Test Bank for Financial Management Theory and Practice, 4th Canadian Edition Eugene Brigham

Test Bank for Financial Management Theory and Practice, 4th Canadian Edition Eugene Brigham

Test Bank for Financial Management Theory and Practice, 4th Canadian Edition Eugene Brigham

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Chap 01_4ce Indicate whether the statement is true or false.

1. Three disadvantages of a proprietorship are (1) the relative difficulty of raising new capital, (2) the owner’s

unlimited personal liability for the business’s debts, and (3) that the proprietorship is easily but expensively formed.

True False 2. Limited partners who are too involved in the business operation can keep their limited liability status.

True False 3. Two key advantages to a proprietorship are that, as a business, it pays no corporate income tax and it is easy

for a proprietorship to obtain the capital needed for growth.

True False 4. If an individual investor trades currently outstanding common shares through a broker, this is a primary market

transaction.

True False 5. Today, banks can never provide trustee services and the difference between trusts and banks has become

clear over time.

True False 6. Equity instruments are a claim upon a residual value, but preferred shares have some features like debt and

some like equity.

True False 7. In a limited liability partnership (LLP), only some partners enjoy limited liability with regard to their business

partners’ professional negligence, and their potential losses are limited to their investment in the LLP. True False 8. If Firm A’s business is to obtain funds from savers in exchange for its own securities and then to use the money

to invest in other businesses’ securities, Firm A is a financial intermediary.

True False

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Chap 01_4ce 9. Since a company’s value is determined by properties of its cash flows, managers could increase the size of the

expected cash flows or speed up their receipt to maximize the firm’s value.

True False 10. The form of organization of a business is an important issue that reflects in some typical stages in the corporate

life cycle.

True False Indicate the answer choice that best completes the statement or answers the question.

11. Which of the following statements best describes financial instruments?

Investors will exchange cash for a financial instrument even if they expect to receive an unacceptable rate of return.

Debt instruments usually do not have specified payments and a specified maturity.

Equity instruments typically have specified payments and a specified maturity.

Shareholders are entitled to cash flows after bondholders, creditors, and other claimants have been satisfied.

12. In Canada, the Canada Deposit Insurance Corporation (CDIC) insures personal bank account balances up to

$100,000. What is the primary reason for this provision?

This can encourage banking institutions to expand their business.

This can prevent a “bank run” and ensure stability in times of economic uncertainty.

This would give the government more control over the banking system.

This is a common practice in the U.S. and all other developed economies.

13. Which statement regarding corporations is most accurate?

Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of businesses begin as corporations.

Large corporations have more tax advantages than partnerships.

Due to legal considerations related to ownership transfers and limited liability, most business is conducted by corporations in spite of large corporations’ often less favourable tax treatment.

Corporate shareholders have unlimited liability when the corporation becomes bankrupt.

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Chap 01_4ce 14. Which of the following statements best describes corporate goals and issues?

The proper goal of the financial manager should be to attempt to maximize the firm’s expected cash flows, because this will add the most to the wealth of the individual shareholders.

Potential agency problems can arise between shareholders and managers, because managers hired as agents to act on behalf of the owners may instead make decisions favourable to themselves rather than the shareholders.

Large, publicly owned firms like Tesla and Apple 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 the shareholders’ 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 shareholders’ best interests.

The primary goal of the corporation should be to maximize shareholder wealth, which means the managers should be unmindful of employee welfare or community concerns.

15. What should be done to maximize shareholder wealth and thus the value of the firm?

Reduce the size of expected cash flows of the company.

Increase the free cash flows of the business.

Increase the risk level of the firm.

Arrange for cash to be received later.

16. Which of the following statements is true regarding hedge funds and private equity funds?

Hedge funds own shares in other companies and often control those companies, but private equity funds usually own many different types of securities.

Investing in hedge funds is far riskier than investing in private equity funds.

Private equity funds are highly regulated, while there are even more controls over the activities of hedge funds.

Both are limited to a relatively small number of large investors.

17. Recently, Hale Corporation, a public company, announced the sale of 4.5 million newly issued common shares

at a price of $32 per share. Hale sold the stock to an investment banker, which in turn sold it to individual and institutional investors. What is the name of the market for this transaction? private market primary market IPO market secondary market

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Chap 01_4ce 18. Which of the following statements best describes interest rates?

If an investment opportunity’s future cash flows are very uncertain and might be much lower than expected, providers require a lower expected return.

The cost of money to fund users is basically determined by the rate of return required by fund providers.

If companies have more good investment opportunities, interest rates are likely to decrease.

If expected inflation decreases, interest rates are likely to increase.

19. What should be the primary operating goal of a publicly owned firm interested in serving its shareholders?

maximize the firm’s expected sales revenue maximize the stock price during a specific period maximize the stock price per share, which is the stock’s fundamental value, over the long run maximize the firm’s expected EPS 20. What is traded on money markets?

corporate shares short-term, highly liquid debt securities intermediate-term debt securities long-term bonds 21. Which of the following statements best describes financial markets?

Rates of return on Government of Canada Treasury bills are the highest among all major financial securities.

Corporate bonds are riskier than Canadian government debt and their risk depends on the strength of the issuer.

Capital markets are markets for short-term, highly liquid debt securities.

Commercial paper is illiquid.

22. Which of the following financial intermediaries is a depository institution?

commercial bank investment bank securities firm finance company 23. Suppose the Bank of Canada announces plans to issue $100 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?

Prices would decrease and interest rates would increase.

Prices and interest rates would both increase.

Prices would increase and interest rates would decrease.

Prices and interest rates would both decrease.

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Chap 01_4ce 24. Which of the following is true of stock ownership in Canada?

Most Canadian households directly own stock.

80% of Canadian households directly own stock.

61% of Canadian households directly own stock.

10% of Canadian households directly own stock.

25. What is one of the drawbacks of switching from a partnership to the corporate form of organization?

It makes the firm’s investors subject to unlimited potential personal liabilities.

It makes its income taxable only as a part of the proprietor’s personal income.

It makes it more difficult for the firm’s investors to transfer their ownership interests.

It subjects the firm to additional regulations.

26. Which of the following services will NOT be offered by life insurance companies?

line of credit investing funds in shares, bonds, real estate, and mortgages offering a variety of tax-deferred savings plans making payments to beneficiaries 27. Which of the following statements best describes firm organization?

One of the advantages of a corporation is that managers are always acting in the best interests of the owners, rather than their own best interests.

It is generally more difficult to transfer one’s ownership interest in a corporation than in a partnership.

One of the advantages of the corporate form of organization is that its income is subject to only corporate taxation, rather than being taxed as a part of the proprietor’s personal income.

One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability.

28. Which circumstance would most likely lead to an increase in interest rates in the economy?

The economy is experiencing a deflation.

The economy falls into a recession.

There is an increase in expected inflation.

The federal government decides to promote economic activity.

29. Which of the following statements best describes firm organization?

Corporate shareholders are exposed to unlimited liability, and the losses may be amplified by the double taxation of incorporation.

A corporation will stop operating if its original owners and managers are deceased.

Partnerships generally face more regulations than corporations.

It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a partnership.

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Chap 01_4ce 30. Which of the following statements best describes partnerships and/or corporations?

In a regular partnership, a partner’s liability for the firm’s debts is limited to the amount they have invested in the business.

Corporations are at a disadvantage relative to partnerships because the earnings of the corporation are taxed at the firm level, not at the individual level.

There must be at least one general partner in a limited partnership.

A slow-growth business would be more likely to set up as a corporation for its business organization than would a fast-growth business.

31. Which of the following is NOT a primary disadvantage of a regular partnership?

ease in transferring ownership limited life of the organization unlimited life of the organization difficulty in transferring ownership 32. Which of the following statements best describes articles of incorporation and bylaws?

The articles of incorporation are concerned with things like the share class description, whereas the bylaws are concerned with things like procedures for electing the board of directors.

An initial registered office address and first board of directors form can be omitted when filed with Corporations Canada.

A professional corporation formed by professionals such as doctors or lawyers can relieve the participation of professional (malpractice) liability.

The corporate bylaws are a standard set of rules established by the state of incorporation, so these rules are identical for all corporations.

33. Which of the following best describes the market price of a stock?

the price observed by investors on financial websites the price at which a security first trades when an exchange opens for the day the price observed in the broad financial markets the price predicted by analysts in research reports 34. Which of the following statements is correct?

A good goal for a firm’s management is maximization of stock price at a target date.

Many Canadian companies’ boards have directors who specifically represent the interests of employees and not just shareholders.

Agency problems easily arise between shareholders and managers in corporations, but they can be addressed by corporate governance.

Income trust cash distributions are taxed at both the trust and individual levels.

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Chap 01_4ce 35. Share price maximization is good for society because consumers benefit. Which of the following best describes

this idea?

Firms that maximize share price minimize costs and produce high-quality goods and services that consumers demand.

Firms that maximize share price minimize costs and produce low-quality goods and services, which benefits only producers.

Firms that maximize share price maximize costs and produce high-quality goods and services, which benefits society.

Firms that maximize share price maximize costs and produce low-quality goods and services, which benefits society.

36. Which of the following statements would most people in business agree with?

A firm’s commitment to business ethics can only be measured by the tendency of its employees to adhere to laws and regulations.

Legal and ethical considerations make firms’ profits and ethics always consistent.

Canada’s federal government passed the Sarbanes-Oxley Act, with a provision designed to protect “whistleblowers.”

Although moral character is developed differently, it is useful to educate people about the adverse consequences of unethical behaviour to themselves, their firms, and the nation.

37. Which of the following statements is true regarding a firm’s value?

A manager’s primary job is to increase the company’s EPS. The intrinsic value is the present value of the firm’s expected free cash flows, discounted at the WACC. To increase the intrinsic value, a firm should increase WACC. To increase the intrinsic value, a firm should reduce FCF. 38. Which of the following best describes the position of the bondholders of an incorporated firm?

They are creditors of the firm and thus expect to be paid interest on their investment according to their bond indenture (contract).

They have voting rights.

They have the same rights and privileges as the preferred shareholders of the firm.

They are owners of the firm, but they do not receive dividends.

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Chap 01_4ce 39. Which of the following statements best describes income trusts?

Since the goal is to distribute as little free cash flow as possible, businesses that have required significant capital expenditures in the past have been the best candidates.

Whereas dividends received by investors are taxed at both the corporate and individual levels, income trust cash distributions are taxed only at the corporate level.

An income trust is an equity investment created to distribute all of a business’s free cash flow to investors in a tax-efficient manner.

Cash-producing assets such as real estate make up only a minority of income trusts.

40. What is the rate of return normally required by investors when investing in a firm?

yield to maturity (YTM) weighted average cost of capital (WACC) internal rate of return (IRR) policy interest rate 41. In which type of organization do all partners enjoy limited liability regarding negligence and potential losses

limited to their investment in the partnership? limited liability partnership (LLP) income trust sole proprietorship general partnership 42. Which of the following statements best describes partnerships and/or corporations?

Corporations can attract large capital more easily due to factors such as limited liability, and the liquidity of the owners’ interests.

In a regular partnership, liability for other partners’ misdeeds is limited to the amount of a particular partner’s investment in the partnership.

