13,573.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False PREFACE NAME: Exhibit Palmer Pens LEARNING OBJECTIVES: FMTP.EHRH.20.28.03 - LO: 28-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quantity discounts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 28.3 MUST be kept together.

DATE CREATED: 8/9/2018 11:07 AM DATE MODIFIED: 11/16/2018 10:17 AM 29. During times of inflation, which of these inventory accounting methods is best for cash flow? a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income. b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement. c. Weighted average, because it smoothes the reported cost of goods sold over time. d. It doesn't matter which you use since cash flow is unaffected by the choice of inventory identification method. e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

ANSWER: a POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.28.04 - LO: 28-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory accounting–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 28: Advanced Issues in Cash Management and Inventory Control DATE CREATED: DATE MODIFIED:

8/9/2018 11:07 AM 11/16/2018 10:17 AM

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Chapter 29: Pension Plan Management 1. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm's pension fund. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.02 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defined contribution plan KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 2. If employees have a right to receive pension benefits even if they leave the company prior to retirement, their pension rights are said to be vested. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.02 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Vesting KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 3. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False Copyright Cengage Learning. Powered by Cognero.

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Chapter 29: Pension Plan Management HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.04 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Contribution plans KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 4. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd's current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years.

Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year's wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd's expected annual retirement benefit, rounded to the nearest thousands of dollars? a. $35,000 b. $57,000 c. $89,000 d. $116,000 e. $132,000 ANSWER: d RATIONALE: Final year's salary = $30,000(1.05)35 = $165,480.46. Salary multiplier = 35(2%) = 70%.

Pension benefit = 0.70($165,480.46) = $115,836.32.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.04 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retirement benefits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 5. Arnold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20,000 at the end of each year following retirement until death.

The firm's pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington's annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows.) a. $2,756 b. $3,642 c. $4,443 Copyright Cengage Learning. Powered by Cognero.

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Chapter 29: Pension Plan Management d. $4,967 e. $5,491 ANSWER: RATIONALE:

c

Find the PV (at retirement) of the 15-year pension payment: $20,000(PVIFA7%, 15 years) = $182,158.28. Find the annual payment needed to accumulate the above amount over 20 years: Annual payment = $182,158.28/FVIFA7%, 20 years = $4,443.37.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.04 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Pension fund mathematics KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 6. The performance measurement of stock portfolio managers must recognize the risk inherent in the investment portfolio.

One way to incorporate risk into performance measurement is to examine the portfolio's alpha, which measures the vertical distance of the portfolio's return above or below the Security Market Line. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.05 - LO: 29-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Performance measurement KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 7. Which of the following statements about pension plan portfolio performance is incorrect? a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance. b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives. c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of Copyright Cengage Learning. Powered by Cognero.

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Chapter 29: Pension Plan Management 10 percent from another advisor. d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates. e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

ANSWER: d RATIONALE: Duration is the immunization technique used to either eliminate, or at least significantly reduce, the risk associated with changing interest rates.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.05 - LO: 29-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Performance measurement KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 8. Which of the following statements about pension plans if any, is incorrect? a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee's final salary. b. A portable pension plan is one that an employee can carry from one employer to another. c. An employer's obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee. d. If assets exceed the present value of benefits, the pension plan is fully funded. e. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

ANSWER: d RATIONALE: If assets exceed the present value of benefits, the plan is overfunded.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.07 - LO: 29-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Pension plan terminology KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Copyright Cengage Learning. Powered by Cognero.

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Chapter 29: Pension Plan Management DATE CREATED: DATE MODIFIED:

8/9/2018 11:09 AM 11/16/2018 10:23 AM

9. Which of the following statements about defined contribution plans is incorrect? a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly riskaverse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments. b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations. c. Defined benefit plans are used more often by large corporations than by small companies. d. The PBGC insures a portion of pension benefits. e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.07 - LO: 29-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defined contribution plan KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:23 AM 10. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio's alpha? a. −0.75% b. −0.15% c. 0% d. 0.15% e. 0.75% ANSWER: b RATIONALE: Portfolio's required rate of return = rRF + (rM − rRF)b = 7% + (12% − 7%)1.15 = 7% + (5%)1.15 = 12.75%.

Alpha = 12.6% − 12.75% = −0.15%.

POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.29.09 - LO: 29-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic Copyright Cengage Learning. Powered by Cognero.