A fast-growth business, with great need for new capital, would be less likely to organize as a corporation than would a slow-growth business.

A major disadvantage of partnerships relative to corporations is the fact that taxes must be paid by the partners and the firm itself.

43. You recently sold 500 shares of Alphabet stock; the transfer was made through a broker, and the trade

occurred on the TSX. Which type of transaction is this? a futures market transaction an IPO market transaction a primary market transaction a secondary market transaction

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Chap 01_4ce 44. Which of the following is an example of providers of cash?

entrepreneurs with ideas individuals who are saving for retirement corporations with growth plans students wishing to borrow money for tuition 45. What does the separation theorem demonstrate?

Firms that separate goods’ prices and cost minimize costs and thus produce more goods, which benefits society.

Firms should separate their management decisions between those that benefit consumers and those that benefit shareholders.

Investors that prefer to receive dividend income now should be separated from investors that prefer to forgo dividends currently.

All investors are better off when firms separate their investment decisions from the preferences of their owners/investors.

46. Why might a business choose to operate as a corporation rather than as a sole proprietorship or a

partnership?

Less of a corporation’s income is generally subjected to taxes than would be true if the firm were a sole proprietorship.

It is difficult for a corporation to obtain the capital needed for growth.

Corporate shareholders escape unlimited liability for the firm’s debts, but this factor may be offset by the double taxation of the corporation.

Corporations can be easily formed and generally face relatively few regulations.

47. Which of the following statements best describes firm organization?

One of the disadvantages of a corporation is that the owners have unlimited liability when the firm goes bankrupt, which means losses can exceed the actual funds invested.

In a sole proprietorship, the proprietor has limited personal liability for the business’s debts and losses are limited to the money the proprietor invested in the business.

Sole proprietorships and partnerships generally have a tax advantage over corporations, especially large ones.

In both regular and limited partnerships, all partners are liable for the debts of the partnership.

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Chap 01_4ce 48. Which of the following statements is NOT correct?

The initial public offering (IPO) market is a subset of the primary market.

The Toronto Stock Exchange is a secondary market, since it deals in outstanding as opposed to newly issued shares.

Since the transactions in private markets are private, they may be structured in any manner that appeals to the two parties.

“Going public” establishes a firm’s true intrinsic value, and it also ensures that a highly liquid market will always exist for the firm’s shares.

49. Which of the following statements best describes financial markets?

Financial asset markets include only long-term debt and common shares.

Money market mutual funds have no default risk.

Foreign banks are now less restricted from operating in Canada than in the past.

The original maturity of a mortgage can go up to 40 years.

50. Which of the following represents the most significant reason for the collapse of the U.S. investment banks in

2008?

In the 1990s, most large U.S. investment banks were reorganized into public trading companies (or were acquired and then operated as subsidiaries of public companies).

In the 2000s, most investment banks started to generate most of their income from fees charged for underwriting, M&A consulting, asset management, and brokerage activities.

New regulations introduced in the 2000s placed more restrictions on the operations of investment banks.

A relaxation of regulations in the 2000s allowed investment banks to issue unprecedented amounts of debt to finance their activities.

51. If the market price of a stock reflects all relevant information, what does its market price reflect?

the stock’s historical value the stock’s intrinsic value the stock’s current value the stock’s extrinsic value 52. Which of the following statements best describes financial markets?

If an investor buys shares through a broker, then this would be an indirect finance transaction.

Commercial paper is issued by firms to larger investors and guaranteed by a bank.

Bankers’ acceptances have a high degree of default risk.

Money market mutual funds have maturities longer than one year.

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Chap 01_4ce 53. Besides strong relationships with groups outside the company, what else supports good businesses?

adequate inventories adequate funding adequate self-interest adequate rules and laws 54. Which of the following statements best describes hedge funds?

Hedge funds always have low risk because they hedge their investments.

Like mutual funds, hedge funds can have thousands of investors.

Hedge funds are risky, although they may be market-neutral.

Hedge funds are more regulated than mutual funds since they use derivatives to form portfolios.

55. Which of the following is an example of a primary market transaction?

Apple issues 10,000,000 new shares and sells them to the public through an investment banker.

You invest $20,000 in a mutual fund, which then uses the money to buy $20,000 of Apple shares on the TSX. One financial institution sells 300,000 Apple shares to another institution with the help of an investment banker.

You sell 500 Apple shares on the TSX through your broker.

56. Cheers Canada operates as a partnership. What will be the effect if the partners decide to convert the business

into a regular corporation? a. The transfer of ownership interests of Cheers Canada will be more difficult. b. Cheers Canada will be subject to more regulations. c. Cheers Canada will find it more difficult to obtain the capital needed for growth. d. Cheers Canada shareholders (the ex-partners) will be exposed to more liability.

57. Which of the following statements best describes financial markets? a. If Apple issues an additional 1,000,000 shares through an investment banker, this would be a secondary

market transaction. b. Capital market transactions involve highly liquid debt securities with maturities of less than one year. c. The IPO market is a major part of the primary market. d. Bank loans and private placements of debt with insurance companies are examples of private public

market transactions.

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Chap 01_4ce 58. Which of the following statements best describes firm organization? a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than

in a regular partnership and sole proprietorship. b. 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. c. It is generally more expensive to form a partnership than a corporation because a partnership requires extensive legal documents. d. In a limited partnership, the limited partners and general partners are liable only for the amount of their investment in the partnership.

59. You recently sold 200 shares of your new company, ABC Corporation, to your brother at a family reunion. At

the reunion your brother gave you a cheque for the shares and you gave your brother the share certificates.

Which of the following best describes this transaction? a. a direct transfer of capital b. an indirect transfer of capital through investment bankers c. an indirect transfer through a financial intermediary d. an exchange of physical assets 60. The primary goal of a company’s management is the maximization of which of the following? a. net profit b. market share c. dividends d. fundamental share price 61. Which of the following is NOT a variable used in the calculation of free cash flow (FCF)? a. sales revenues b. interest and dividends c. required investments in operating capital d. operating costs

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Chap 01_4ce Answer Key 1. False 2. False 3. False 4. False 5. False 6. True 7. False 8. True 9. True 10. True 11. d 12. b 13. c 14. b 15. b 16. d 17. b 18. b 19. c 20. b 21. b 22. a 23. a 24. d 25. d 26. a

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Chap 01_4ce 27. d 28. c 29. d 30. c 31. c 32. a 33. c 34. c 35. a 36. d 37. b 38. a 39. c 40. b 41. a 42. a 43. d 44. b 45. d 46. c 47. c 48. d 49. c 50. d 51. b 52. a 53. b 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 01_4ce 55. a 56. b 57. c 58. a 59. a 60. d 61. b

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Chap 02_4ce Indicate whether the statement is true or false.

1. The balance sheet is a financial statement that reports a company’s assets, liabilities, and shareholders’ equity at a specific point in time, while the income statement measures a company’s performance over a certain time period. a. True b. False 2. As a good measurement for comparing managers’ performance, net operating profit after taxes (NOPAT) is the profit a company would generate from its operations if it had no debt and held no financial assets. a. True b. False 3. The intrinsic value of a company is determined by the stream of cash flows that investors expect to receive now and in the future. So, the way for managers to make their companies more valuable is to increase free cash flow now and in the future. a. True b. False 4. According to regulations, income statements must be prepared on an annual or quarterly basis. a. True b. False 5. Retained earnings is the existing shareholders’ reinvested profit and does not represent cash, nor is it “available” for the payment of dividends or anything else. a. True b. False 6. In terms of how free cash flow (FCF) is used, FCF is equal to after-tax operating profit minus the amount of new expenditures necessary to sustain the business. a. True b. False 7. The FIFO method always leads to a lower balance sheet inventory value, but a higher cost of goods sold in the income statement. a. True b. False 8. A firm needs $1 of pre-tax income to pay $1 of interest, but if it is in the 27% federal-plus-British Columbia tax bracket, it must earn $1.37 of pre-tax income to pay $1 of dividends. a. True b. False 9. Interest income received by a corporation is taxed at its regular corporate tax rate, whereas such income earned by a Canadian-controlled private corporation (CCPC) is taxed at a lower rate than the CCPC’s regular tax rate. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 02_4ce 10. Unlike the balance sheet, which is a snapshot of a firm during a period, the income statement reflects performance at a point in time. a. True b. False 11. The term “amortization” is usually used to describe the depreciation of intangible assets, while “depletion” is used to refer to the depreciation of natural resources such as oil or natural gas. a. True b. False 12. The dividends paid by a corporation are deducted from its operating income to obtain its taxable income, but interest paid is not deductible. a. True b. False 13. If some marketable securities mature very soon and can be converted quickly into cash at prices close to their book values, they are regarded as “cash equivalents” and are included with cash. a. True b. False 14. The time dimension is important in financial statement analysis. The balance sheet shows the firm’s financial position over a period of time, the income statement shows results at a given point in time, and the statement of cash flows reflects changes in the firm’s accounts over that period of time. a. True b. False 15. A business’s net cash flow generally differs from its accounting profit, and the net cash flow equals net income plus noncash revenues minus noncash charges. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

16. What is the tax liability for a small Canadian-controlled private corporation (CCPC) located in British Columbia having earnings before taxes (EBT) of $590,000? The relevant combined federal and provincial corporate income tax rate is 13% for taxable income up to $500,000 and 27% for the amount exceeding $500,000. a. $89,300 b. $90,700 c. $91,250 d. $92,060

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Chap 02_4ce 17. Formed in 2008, ABC Ltd. had taxable income of $103,000 in 2017; $82,000 in 2018; $60,000 in 2019; $90,000 in 2020, and –$170,000 in 2021. What is the tax recovery for 2021? Assume that ABC is a CCPC in Manitoba with a combined federal and provincial corporate income tax rate of 12.5%. a. $18,260 b. $19,833 c. $21,250 d. $21,530 18. Which of the following statements is correct? a. Since working capital is usually small, changes in working capital have no effect on free cash flow. b. Free cash flow (FCF) can be calculated as follows: FCF = EBIT(1 – T) + Depreciation and amortization – Gross investment in fixed assets – Investment in NOWC c. Free cash flow (FCF) can be calculated as follows: FCF = EBIT(1 – T) – Depreciation and amortization + Capital expenditures d. Free cash flow (FCF) can be calculated as follows: FCF = EBIT(1 – T) + Depreciation and amortization – Net investment in fixed assets + Investment in NOWC 19. Which statement about the balance sheet is true? a. A balance sheet lists the most liquid assets first and the least liquid assets last. b. The balance sheet for a given year tells us how the company’s activities affect its cash positions during that year. c. The amounts shown on the balance sheet are often book values, which are the same as the market values of the company’s stock. d. The difference between the total assets and liabilities reported on the balance sheet tells us the current market value of the shareholders’ equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP).

20. T-road Aircraft recently announced that its net income decreased from the previous year, yet its net cash flow from operations increased. What could explain this performance? a. The company’s depreciation and amortization expenses increased. b. The company’s expenditures on equipment increased. c. The company’s cost of goods sold decreased. d. The company’s interest expense decreased.

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Chap 02_4ce 21. 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

$20 20 60 50 150 100 $250

Accounts payable Accruals Notes payable Current liabilities Long-term debt Common equity Retained earnings Total liab. and equity

$30 30 60 120 0 40 90 $250

a. $70.00 b. $71.85 c. $72.52 d. $73.04 22. Last year, Tiemann Technologies reported $14,500 of sales, $7,050 of operating costs other than depreciation, and $1,450 of depreciation. The company had no amortization charges, it had $6,000 of bonds that carry a 7% interest rate, and its combined federal and provincial income tax rate was 33%. This year’s data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $820. By how much will net aftertax income change as a result of the change in depreciation? Assume for this question that the company uses the same depreciation calculations for tax and shareholder reporting purposes. a. –$513.96 b. –$527.50 c. –$549.40 d. –$562.47 23. A start-up firm is making an initial investment in new plant and equipment. Assume that currently its equipment is being depreciated on a straight-line basis over 6 years, but now in Year 2 the company must depreciate the equipment over 9 years. Assume for this question that the company uses the same depreciation method for tax and shareholder reporting purposes. What would occur in Year 2? a. The firm’s taxable income would decrease. b. The firm’s reported net income would decrease. c. The firm’s tax payments would decrease. d. The firm’s net cash flow would decrease.

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Chap 02_4ce 24. Mr. X lives in Saskatchewan. In 2021, he had employment income of $90,000 and income from capital gains of $18,000. What is his total tax liability? The applicable tax tables are as follows: Federal Rate Tax Bracket Provincial Rate Tax Bracket Fed. 15% $0 – $49,020 Sask. 10.5% $0 – $33,723 Fed. 20.5% $49,021 – $98,040 Sask. 12.5% $33,724 – $72,885 Fed. 26% $98,041 – $151,978 Sask. 14.5% Over $72,885 a. $29,552 b. $29,875 c. $31,249 d. $32,774 25. Companies generate income from their “regular” operations and from other sources such as interest earned on the securities they hold, which is called nonoperating income. Lindley Textiles recently reported $17,500 of sales, $8,450 of operating costs other than depreciation, and $2,000 of depreciation. The company had no amortization charges and no nonoperating income. It had $9,000 of bonds outstanding that carry a 6.5% interest rate, and its combined federal and provincial income tax rate was 38%. How much was Lindley’s operating income, or EBIT? a. $6,531 b. $7,050 c. $8,062 d. $8,946 26. What would be most likely to occur in the year when companies have to depreciate equipment over shorter lives?

Assume for this question that sales, other operating costs, and tax rates are not affected, and the same depreciation method is used for tax and shareholder reporting purposes. a. Companies’ NOPAT would increase. b. Companies’ cash positions would increase. c. Companies’ cash flows would decrease. d. Companies’ reported net income would increase.

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Chap 02_4ce 27. Below are the 2019 and 2020 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 Notes payable Total current liabilities Long-term debt Common shares Retained earnings Total common equity Total liabilities and equity

$ 1,400,000 1,600,000 $3,000,000 2,400,000 3,000,000 664,000 $3,664,000 $9,064,000

$1,090,000 1,800,000 $2,890,000 2,400,000 2,000,000 580,000 $2,580,000 $7,870,000

Wolken has never paid a dividend on its common shares, and it issued $2,400,000 of 15-year non-callable, longterm 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 issued long-term debt in 2020. b. Wolken issued new common shares in 2020. c. Wolken made a loss in 2020. d. Wolken repurchased some common shares in 2020.

28. In 2021, XYZ Inc. located in Ontario had income from operations of $4,650,000, received interest of $220,000, paid $350,000 in interest, received dividends from another Canadian corporation of $220,000, and paid $510,000 in dividends to its common shareholders. If the applicable income tax rate is 35%, what is the corporation’s tax liability? a. $1,265,000 b. $1,391,000 c. $1,470,000 d. $1,582,000

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Chap 02_4ce 29. Why are annual reports important to finance professionals and investors? a. Annual reports are skewed in favour of management and professionals, and thus are not important to investors. b. Annual reports are used by investors and finance professionals when they form expectations about a firm’s future cash flows, profits, and distributions. c. Annual reports are important only to management because investors do not trust management and investors rely only on the recommendation of financial analysts. d. None of the above is the reason that annual reports are important.

30. Which statement about the income statement is true? a. The income statement for a given year is designed to give us an idea of how much profit the company made in that year. b. Since neither depreciation nor amortization is paid in cash, EBITDA is a worse measure of financial strength than is net income. c. Other comprehensive income (OCI) is generally a large amount, and all companies have OCI to report. d. Amortization applies to tangible assets, such as plant and equipment, whereas depreciation applies to intangible assets such as patents, copyrights, and trademarks.

31. Which statement regarding the tax system is true? a. For small Canadian-controlled private corporations, income less than $6400,000 is exempt from taxes.

Thus, government receives no tax revenue from these businesses. b. Tax rates placed on corporations vary based on their size, location, and type of income being earned. The various tax rates partly reflect governments encouraging the establishment of certain types of businesses. c. All businesses, regardless of their legal form of organization and their location, are taxed by the Canada Revenue Agency (CRA). d. All corporations other than nonprofit corporations are subject to corporate income taxes, which are 26.5% for the lowest amounts of income and 33% for the highest amounts of income.

32. Hunter Manufacturing Inc.’s December 31, 2020, balance sheet showed total common equity of $3,250,000 and 150,000 shares outstanding. During 2021, Hunter had $950,000 of net income, and it declared $200,000 in dividends. What was the book value per share at December 31, 2021, assuming that Hunter neither issued nor retired any common shares during 2021? a. $26.67 b. $27.00 c. $28.34 d. $29.15

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Chap 02_4ce 33. Which statement regarding financial statements is true? a. Accounts receivable are reported as a current liability on the balance sheet. b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause an increase in its current assets as shown on the balance sheet. c. If a company pays less in dividends than it generates in net income, its retained earnings as reported on the balance sheet will increase from the previous year’s balance. d. If a company issues new long-term bonds during the current year, this will decrease its reported current liabilities at the end of the year.

34. Meric Mining Inc. recently reported $21,000 of sales, $9,200 of operating costs other than depreciation, and $1,400 of depreciation. The company had no amortization charges, it had $8,200 of outstanding bonds that carry a 7% interest rate, and its combined federal and provincial income tax rate was 33%. How much was the firm’s net income after taxes? Assume for this question that Meric uses the same depreciation expense for tax and shareholder reporting purposes. a. $6,284.73 b. $6,457.12 c. $6,583.42 d. $6,830.94 35. Bartling Energy Systems recently reported $12,650 of sales, $7,250 of operating costs other than depreciation, and $900 of depreciation. The company had no amortization charges, it had $4,500 of outstanding bonds that carry a 6% interest rate, and its combined federal and provincial income tax rate was 33%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to make $1,850 of capital expenditures on new fixed assets and to invest $500 in net operating working capital. By how much did the firm’s net income exceed its free cash flow? a. $998.05 b. $1,045.23 c. $1,176.40 d. $1,269.10 36. Which of the following statements is correct? a. EVA stands for economic value added, and it is defined as follows: EVA = NOPAT – (Total net operating capital)(WACC) b. MVA stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) + Total common equity c. MVA gives us an idea about the managerial effectiveness in a given year. d. EVA gives us an idea about the difference between the market value of the firm’s stock and the amount of equity capital that was supplied by shareholders.

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Chap 02_4ce 37. TSW Inc. had the following data for last year: Net income = $1,000; Net operating profit after taxes (NOPAT) = $850; Total assets = $4,300; and Total operating capital = $3,100. Information for the just-completed year is as follows: Net income = $1,400; Net operating profit after taxes (NOPAT) = $1,075; Total assets = $3,600; and Total operating capital = $3,400. How much free cash flow did the firm generate during the just-completed year? a. $740 b. $759 c. $762 d. $775 38. Which statement about net cash flow is true? a. The firm’s net cash flow is often called “the bottom line” since it is the lowest entry on the income statement. b. Depreciation reduces a firm’s asset balance, so an increase in depreciation would normally lead to a decrease in the firm’s net cash flow. c. Net Cash Flow = Net Income – Depreciation and Amortization Charges. d. Net Cash Flow = Net Income + Noncash Charges – Noncash Revenues.

39. Which of the following is included in calculating total investor-supplied capital? a. preferred shares b. accounts payable c. short-term bonds d. retained earnings 40. Which of the following statements is correct? a. Free cash flow (FCF) equals NOPAT plus net investment in operating capital. b. Other things held constant, if the tax rate increases, NOPAT would increase. c. Net operating working capital (NOWC) is defined as operating current assets plus operating current liabilities. d. The standard financial statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period.

41. The annual financial statements of a firm contain which of the following basic financial statements? a. a balance sheet, an income statement, a statement of cash flows, and a statement of shareholders’ equity b. a balance sheet, an income statement, and a statement of net cash flow c. a balance sheet, an income statement, and a statement of net cash flow and changes in equity d. a balance sheet, an income statement, and a statement of net cash flow and retained earnings

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Chap 02_4ce 42. 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 (35%) Net income

$2,700 1,800 450 450 120 330 115.50 $214.50

a. $292.50 b. $294.71 c. $296.08 d. $297.30 43. If a local Firm X owns 42% of the shares of a Canadian-owned Firm Y, and Y pays dividends to all of its shareholders, what percentage of the dividends received by X can be exempted from its taxable income? a. 10% b. 42% c. 75% d. 100% 44. To estimate a firm’s cash flow from operations, depreciation is added back to net income. Which of the following is true regarding depreciation? a. Depreciation is an extraordinary expense that is not always deducted when calculating net income, and it should not be added back to net income when calculating a firm’s cash flow from operations. b. Depreciation is an extraordinary expense that is not always deducted when calculating net income, and it must be added back to net income when calculating a firm’s cash flow from operations. c. Depreciation is a noncash expense resulting from the purchase of fixed assets, but it should not be added back to net income when determining a firm’s cash flow from operations. d. Depreciation is a noncash expense resulting from the purchase of fixed assets, and it must be added back to net income when determining a firm’s cash flow from operations.

45. Tibbs Inc. had the following data for the year ended December 31, 2020: Net income = $500; Net operating profit after taxes (NOPAT) = $600; Total assets = $3,400; Short-term investments = $400; Shareholders’ equity = $2,200; Total debt = $1,200; and Total operating capital = $2,800. What was its return on invested capital (ROIC)? a. 19.96% b. 20.07% c. 21.43% d. 22.39%

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Chap 02_4ce 46. Which of the following items can be found on a firm’s balance sheet under current liabilities? a. long-term lease obligations b. long-term bonds c. notes payable d. cost of goods sold 47. According to the fundamental equation of accounting, total assets should equal which of the following? a. long-term debt and shareholders’ equity b. working capital and shareholders’ equity c. total liabilities and shareholders’ equity d. total liabilities and total cash 48. Bae Inc. 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 (33%) Net income

$3,000 1,900 250 850 220 630 207.90 $422.10

a. $554.01 b. $569.50 c. $574.36 d. $580.25 49. HHH Inc. reported $23,500 of sales and $11,050 of operating costs (including depreciation). The company had $20,250 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 10%, and the combined federal and provincial income tax rate was 38%. How much value did management add to shareholders’ wealth during the year? a. $5,532.17 b. $5,694.00 c. $5,730.08 d. $5,813.69

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Chap 02_4ce 50. Which statement regarding retained earnings is true? a. Since depreciation is a source of funds, the less depreciation a company has, the smaller its retained earnings will be, other things held constant. b. If a firm reports a zero profit on its income statement, then the retained earnings shown on the balance sheet will be zero. c. The retained earnings as shown on the balance sheet represents cash and is “available” for the payment of dividends or anything else. d. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments.