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Chapter 29: Pension Plan Management STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: DATE CREATED: DATE MODIFIED:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Performance measurement Bloom’s: Analysis TYPE: Multiple Choice: Problem 8/9/2018 11:09 AM 11/16/2018 10:23 AM

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Chapter 30: Financial Management in Not-for-Profit Businesses 1. The primary goal of investor-owned firms is shareholder wealth maximization, while the primary goal of not-for-profit firms is typically stated in terms of some mission; for example, to provide health care services to the communities served. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Easy QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.02 - LO: 30-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goals of the firm KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 2. Since not-for-profit firms do not pay taxes, they receive no tax benefits whatsoever from using debt financing. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.03 - LO: 30-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Tax considerations KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 3. Not-for-profit firms have fund capital in place of equity capital. Since fund capital does not have to provide a return to stockholders, the appropriate cost of fund capital in a cost of capital estimate is zero. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Easy Copyright Cengage Learning. Powered by Cognero.

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Chapter 30: Financial Management in Not-for-Profit Businesses QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.03 - LO: 30-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of capital KEYWORDS: Bloom’s: Knowledge DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 4. The net present social value model formally recognizes that not-for-profit firms must consider the social value along with the financial value of proposed new projects. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: True / False HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.05 - LO: 30-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net present social value KEYWORDS: Bloom’s: Comprehension DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 5. Which of the following statements about project risk analysis in not-for-profit firms is incorrect? a. A project's corporate beta measures the contribution of the project to the overall corporate risk of the firm. b. A project's corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio. c. A project's corporate beta is defined as (σP/σF)rPF, where σP is the standard deviation of the project's returns, σF is the standard deviation of the firm's returns, and rPF is the correlation among the two sets of returns. d. In practice, it is usually difficult, if not impossible, to directly measure a project's corporate risk, so project risk analysis typically focuses on stand-alone risk. e. The market risk of a project is not relevant to not-for-profit firms.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice Copyright Cengage Learning. Powered by Cognero.

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Chapter 30: Financial Management in Not-for-Profit Businesses HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.05 - LO: 30-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 6. Which of the following statements about municipal bond financing is most correct? a. Whereas the vast majority of Treasury and corporate bonds are held by institutions, no municipal bonds are held by individual investors. b. The primary attraction of municipal bonds to individual investors is their high before-tax yields. c. Municipal bonds usually pay higher coupon rates than corporate bonds with similar ratings. d. Municipal bonds are risk-free. e. In contrast to corporate bonds, municipal bond issues are not required to be registered with the Securities and Exchange Commission.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.06 - LO: 30-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Municipal bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 7. Which of the following statements about a not-for-profit firm's ownership is most correct? a. The residual earnings (profits) of not-for-profit firms can be distributed to the firm's top managers. b. Not-for-profit firms are exempt from federal taxes, but they must pay state and local taxes, including property taxes. c. Upon liquidation of a not-for-profit firm, the proceeds from the sale of its assets are distributed, on a pro rata basis, to the firm's employees. d. None of the profits are used for private inurement. e. Not-for-profit firms are governed by a board of trustees whose members are elected by the community at large.

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Chapter 30: Financial Management in Not-for-Profit Businesses ANSWER: d POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.07 - LO: 30-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Ownership KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 8. Which of the following statements about a not-for-profit firm's cost of capital estimate is most correct? a. The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings. b. The cost of tax-exempt debt issued by not-for-profit firms is increased ("grossed up") by 1 − T in the WACC estimate to reflect the fact that such firms do not pay taxes. c. Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investorowned companies. d. Not-for-profit firms have a zero cost of capital. e. Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.

ANSWER: c POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.04 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 9. Which of the following statements about a not-for-profit firm's fund capital is most correct? a. The sole source of fund capital is the excess of revenues over expenses. b. Fund capital has a zero opportunity cost.

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Chapter 30: Financial Management in Not-for-Profit Businesses c. Fund capital can only come from donations. d. Fund capital does not change over time. e. Fund capital is equivalent to equity capital in investor-owned firms.

ANSWER: e POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.04 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fund capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM 10. Which of the following statements about a not-for-profit firm's sources of capital is most correct? a. Fund capital is obtained by retaining earnings⎯if all earnings are paid out as dividends, no fund capital is created. b. Preferred stock is never used by not-for-profit firms. c. Not-for-profit firms are not allowed to raise capital by borrowing. d. Not-for-profit firms usually have high dividend payouts. e. Since not-for-profit firms are tax exempt, there is no tax advantage to debt capital.

ANSWER: b POINTS: 1 DIFFICULTY: Moderate QUESTION TYPE: Multiple Choice HAS VARIABLES: False LEARNING OBJECTIVES: FMTP.EHRH.20.30.04 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital sources KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual DATE CREATED: 8/9/2018 11:09 AM DATE MODIFIED: 11/16/2018 10:27 AM

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