51. Which statement regarding the tax system is true? a. Capital gains are taxed at one-half the rate of ordinary income, and a capital gain on the sale of your principal residence is also subject to any capital gains tax in Canada. b. In Canada, the maximum federal personal tax rate in 2021 is 31%. c. Interest paid to an individual is counted as income for tax purposes and taxed at the individual’s regular tax rate. d. Ordinary corporate operating losses can be carried back to each of the preceding 3 years and forward for the next 10 years and used to offset taxable income in those years.

52. Which statement regarding EVA is true? a. One way to increase EVA is to achieve the same level of operating income but with more investorsupplied 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.

53. Tucker Electronic System’s current balance sheet shows total common equity of $4,785,000. The company has 165,000 shares outstanding, and they sell at a price of $54.50 per share. By how much do the firm’s market and book values per share differ? a. $23.95 b. $24.88 c. $25.50 d. $26.73 54. IBC Corporation just purchased an expensive piece of equipment. Originally, the firm planned to depreciate the equipment over 11 years on a straight-line basis, but now wants to depreciate the equipment on a straight-line basis over 8 years. Other things held constant, what will occur as a result of this change? Assume for this question that the company uses the same depreciation method for tax and shareholder reporting purposes. a. IBC’s reported net income will increase. b. IBC’s cash flow will decrease. c. IBC’s net fixed assets as shown on the balance sheet will be lower at the end of the year. d. IBC’s income tax expense for the year will increase.

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Chap 02_4ce 55. Which statement regarding the statement of cash flows is correct? a. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of transactions involving short-term financial investments. b. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital, like accounts payable. c. The statement of cash flows separates a company’s activities into three categories—operating, investing, and financing—and shows how much the firm’s cash increased or decreased during a given year. d. The statement of cash flows reflects cash flows from operations and from investing, but it does not reflect cash used for share repurchases.

56. During 2021, Bascom Bakery Inc. paid out $36,910 of common dividends. It ended the year with $214,500 of retained earnings versus the prior year’s retained earnings of $146,250. How much net income did the firm earn during the year? a. $102,840 b. $103,220 c. $104,370 d. $105,160 57. The CFO of Sasa Industries plans to have the company issue $400 million common shares 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’s net income would decrease. b. The company would have the same common equity. c. The company’s interest expense would remain constant. d. The company’s taxable income would increase.

58. Assume that Cool Beverages Inc. can reduce its depreciation expense by half for the upcoming year while sales revenue and the tax rate remain unchanged. Prior to the change, the company’s net income after taxes was forecast to be $5 million. What impact will this change have on the company’s financial statements? Assume that the company uses the same depreciation method for tax and shareholder reporting purposes. a. Net fixed assets on the balance sheet will increase. b. Net fixed assets on the balance sheet will decrease. c. The provision will decrease the company’s tax payments. d. The provision will decrease the company’s net income.

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Chap 02_4ce 59. Below is the common equity section (in millions) of Teenie Technology’s last two year-end balance sheets: 2020 2019 Common shares $2,000 $1,000 Retained earnings 2,000 2,340 Total common equity $4,000 $3,340 Teenie has never paid a dividend to its common shareholders. Which of the following statements is correct? a. The company’s net income in 2019 was lower than in 2020. b. The market price of Teenie’s stock doubled in 2020. c. Teenie issued some common shares in 2020. d. The company had positive net income in both years, but the net income in 2020 was lower than that in 2019.

60. Which of the following items is NOT included in current assets? a. long-term investments b. inventory c. net plant and equipment d. intellectual property 61. Last year, Michelson Manufacturing reported $23,150 of sales, $7,500 of operating costs other than depreciation, and $3,350 of depreciation. The company had no amortization charges, it had $4,500 of bonds outstanding that carry a 7% interest rate, and its combined federal and provincial income tax rate was 37%. This year’s data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $865. By how much will the depreciation change cause the firm’s net after-tax income and its net cash flow to change?

Assume for this question that the company uses the same depreciation calculations for tax and shareholder reporting purposes. a. –$524.63; $309.84 b. –$536.18; $313.01 c. –$544.95; $320.05 d. –$552.75; $341.02 62. JBS Inc. recently reported net income of $6,450 and depreciation of $1,035. How much was its net cash flow, assuming it had no amortization expense and sold none of its fixed assets? a. $5,912 b. $6,085 c. $7,485 d. $8,635

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Chap 02_4ce 63. Last year, CBS Company’s operations provided a negative net cash flow, but the cash shown on its balance sheet increased. What could be a reason for the increase in cash, assuming the company followed generally accepted accounting principles? a. The company used cash to repurchase some of its common shares. b. The company sold one of its large plants. c. The company had large capital expenditures. d. The company had large amortization expenses.

64. Net income available to shareholders excludes which of the following? a. gains or losses on foreign exchange b. investment income c. common share dividends d. sales revenue 65. On its 2020 balance sheet, Hope Books showed $620 million of retained earnings, and exactly that same amount was shown the following year. Assuming that there were no earnings restatements, which of the following statements is correct? a. The company must have had zero net income in 2020 due to poor management. b. The company must have paid no dividends in 2020. c. The company might have paid out more than half of its 2020 earnings as dividends. d. The company might have paid out the whole earnings for the year as dividends.

66. CAD Corp Inc. reported $29,000 of sales and $10,000 of operating costs (including depreciation). The company had $23,150 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 11%, and the combined federal and provincial income tax rate was 35%. How much value did management add to shareholders’ wealth during the year? a. $9,504.26 b. $9,605.11 c. $9,716.20 d. $9,803.50 67. Assume for this question that Pappas Company commenced operations on January 1, 2020, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 12 years, but in December 2020 management realized that the assets would last for 17 years. The firm’s accountants plan to report the 2020 financial statements based on this new information. How would the new depreciation assumption affect the company’s financial statements? a. The firm’s reported net fixed assets would decrease. b. The firm’s cash position in 2020 would decrease. c. The firm’s reported 2020 earnings per share would decrease. d. The firm’s EBIT would decrease.

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Chap 02_4ce 68. On December 31, 2021, Heaton Industries Inc. reported retained earnings of $845,000 on its balance sheet, and it reported $341,500 of net income during the year. On its previous balance sheet, at December 31, 2020, the company had reported $637,000 of retained earnings. No shares were repurchased during 2021. How much in dividends did Heaton pay during 2021? a. $133,500 b. $145,670 c. $152,830 d. $169,020 69. An individual living in Alberta with wage earnings of $89,000 has invested $36,000 for 1 year in corporate bonds yielding 7%. What is the after-tax return? The relevant federal and provincial tax rates are 21% and 12%. a. $1,688.40 b. $1,679.68 c. $1,664.21 d. $1,655.90 70. Other things held constant, which action would decrease the amount of cash on a company’s balance sheet? a. The company sells a piece of equipment. b. The company issues new common shares. c. The company gives customers less time to pay their bills. d. The company repurchases its common shares.

71. Which of the following statements is correct? a. If a firm is more profitable than other firms, the stock price of the company will exceed its book value per share. b. If a firm is more profitable than other firms, the book value per share of the company will exceed its stock price. c. Typically, a firm’s EPS is less than its DPS. d. Typically, a firm’s EBITDA is less than its EBIT. 72. Wells Water Systems recently reported $9,750 of sales, $4,800 of operating costs other than depreciation, and $1,150 of depreciation. The company had no amortization charges, it had $4,150 of outstanding bonds that carry a 6.25% interest rate, and its combined federal and provincial income tax rate was 33%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to spend $830 to buy new fixed assets and to invest $290 in net operating working capital. How much free cash flow did Wells generate? a. $2,207.00 b. $2,341.50 c. $2,491.43 d. $2,576.00

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Chap 02_4ce 73. Formed in 2021, ABC Ltd. had an operating loss of $125,000, with projected taxable income of $80,000 in 2022, $79,000 in 2023, and $96,000 in 2024. What will the corporate tax liability be in 2024? Assume that ABC is a CCPC in Quebec with a combined federal and provincial corporate income tax rate of 18%. a. $16,732 b. $17,280 c. $18,410 d. $19,620 74. Last year, Future Technologies 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 factor could explain this situation? a. The company had a sharp increase in accrued employee wages. b. The company had a sharp increase in depreciation expenses. c. The company purchased new equipment early in the year. d. The company sold a new issue of common shares.

75. Which of the following reporting standards are used by publicly traded Canadian firms when reporting their financial results? a. Accounting Standards for Private Enterprises (ASPE) b. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) c. International Financial Reporting Standards (IFRS) d. Generally Accepted Accounting Principles (GAAP) 76. Frederickson Office Supplies recently reported $17,500 of sales, $8,450 of operating costs other than depreciation, and $2,000 of depreciation. Assume for this question that the company uses the same depreciation method for tax and shareholder reporting purposes. The company had no amortization charges and no nonoperating income. It had $9,000 of bonds outstanding that carry a 6.5% interest rate, and its combined federal and provincial income tax rate was 38%. How much was the firm’s taxable income, or earnings before taxes (EBT)? a. $3,921 b. $4,336 c. $5,570 d. $6,465 77. A firm reports net income of $340,000. Its board of directors declared preferred dividends of $46,000. If the firm has 110,000 common shareholders, what would be the firm’s EPS for the fiscal year? a. $2.67 b. $2.71 c. $2.80 d. $2.95

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Chap 02_4ce 78. Barnes Brothers has the following data for the year ended December 31, 2021: Net income = $800; Net operating profit after taxes (NOPAT) = $900; Total assets = $2,800; Short-term investments = $230; Shareholders’ equity = $1,900; Total debt = $900; and Total operating capital = $2,400. Barnes’ weighted average cost of capital is 11%. What is its economic value added (EVA)? a. $620.11 b. $636.00 c. $648.50 d. $659.02 79. 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 depreciation Net fixed assets Total assets

$ 30 20 35 75 160 170 50 120 $280

Accounts payable Accruals Notes payable Current liabilities Long-term debt Common shares Retained earnings Total common equity Total liabilities and equity

$ 45 55 30 130 70 35 45 80 $280

a. $39 b. $143 c. $157 d. $160 80. Which of the following is considered a “positive” use of free cash flow? a. paying senior management bonuses b. repaying debtholders c. selling other nonoperating assets d. issuing new shares 81. Over the years, Janjigian Corporation’s shareholders have provided $28,350 of capital, part when they purchased new share issues and part when they allowed management to retain some of the firm’s earnings. The firm now has 1,200 common shares outstanding selling at a price of $56 per share. How much value has Janjigian’s management added to shareholder wealth over the years; that is, what is Janjigian’s MVA? a. $37,235 b. $38,850 c. $39,613 d. $40,927

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Chap 02_4ce 82. Consider the balance sheet of Wilkes Industries as shown below. Wilkes has $1,200,000 in common equity. As a result, which of the following can we state regarding Wilkes?

Cash Inventory Accounts receivable Total current assets Net fixed assets

$ 150,000 200,000 250,000 600,000 1,000,000

Total assets

$1,600,000

Accounts payable Accruals Total current liabilities Debt Common shares Retained earnings Total liab. and equity

$ 100,000 100,000 200,000 200,000 300,000 900,000 $1,600,000

a. 25% of Wilkes’ shareholders’ equity comes from accumulated profitable earnings of prior years’ operations. b. 75% of Wilkes’ shareholders’ equity comes from issuing more shares. c. 19.75% of Wilkes’ shareholders’ equity comes from issuing more shares. d. 75% of Wilkes’ shareholders’ equity comes from accumulated profitable earnings of prior years’ operations. .

83. Swinnerton Clothing Company’s balance sheet showed total current assets of $3,050, all of which were required in operations. Its current liabilities consisted of $625 of accounts payable, $500 of 7% short-term notes payable to the bank, and $183 of accrued wages and taxes. What was its net operating working capital that was financed by investors? a. $2,242 b. $2,350 c. $2,407 d. $2,571 84. NNR Inc.’s balance sheet showed total current assets of $2,465,000 plus $5,065,000 of net fixed assets. All of these assets were required in operations. The firm’s current liabilities consisted of $515,000 of accounts payable, $465,000 of 7% short-term notes payable to the bank, and $180,000 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. $5,017,000 b. $6,835,000 c. $7,349,000 d. $8,142,000

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Chap 02_4ce 85. Which statement about financial statements is correct? a. The balance sheet reflects the firm’s performance over a period of time. b. The income statement gives us a picture of the firm’s financial position at a point in time. c. The statement of cash flows tells us the amount of cash and cash equivalents entering and leaving a company during a given period. d. The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.

86. Which statement regarding the statement of cash flows is true? a. In the statement of cash flows, depreciation charges are subtracted from net income in operating activities. b. In the statement of cash flows, an increase in inventories is added to net income in operating activities. c. In the statement of cash flows, an increase in accounts receivable is added to net income in operating activities. d. In the statement of cash flows, an increase in accounts payable is added to net income in operating activities.

87. Saskatchewan Corporation has the following balance sheet. How much net operating working capital does the firm have?

Cash $35 Accounts payable $50 Short-term investments 40 Accruals 25 Accounts receivable 85 Notes payable 75 Inventory 50 Current liabilities 150 Current assets 210 Long-term debt 0 Net fixed assets 130 Common equity 120 Retained earnings 70 Total assets $340 Total liab. and equity $340

a. $91 b. $94 c. $95 d. $98 88. Analysts who follow Honey Industries recently noted that, relative to the previous year, the company’s operating net cash flow increased, yet cash as reported on the balance sheet decreased. Which factor could explain this situation? a. The company paid no dividends. b. The company issued new long-term debt. c. The company issued new common shares. d. The company purchased a profitable new plant.

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Chap 02_4ce 89. A security analyst obtained the following information from Austin Products’ financial statements: – Retained earnings at the end of 2019 were $900,000, but retained earnings at the end of 2020 had declined to $510,000 – 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 flow for 2020 was $180,000.

On the basis of this information, which of the following statements is correct? a. The company’s depreciation expense in 2020 was less than $180,000. b. The company had negative net income in 2020. c. The company had positive net income in 2020, and its income was greater than its 2019 income. d. The company’s cash on the balance sheet at the end of 2019 must be higher than the cash it had at the end of 2020.

90. Which of the following is correct regarding the payment of dividends by a corporation? a. Dividends are paid out of EBIT and thus are not tax deductible by the corporation. b. Dividends are paid out of net after-tax income and thus are not tax deductible by the corporation. c. Dividends are paid out of net after-tax income and thus are tax deductible by the corporation in the following tax year. d. Dividends are paid out of EBIT and thus are tax deductible by the corporation.

91. Which factor could explain why Alectra Energy had a negative net cash flow last year, even though the cash on its balance sheet increased? a. The company had large depreciation expenses. b. The company purchased some new intellectual property. c. The company sold a new issue of bonds. d. The company repurchased 30% of its common shares.

92. An individual made $62,000 last year, paying $17,350 in taxes. What is the taxpayer’s average tax rate? a. 25.71% b. 26.49% c. 26.03% d. 27.98%

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Chap 02_4ce Answer Key 1. True 2. True 3. True 4. False 5. True 6. False 7. False 8. True 9. False 10. False 11. True 12. False 13. True 14. False 15. False 16. a 17. c 18. b 19. a 20. a 21. a 22. c 23. d 24. b 25. b 26. b

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Chap 02_4ce 27. b 28. d 29. b 30. a 31. b 32. a 33. c 34. c 35. d 36. a 37. d 38. d 39. a 40. d 41. a 42. a 43. d 44. d 45. c 46. c 47. c 48. b 49. b 50. d 51. c 52. d 53. c 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 02_4ce 55. c 56. d 57. d 58. a 59. c 60. b 61. c 62. c 63. b 64. c 65. d 66. d 67. b 68. a 69. a 70. d 71. a 72. d 73. b 74. d 75. c 76. d 77. a 78. b 79. d 80. b 81. b 82. d Copyright Cengage Learning. Powered by Cognero.

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Chap 02_4ce 83. a 84. b 85. c 86. d 87. c 88. d 89. b 90. b 91. c 92. d

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Chap 03_4ce Indicate whether the statement is true or false.

1. If a firm finances with only debt and common equity, and if its equity multiplier is 4.0, then its debt ratio must be 0.75. a. True b. False 2. The current ratio and the quick ratio both help measure a firm’s liquidity. The quick ratio measures the relationship of a firm’s current assets to its current liabilities, while the current ratio subtracts inventory from other current assets. a. True b. False 3. Other things held constant, a decrease in sales and a simultaneous decrease in financial leverage must result in a higher profit margin. a. True b. False 4. The inventory turnover ratio is a ratio used to assess how effectively a firm is managing its assets, but days’ sales outstanding (DSO) is not. a. True b. False 5. An increase in a firm’s inventory turnover ratio suggests that it is managing its inventory less efficiently and that its liquidity position is deteriorating; that is, it is becoming less liquid. a. True b. False 6. Trends indicate whether a firm’s financial condition is likely to improve or to deteriorate. A trend analysis can be done simply by plotting a ratio over time. a. True b. False 7. To take full advantage of the credit term provided, management should try to lengthen the average payables period with cautions. a. True b. False 8. Profitability is the net result of a number of policies and decisions, which can be reflected by profitability ratios. a. True b. False 9. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, and the sales. With this information, the firm can calculate the amount of operating costs required to achieve its target TIE ratio. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 10. If a firm uses financial leverage and earns more on investments financed with borrowed funds than it pays in interest, then its shareholders’ returns are “leveraged,” but their risks are also magnified. a. True b. False 11. The inventory turnover ratio and the current ratio are related. The combination of a low current ratio and a high 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 12. The basic earning power ratio (BEP) is unsuitable for comparing firms with different tax situations and different degrees of financial leverage since it will be influenced by financial leverage and tax effects. a. True b. False 13. Assume inflation is prevalent. If we compare Company A, which chooses to show PPE at net book value, with Company B, which shows PPE at fair value, we will probably find that Company A has a higher fixed assets turnover ratio. a. True b. False 14. An example of seasonal factors influencing ratio analysis is that the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus just after the close of the canning season. a. True b. False 15. Market value ratios are a way to measure the value of a company’s stock relative to that of another company. a. True b. False 16. One problem with ratio analysis is that relationships can be manipulated. For example, if the current ratio is 1.8, then using some cash to pay off some current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True b. False 17. Creditors count on the owner supplied funds to provide a margin of safety, so the higher the proportion of funding supplied by shareholders, the higher the risk creditors face. a. True b. False

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Chap 03_4ce 18. It is particularly useful to use average inventory in calculating inventory turnover if the firm’s business is highly seasonal, or if there has been a strong upward or downward sales trend during the year. a. True b. False 19. Although the ROA measures the firm’s effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT may have different ROAs. a. True b. False 20. The average payables period (APP) tells the average length of time that the firm takes to pay suppliers. a. True b. False 21. Different accounting practices, such as different methods of inventory valuation, can affect financial statements and thus distort comparisons between businesses. a. True b. False 22. Since a full liquidity analysis requires the use of a cash budget, the current and quick ratios cannot measure a firm’s liquidity position quickly. a. True b. False 23. 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, firms that have high asset turnover ratios will tend to have low profit margins, and firms with low asset turnover ratios will tend to have high profit margins. a. True b. False 24. If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decrease. a. True b. False 25. 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, A’s current ratio might be less than that of B. a. True b. False 26. One problem with ratio analysis is that relationships can be manipulated. For example, if the current ratio is 0.8, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to decrease. a. True b. False

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Chap 03_4ce 27. The basic earning power ratio (BEP) reflects the earning power of the firm’s assets inclusive of the effects of leverage and taxes. Therefore, this ratio measures the net earning power of the firm reflecting the magnitude of the leverage employed. a. True b. False 28. Firms A and B have the same current ratio, 0.83; the same sales, $1,000,000; and the same current liabilities, $600,000. However, Firm B has less inventories than A. Therefore, we can conclude that B’s quick ratio must be smaller than A’s. a. True b. False 29. The times-interest-earned ratio is the only measure of a firm’s ability to meet its long-term and short-term debt obligations. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

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Chap 03_4ce

Scenario: 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 debt Common shares Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr’n Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Interest rate on notes payable & L-T bonds Federal plus provincial income tax rate Year-end stock price

2020 $2,305.0 8,950.0 16,200.0 27,455.0 21,545.0 $49,000.0 $8,100.0 6,700.0 5,300.0 20,100.0 10,900.0 31,000.0 7,370.0 10,630.0 18,000.0 $49,000.0 2020 $69,500.0 62,850.0 1,250.0 5,400.0 1,232.0 4,168.0 1375.4 $2,792.6 200 $730 7% 33% $88.50

30. Refer to Scenario: Pettijohn Inc. What is the firm’s current ratio? a. 1.37 b. 1.45 c. 1.60 d. 1.82 Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce

31. LeCompte Corp. has $406,000 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $750,000, and its net income after taxes was $30,200. Shareholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 18%. What profit margin would LeCompte need in order to achieve the 18% ROE, holding everything else constant? a. 9.52% b. 9.60% c. 9.74% d. 9.88% 32. Last year, Rosenberg Corp. had $247,000 of assets, $21,580 of net income, and a debt-to-total-assets ratio of 38%. Now suppose the new CFO convinces the president to increase the debt ratio to 52%. Sales and total assets will not be affected, but interest expense 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. 4.05% b. 4.11% c. 4.29% d. 4.30% 33. Amram Company’s current ratio is 2.4. Considered alone, which action would reduce the company’s current ratio? a. use cash to reduce accruals b. use cash to reduce accounts payable c. borrow using short-term notes payable and use the proceeds to reduce accrued taxes d. borrow using short-term notes payable and use the proceeds to purchase new equipment 34. Companies X and Y each reported the same earnings per share (EPS), but Company X’s stock trades at a lower price. Which of the following statements is correct? a. Company X must have a lower market-to-book ratio than Company Y. b. Company X trades at a lower P/E ratio than Company Y. c. Company X probably has more growth opportunities than Company Y. d. Company X is probably judged by investors to be safer than Company Y. 35. Which of the following statements is correct? a. If a firm sold some inventory on credit, there is no reason to think that either its current or quick ratio would change. b. If a firm sold some inventory for cash and left the proceeds in its bank account, its current ratio would probably not change much, but its quick ratio would decrease. c. The inventory turnover ratio and days’ sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets. d. If a firm sold some inventory on credit, its current ratio would probably not change much but its quick ratio would decrease.

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Chap 03_4ce 36. Refer to Scenario: Pettijohn Inc. What is the firm’s debt ratio? a. 61.85% b. 63.27% c. 66.30% d. 68.00% 37. Refer to Scenario: Pettijohn Inc. What is the firm’s inventory turnover ratio, using sales because cost of goods sold is unknown? a. 3.85 b. 4.12 c. 4.29 d. 4.50 38. Which of the following statements is correct? a. If a firm has the highest price/cash flow ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should be displeased with the performance. b. Other things held constant, the lower a firm’s expected future growth rate, the higher its price/cash flow ratio is likely to be. c. 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 be pleased with the performance. d. Other things held constant, the lower a firm’s expected future growth rate, the higher its P/E ratio is likely to be.

39. Which of the following statements is correct? a. If two firms have the same ROA, the firm with less debt can be expected to have the higher ROE. b. An increase in the DSO, other things held constant, could be expected to decrease the total assets turnover ratio. c. An increase in the DSO, other things held constant, could be expected to increase the ROE. d. An increase in a firm’s debt ratio, with no changes in its sales or operating costs, could be expected to increase the profit margin.

40. Which statement about comparative ratios is correct? a. Comparative ratios are available from a number of sources, and the ratios presented by different sources have the same definitions. b. In a ratio analysis, we only need to compare a company’s ratios with those of other firms in the same industry; that is, with industry average figures. c. The technique of comparing a company’s ratios with industry average figures is called benchmarking. d. In a ratio analysis, many companies also benchmark various parts of their overall operations against top companies, whether they are in the same industry or not.

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Chap 03_4ce 41. Refer to Scenario: Pettijohn Inc. What is the firm’s book value per share? a. $84.92 b. $87.50 c. $90.00 d. $93.00 42. Vang Corp.’s stock price at the end of last year was $52.80 and its earnings per share for the year was $3.25.

What was its P/E ratio? a. 13.92 b. 14.64 c. 15.70 d. 16.25 43. Harper Corp.’s sales last year were $502,000, and its year-end receivables were $65,000. Harper sells on terms that call for customers to pay 33 days after the purchase, but many delay payment beyond Day 33. On average, how many days late do customers pay? Base your answer on this equation: DSO – Allowed credit period = Average 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. 13.63 b. 14.26 c. 15.70 d. 16.09 44. Ziebart Corp.’s EBITDA last year was $470,000 (EBIT + depreciation + amortization), its interest charges were $11,500, it had to repay $30,000 of long-term debt, and it had to make a payment of $20,300 under a longterm lease. The firm had no amortization charges. What was the EBITDA coverage ratio? a. 7.61 b. 7.75 c. 7.80 d. 7.93 45. Which of the following is an example of window dressing? a. using some of the firm’s cash to reduce long-term debt b. offering early shipment 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 c. borrowing on a 3-year basis in late December and holding the proceeds of the loan as cash d. borrowing by using short-term notes payable and then using the proceeds to retire long-term debt

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Chap 03_4ce 46. Aziz Industries has sales of $200,000 and accounts receivable of $21,000, and it gives its customers 30 days to pay. The industry average DSO is 30 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 9% on any cash freed up by this change, how would that affect its net income, assuming other things are held constant? a. $392.60 b. $405.03 c. $410.55 d. $429.00 47. Last year, Central Chemicals had sales of $315,000, assets of $183,000, a profit margin of 6.1%, and an equity multiplier of 1.4. The CFO believes that the company could reduce its assets by $32,000 without affecting either sales or costs. Had it reduced its assets in this amount, and had the debt ratio, sales, and costs remained constant, by how much would the ROE have changed? a. 2.50% b. 2.85% c. 3.08% d. 3.16% 48. Nikko Corp.’s total common equity at the end of last year was $702,000, and its net income after taxes was $150,000. What was its ROE? a. 21.37% b. 22.04% c. 23.80% d. 24.45% 49. Bonner Corp.’s sales last year were $530,000, and its year-end total assets were $403,000. The average firm in the industry has a total assets turnover ratio (TATO) of 3.1. 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. $221,420 b. $232,032 c. $245,330 d. $260,080 50. Which of the following would generally indicate a deterioration in a company’s financial position, other things held constant? a. the EBITDA coverage ratio increases b. the TIE ratio decreases c. the current ratio increases d. the total assets turnover ratio increases

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Chap 03_4ce 51. Pace Corp.’s assets are $730,000, and its total debt outstanding is $202,000. The new CFO wants to employ a debt ratio of 60%. How much debt must the company add, without changing total assets, to achieve the target debt ratio? a. $217,082 b. $225,311 c. $236,000 d. $240,050 52. Orono Corp.’s sales last year were $680,000, its operating costs were $417,500, and its interest charges were $30,700. What was the firm’s times-interest-earned (TIE) ratio? a. 7.36 b. 8.55 c. 9.51 d. 10.02 53. Crindle Canada’s stock price at the end of last year was $280.60, and its book value per share was $109.37.

What was its market/book ratio? a. 2.57 b. 2.78 c. 3.00 d. 3.45 54. Refer to Scenario: Pettijohn Inc. What is the firm’s equity multiplier? a. 2.14 b. 2.50 c. 2.72 d. 2.93 55. Last year Altman Corp. had $318,000 of assets, $421,000 of sales, $29,810 of net income, and a debt-to-totalassets ratio of 45%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $203,000. Sales, costs, and net income would not be affected, and the firm would maintain the 45% debt ratio. By how much would the reduction in assets improve the ROE? a. 9.66% b. 10.15% c. 10.42% d. 10.70% 56. Canada Corp. recently reported total assets of $230,000 and total common equity of $82,000 on its balance sheet. If the firm’s P/E ratio is 17, what is the firm’s equity multiplier? a. 2.80 b. 2.95 c. 3.20 d. 3.69

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Chap 03_4ce 57. Refer to Scenario: Pettijohn Inc. What is the firm’s TIE ratio? a. 4.25 b. 4.38 c. 4.50 d. 4.71 58. Walter Industries’ current ratio is 0.9. Considered alone, which of the following actions would increase the company’s current ratio? a. Use cash to purchase inventories. b. Borrow using short-term notes payable and use the cash to purchase marketable securities. c. Use cash to reduce accrued taxes. d. Use cash to reduce long-term bonds outstanding.

59. Refer to Scenario: Pettijohn Inc. What is the firm’s dividends per share? a. $3.20 b. $3.65 c. $3.80 d. $4.15 60. Other things held constant, which of the following alternatives would increase a company’s cash flow for the current year? a. Pay down short-term notes payable. b. Pay suppliers more frequently to decrease the accounts payable. c. Increase the inventory turnover ratio without affecting sales or operating costs. d. Increase the number of years over which fixed assets are depreciated for tax purposes.

61. Chambliss Corp.’s total assets at the end of last year were $540,000 and its EBIT was $130,200. What was its basic earning power (BEP)? a. 22.06% b. 23.50% c. 24.11% d. 25.20% 62. Arshadi Corp.’s sales last year were $67,000, and its total assets were $31,000. What was Arshadi’s total assets turnover ratio (TATO)? a. 2.16 b. 2.25 c. 2.30 d. 2.49

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Chap 03_4ce 63. Stewart Inc.’s latest EPS was $4.20, its book value per share was $28.34, it had 355,000 shares outstanding, and its debt ratio was 51%. How much debt was outstanding? a. $10,232,960 b. $10,385,004 c. $10,471,341 d. $10,620,715 64. Which of the following is correct regarding Canadian household debt? a. Average overall Canadian household debt has varied between 34% and 50% of assets over the past 30 years. b. A Canadian household’s debt-to-assets level has no relationship with the likelihood of financial distress. c. Statistics Canada inferred that the household debt-to-assets ratio may be a better predictor of financial distress than the more commonly used debt-to-income measure. d. Average overall Canadian household debt has kept increasing since 2017.

65. You observe that a firm’s ROE is below the industry average, but its profit margin and debt ratio are both above the industry average. Which of the following statements is correct? a. Its total assets turnover must be above the industry average. b. Its TIE ratio must be above the industry average. c. Its return on assets must equal the industry average. d. Its total assets turnover must be below the industry average.

66. Last year, Swensen Corp. had sales of $421,800, operating costs of $302,300, and year-end assets of $256,000.

The debt-to-total-assets ratio was 30%, the interest rate on the debt was 9%, and the firm’s tax rate was 35%.

The new CFO wants to see how the ROE would have been affected if the firm had used a 48% 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 ROE change in response to the change in the capital structure? a. 11.65% b. 12.11% c. 13.50% d. 14.02% 67. Companies HD and LD have the same tax rate, total sales, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a lower debt ratio and, therefore, a lower interest expense. 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 lower ROA than Company LD. c. Company HD pays less in taxes than Company LD. d. Company HD has a higher equity multiplier than Company LD.

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Chap 03_4ce 68. What does ratio analysis involve? a. analyzing the statement of cash flows in order to appraise a firm’s cash flow position and strength b. analyzing financial statements in order to appraise a firm’s stock market position and strength c. analyzing financial statements in order to appraise a firm’s financial position and strength d. analyzing the statement of cash flows in order to appraise the free cash flow (FCF) and return on invested capital (ROIC) 69. Canada Corp.’s market price is currently $43 per share. If the firm reported net earnings of $8,000,000 on total outstanding common shares of 2.5 million, what is the firm’s P/E ratio? a. 12.87 b. 13.44 c. 14.20 d. 15.00 70. Muscarella Inc. has the following balance sheet and income statement data: Cash $ 15,000 Accounts payable Receivables 80,000 Other current liabilities Inventories 230,000 Total CL Total CA 325,000 Long-term debt Net fixed assets 155,000 Common equity Total assets $480,000 Total liab. and equity Sales $310,000 Net income $26,000

$ 48,000 32,000 80,000 90,000 310,000 $480,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.8, 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 shares at book value, by how much would the ROE change? a. 3.51% b. 3.80% c. 4.05% d. 4.29% 71. Casey Communications recently issued new common shares and used the proceeds to pay off some of its accounts payable. This action had no effect on the company’s total assets or operating income. What would occur as a result of this action? a. The company’s current ratio would decrease. b. The company’s quick ratio would increase. c. The company’s equity multiplier would increase. d. The company’s debt ratio would increase.

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Chap 03_4ce 72. Which of the following statements is correct? a. Sound financial analysis involves just calculating and comparing ratios; that is, considering quantitative factors. b. Reliance on single customers, products, or suppliers would decrease a firm’s risk. c. Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability. d. The legal and regulatory environments should not be considered when evaluating a company’s likely future financial performance.

73. HD Corp. and LD Corp. have identical total assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD has less debt than LD. Which of the following statements is correct? a. HD would have the higher equity multiplier for use in the DuPont equation. b. HD would have less taxable income c. HD would have the lower net profit margin as shown on the income statement. d. HD would have the higher net profit margin as shown on the income statement.

74. Refer to Scenario: Pettijohn Inc. What is the firm’s EPS? a. $13.96 b. $14.80 c. $15.07 d. $16.20 75. Which statement regarding the Du Pont analysis is correct? a. Suppose a firm’s total assets turnover ratio falls from 1.5 to 1.2, but at the same time its profit margin rises from 8% to 11% and its debt increases from 50% of total assets to 70%. Without additional information, we cannot tell what will happen to the ROE. b. Suppose a firm’s total assets turnover ratio falls from 1.5 to 1.2, but at the same time its profit margin rises from 8% to 11% and its debt increases from 50% of total assets to 70%. Under these conditions, the ROE will increase. c. Suppose a firm’s total assets turnover ratio falls from 1.5 to 1.2, but at the same time its profit margin rises from 8% to 11% and its debt increases from 50% of total assets to 70%. Under these conditions, the ROE will decrease. 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. 76. Which of the following statements is correct? a. If Firm X’s P/E ratio is higher than that of Firm Y, then X’s market-to-book ratio is also higher than that of Y. b. If Firm X’s P/E ratio is less than that of Firm Y, then X is likely to be less risky and also to be expected to grow at a faster rate. c. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market/book ratios must also be the same. d. 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.

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Chap 03_4ce 77. Refer to Scenario: Pettijohn Inc. What is the firm’s cash flow per share? a. $17.50 b. $19.45 c. $20.21 d. $22.30 78. Beranek Corp. has $520,000 of assets, and it uses no debt—it is financed only with common equity. The new CFO wants to employ enough debt to bring the debt/assets ratio to 55%, using the proceeds from the borrowing to buy back common shares at book value. How much must the firm borrow to achieve the target debt ratio? a. $255,460 b. $264,801 c. $270,317 d. $286,000 79. Last year, Mason Inc. had a total assets turnover of 1.82 and an equity multiplier of 1.94. Its sales were $263,000 and its net income was $17,335. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $6,890 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. 8.73% b. 9.00% c. 9.25% d. 9.45% 80. Which of the following statements is correct? a. If two firms have identical ROA and assets, the firm with a higher debt ratio will have a lower ROE than the firm with a lower debt ratio. b. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with more debt will generally have the lower expected ROA. c. A firm with lower financial leverage will have a lower equity multiplier than an otherwise identical firm with a higher financial leverage. 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 more debt will generally have the lower expected ROE. 81. A firm wants to strengthen its financial position. Which action would increase its current ratio? a. Issue new shares and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. b. Borrow using short-term debt and use the proceeds to repurchase the company’s common shares. c. Use existing cash to repurchase some of the company’s own shares. d. Use existing cash to acquire fixed assets.

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Chap 03_4ce

Scenario: 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 debt Common shares Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr’n Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Interest rate on notes payable & L-T bonds Federal plus provincial income tax rate Year-end stock price

2020 $2,305.0 8,950.0 16,200.0 27,455.0 21,545.0 $49,000.0 $8,100.0 6,700.0 5,300.0 20,100.0 10,900.0 31,000.0 7,370.0 10,630.0 18,000.0 $49,000.0 2020 $69,500.0 62,850.0 1,250.0 5,400.0 1,232.0 4,168.0 1375.4 $2,792.6 200 $730 7% 33% $88.50

82. Refer to Scenario: Pettijohn Inc. What is the firm’s total assets turnover? a. 1.74 b. 1.20 c. 1.35 d. 1.42 Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 83. Which of the following would indicate an improvement in a company’s financial position, other things held constant? a. the basic earning power ratio increases b. the EBITDA coverage ratio decreases c. the inventory turnover ratio and the total assets turnover ratio both decrease d. the current and quick ratios both decrease 84. Refer to Scenario: Pettijohn Inc. What is the firm’s ROA? a. 5.36% b. 5.50% c. 5.70% d. 5.92% 85. A firm wants to strengthen its financial position. Which action would increase its quick ratio? a. issue new common shares and use the proceeds to purchase new equipment b. offer price reductions and enable the firm to sell some of its excess inventory c. collect part of accounts receivable and use the cash generated to establish a plant d. sell some marketable securities and use the cash to purchase inventory 86. Northwest Lumber had a profit margin of 6.8%, a total assets turnover of 1.6, and an equity multiplier of 2.3.

What was the firm’s ROE? a. 25.02% b. 26.34% c. 27.00% d. 28.65% 87. Heaton Corp. sells on terms that allow customers 50 days to pay for merchandise. Its sales last year were $510,000, and its year-end receivables were $90,000. If its DSO is less than the 50-day credit period, then customers are paying on time. Otherwise, they are paying late. On average, by how much are customers paying early or late? Base your answer on this equation: DSO – Allowed credit period = Average 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. 14.41 b. 15.26 c. 16.05 d. 17.30 88. Last year, Vaughn Corp. had sales of $462,000 and a net income of $20,540, and its year-end assets were $331,000. The firm’s total-debt-to-total-assets ratio was 46.0%. Based on the DuPont equation, what was Vaughn’s ROE? a. 10.05% b. 11.53% c. 12.65% d. 13.78% Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 89. Refer to Scenario: Pettijohn Inc. What is the firm’s BEP? a. 11.02% b. 11.47% c. 11.60% d. 11.90% 90. Last year, Urbana Corp. had $210,600 of assets, $448,000 of sales, $28,630 of net income, and a debt-to-totalassets ratio of 42%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $49,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE? a. 16.68% b. 17.30% c. 18.72% d. 19.11% 91. Which statement about accounts receivable is correct? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding (DSO) will decrease. b. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding (DSO) will increase. c. If a firm increases its accounts receivable while holding its sales constant, then, other things held constant, its days’ sales outstanding (DSO) will decrease. d. If a firm’s days’ sales outstanding (DSO) was higher than the industry average and kept increasing, this would be interpreted as a positive sign and the firm would collect the receivables easily.

92. Lindley Corp.’s stock price at the end of last year was $48.71, and its book value per share was $40.50. What was its market/book ratio? a. 1.56 b. 1.40 c. 1.31 d. 1.20 93. Companies HD and LD are both profitable, and they have the same total assets (TA), total fixed assets (FA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has the lower debt ratio.

Which of the following statements is correct? a. Company HD has a lower ROE than Company LD. b. Company HD has a higher equity multiplier than Company LD. c. Company HD has a lower fixed assets turnover than Company LD. d. Company HD has a higher total assets turnover than Company LD.

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Chap 03_4ce 94. Refer to Scenario: Pettijohn Inc. What is the firm’s profit margin? a. 3.80% b. 4.02% c. 4.50% d. 4.79% 95. Safeco’s current assets total $30 million, versus $15 million of current liabilities, while Risco’s current assets are $20 million, versus $40 million of current liabilities. Both firms would like to “window dress” their end-of-year financial statements, and to do so they tentatively plan to borrow $20 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which statement below best describes the results of these transactions? a. The transactions would increase both firms’ financial strength as measured by their current ratios. b. The transactions would decrease both firms’ financial strength as measured by their current ratios. c. The transactions would increase Safeco’s financial strength as measured by its current ratio but decrease Risco’s current ratio. d. The transactions would decrease Safeco’s financial strength as measured by its current ratio but increase Risco’s current ratio.

96. ABC Inc. has a 65-day average payables period. The account payables are $2,960.60 at the beginning and $3,850.40 at the end of the year. What is the annual cost of goods sold? Use a 365-day year when calculating the APP. a. $16,810 b. $17,322 c. $18,190 d. $19,123

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Chap 03_4ce

Scenario: 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 debt Common shares Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr’n Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Interest rate on notes payable & L-T bonds Federal plus provincial income tax rate Year-end stock price

2020 $2,305.0 8,950.0 16,200.0 27,455.0 21,545.0 $49,000.0 $8,100.0 6,700.0 5,300.0 20,100.0 10,900.0 31,000.0 7,370.0 10,630.0 18,000.0 $49,000.0 2020 $69,500.0 62,850.0 1,250.0 5,400.0 1,232.0 4,168.0 1375.4 $2,792.6 200 $730 7% 33% $88.50

97. Refer to Scenario: Pettijohn Inc. What is the firm’s quick ratio? a. 0.25 b. 0.30 c. 0.42 d. 0.56 Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 98. Which of the following statements is correct? a. If one firm has a lower debt ratio than another, we can be certain that the firm with the lower debt ratio will have the higher TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. b. A firm’s debt ratio will not influence its profit margin and times-interest-earned ratio. c. 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 lower debt ratio, the firm that uses less debt will have a higher 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 lower debt ratio, the firm that uses less debt will have a lower profit margin on sales.

99. If a bank loan officer were considering a company’s request for a loan, which of the following statements is correct? a. Other things held constant, the higher the quick ratio, the higher the interest rate the bank would charge the firm. b. Other things held constant, the higher the company’s TIE ratio, the higher the interest rate the bank would charge the firm. c. Other things held constant, the higher the current ratio, the higher the interest rate the bank would charge the firm. d. Other things held constant, the higher the debt ratio, the higher the interest rate the bank would charge the firm.

100. Refer to Scenario: Pettijohn Inc. What is the firm’s ROE? a. 12.01% b. 13.25% c. 14.90% d. 15.51% 101. Rappaport Corp.’s sales last year were $490,000, and its net income after taxes was $38,000. What was its profit margin on sales? a. 7.49% b. 7.60% c. 7.76% d. 7.83% 102. Companies HD and LD have the same total sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a lower debt ratio and, therefore, a lower interest expense. Which of the following statements is correct? a. Company HD has a higher equity multiplier than Company LD. b. Company HD pays more in taxes than Company LD. c. Company HD has a lower ROA than Company LD. d. Company HD has less net income than Company LD. Scenario: Pettijohn Inc. Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 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 debt Common shares Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr’n Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Interest rate on notes payable & L-T bonds Federal plus provincial income tax rate Year-end stock price

2020 $2,305.0 8,950.0 16,200.0 27,455.0 21,545.0 $49,000.0 $8,100.0 6,700.0 5,300.0 20,100.0 10,900.0 31,000.0 7,370.0 10,630.0 18,000.0 $49,000.0 2020 $69,500.0 62,850.0 1,250.0 5,400.0 1,232.0 4,168.0 1375.4 $2,792.6 200 $730 7% 33% $88.50

103. Refer to Scenario: Pettijohn Inc. What is the firm’s days sales outstanding? Assume a 360-day year for this calculation. a. 46.36 b. 47.28 c. 48.05 d. 49.00

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Chap 03_4ce 104. Helmuth Inc.’s latest net income was $2,840,000, and it had 260,000 shares outstanding. The company wants to pay out 50% of its income. What dividend per share should it declare? a. $5.20 b. $5.46 c. $5.78 d. $5.90 105. Taggart Technologies is considering issuing common shares and using the proceeds to reduce its outstanding debt. The share issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate.

What is likely to occur if the company proceeds with the share issue? a. The debt ratio will increase. b. The times-interest-earned ratio will decrease. c. The ROA will increase. d. The basic earning power ratio will decrease.

106. A new firm is developing its business plan. It will require $680,000 of assets, and it projects $551,300 of sales and $402,100 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 8.1%, but the bank requires it to have a TIE ratio of at least 4.6, and if the TIE ratio falls below this level the bank will call in the loan and the firm will go bankrupt. What is the maximum debt 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. 56.31% b. 57.60% c. 58.89% d. 59.02% 107. Considered alone, an increase in which of the following would decrease a company’s current ratio? a. accounts receivable b. inventories c. accounts payable d. short-term investments 108. Refer to Scenario: Pettijohn Inc. What is the firm’s market-to-book ratio? a. 0.70 b. 0.98 c. 1.06 d. 1.35

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Chap 03_4ce 109. Which of the following statements is correct? a. The D/E ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. b. EBIT can represent all the cash flow available to service debt, especially if a firm has high depreciation and/or amortization charges. So, the TIE ratio is very useful. c. The TIE ratio takes all of the “cash” earnings into account in the numerator and the financial charges in the denominator. d. The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate–backed loans) for longer than about 5 years.

110. Refer to Scenario: Pettijohn Inc. What is the firm’s EBITDA coverage ratio? a. 5.40 b. 5.68 c. 5.74 d. 5.82 111. Calgary Corp. recently reported total assets of $27,000 and total common equity of $11,000 on its balance sheet.

If the firm’s current stock price is $42 per share, what is the firm’s equity multiplier? a. 1.55 b. 1.83 c. 2.10 d. 2.45 112. Branch Corp.’s total assets at the end of last year were $525,000 and its net income after taxes was $45,000.

What was its return on total assets? a. 8.22% b. 8.36% c. 8.40% d. 8.57% 113. Which statement about inventories is correct? a. A reduction in inventories held would increase the current ratio. b. An increase in accounts payable would increase the current ratio. c. An increase in accrued taxes would increase the current ratio. d. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.

114. If the CEO of a large, diversified firm were filling out an evaluation report on a division manager (i.e., grading the manager), which of the following situations would likely result in the manager receiving a better grade? In all cases, assume that other things are held constant. a. The division’s DSO is 50, whereas the average for its competitors is 40. b. The division’s inventory turnover ratio is below the average for other firms in its industry. c. The division’s times-interest-earned ratio is above the average for other firms in its industry. d. The division’s inventory turnover is 4, whereas the average for its competitors is 9.

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Chap 03_4ce 115. An investor is considering starting a new business. The company would require $608,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if they think the firm can provide a 16.2% return on the invested capital, which means that the firm must have an ROE of 16.2%. How much net income must be expected to warrant starting the business? a. $98,245 b. $98,496 c. $98,503 d. $98,600 116. Refer to Scenario: Pettijohn Inc. What is the firm’s P/E ratio? a. 5.50 b. 5.73 c. 6.10 d. 6.34 117. Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $386,000, operating costs to be $291,000, assets to be $300,000, and its tax rate to be 33%. Under Plan A it would use 30% debt and 70% common equity. The interest rate on the debt would be 9%, but the TIE ratio would have to be kept at 5 or more. Under Plan B the maximum debt that met the TIE ratio 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. 27.40% b. 28.62% c. 29.55% d. 30.05% 118. A firm’s new president wants to strengthen the company’s financial position. Which action would make it financially stronger? a. increase inventories while holding sales constant b. decrease EBIT while holding sales constant c. issue common shares while holding sales constant d. decrease accounts receivable while holding sales constant

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Chap 03_4ce Answer Key 1. True 2. False 3. True 4. False 5. False 6. True 7. True 8. True 9. True 10. True 11. False 12. False 13. True 14. True 15. True 16. True 17. False 18. True 19. True 20. True 21. True 22. False 23. True 24. False 25. True 26. False

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Chap 03_4ce 27. False 28. False 29. False 30. a 31. c 32. b 33. d 34. b 35. c 36. b 37. c 38. c 39. b 40. d 41. c 42. d 43. b 44. d 45. c 46. c 47. d 48. a 49. b 50. b 51. c 52. b 53. a 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 55. a 56. a 57. b 58. b 59. b 60. c 61. c 62. a 63. c 64. c 65. d 66. b 67. a 68. c 69. b 70. c 71. b 72. c 73. d 74. a 75. b 76. d 77. c 78. d 79. c 80. c 81. a 82. d Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 83. a 84. c 85. b 86. a 87. a 88. b 89. a 90. a 91. a 92. d 93. a 94. b 95. d 96. d 97. d 98. c 99. d 100. d 101. c 102. b 103. a 104. b 105. c 106. c 107. c 108. b 109. d 110. a Copyright Cengage Learning. Powered by Cognero.

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Chap 03_4ce 111. d 112. c 113. d 114. c 115. b 116. d 117. c 118. d

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Chap 04_4ce Indicate whether the statement is true or false.

1. As a result of compounding, the effective annual rate on a bank deposit (or loan) may be less than the nominal rate on the deposit (or loan). a. True b. False 2. 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 3. If we are given a periodic interest rate, say a quarterly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year. a. True b. False 4. Suppose an investor plans to invest a given sum of money. She can earn an effective annual rate of 8% on Security A, while Security B will provide an effective annual rate of 15%. Within 13 years’ time, the compounded value of Security B will be more than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.) a. True b. False 5. Midway through the life of an amortized loan, the percentage of the payment that represents interest is equal to the percentage that represents principal repayment. This is true regardless of the original life of the loan. a. True b. False 6. Disregarding risk, if money has time value, the future value of a given sum is always less than its present value. a. True b. False 7. When inputting information into a financial calculator, all cash flow components can be positive although the calculator is set up to solve an equation equal to zero. a. True b. False 8. 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 interest. a. True b. False 9. If a bank compounds savings accounts monthly, the effective annual rate will exceed the nominal rate. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 10. 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 11. Calculating present value and future value using compound interest will result in a larger PV and FV than the same calculation using simple interest. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

12. Which statement best describes annuities? a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. b. If a series of equal cash flows occurs at unequal intervals, then the series is by definition an annuity. c. The cash flows for an annuity must all be equal, and they must occur at fixed intervals, such as once a year or once a quarter. d. Part of the cash flows for an annuity due can occur at the end of each period.

13. After graduation, you plan to work for Dynamo Corporation for 14 years and then start your own business. You expect to save and deposit $7,000 a year for the first 7 years and $14,000 annually for the following 7 years, with the first deposit being made a year from today. In addition, your grandfather just gave you a $28,000 graduation gift, which you will deposit immediately. If the account earns 8%, compounded annually, how much will you have when you start your business 14 years from now? a. $308,154 b. $314,205 c. $326,907 d. $339,061 14. What is the present value of the following cash flow stream if the interest rate is 7% per year: 0 at Time 0; $1,300 at the end of Year 1; and $2,500 at the end of Years 2, 3, and 4? a. $7,047.81 b. $7,186.16 c. $7,200.46 d. $7,346.53 15. You own an oil well that will pay you $35,000 per year for 9 years, with the first payment being made today. If you think a fair return on the well is 8.8%, how much should you ask for if you decide to sell it? a. $229,893 b. $230,167 c. $224,250 d. $235,463

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Chap 04_4ce 16. Which of the following statements is correct regarding interest rates? a. The nominal rate is the rate that is generally shown on time lines and used in calculations. b. The effective annual rate does take the compounding period into account. c. The annual percentage rate should be used to compare the effective cost or rate of return on loans or investments when payment periods differ. d. The effective annual rate is the nominal annual interest rate actually charged on loans.

17. You want to accumulate $2,700,000 in your RRSP by your retirement date, which is 30 years from now. You will make 30 deposits into your plan, with the first deposit occurring today. The plan’s rate of return typically averages 10%. You expect to increase each deposit by 3% as your income grows with inflation. (That is, your second deposit will be 3% greater than your first, the third will be 3% greater than the second, etc.) How much must your first deposit at t = 0 be to enable you to meet your goal? a. $8,643.25 b. $9,871.53 c. $10,645.58 d. $11,437.66 18. You plan to borrow $80,000 at a 6.5% annual interest rate. The terms require you to amortize the loan with 12 equal end-of-year payments. How much interest would you be paying in Year 2? a. $4,895.19 b. $4,900.65 c. $5,037.04 d. $5,104.52 19. Suppose you inherited $355,000 and invested it at 8.9% per year. How much could you withdraw at the beginning of each of the next 25 years? a. $29,598.64 b. $30,788.01 c. $31,040.07 d. $32,919.01 20. Which of the following is true regarding the present value of a loan? a. The present value of a loan will equal the future value of all payments compounded at the effective loan rate. b. The present value of a loan will be greater than its expected future value at the end of the loan term. c. The present value of a loan will be greater than the par value of the expected future cash flows, compounded at the prime rate. d. The present value of a loan will equal the amount of borrowed money requested by the borrower.

21. What’s the rate of return you would earn if you paid $1,050 for a perpetuity that pays $95 per year? a. 7.52% b. 8.25% c. 9.05% d. 9.84% Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 22. You are negotiating to make a 7-year loan of $27,000 to Breck Inc. To repay you, Breck will pay $2,600 at the end of Year 1, $6,000 at the end of Year 2, and $8,200 at the end of Year 3, plus a fixed but currently unspecified cash flow, X, at the end of Years 4 through 7. Breck is essentially riskless, so you are confident the payments will be made, and you regard 7.5% as an appropriate rate of return on low-risk 7-year loans. What cash flow must the investment provide at the end of each of the final four years; that is, what is X? a. $4,398.02 b. $4,517.49 c. $4,602.15 d. $4,743.46 23. Which of the following statements regarding a 20-year monthly payment amortized mortgage with a nominal interest rate of 12% is correct? a. The monthly payments will increase over time. b. The amount representing interest in the first payment would be lower if the nominal interest rate were 15% rather than 12%. 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. Exactly 12% of the first monthly payment represents interest.

24. Suppose a bank offers to lend you $10,000 for 1 year on a loan contract that calls for you to make interest payments of $300 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. 10.46% b. 11.37% c. 11.86% d. 12.55% 25. If a bank pays a 5.5% nominal rate, with monthly compounding on deposits, what effective annual rate (EFF%) does the bank pay? a. 5.35% b. 5.64% c. 6.13% d. 6.59% 26. 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: 12.0% with monthly compounding b. Bank 2: 12.0% with annual compounding c. Bank 3: 12.0% with quarterly compounding d. Bank 4: 12.0% with daily (365-day) compounding

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Chap 04_4ce 27. Your uncle has $600,000 invested at 7.6%, and he now wants to retire. He wants to withdraw $58,000 at the beginning of each year, beginning immediately. How many years will it take to exhaust his funds; that is, run the account down to zero? a. 15.38 b. 16.58 c. 17.04 d. 17.91 28. You anticipate that you will need $1,300,000 when you retire 28 years from now. You plan to make 28 deposits, beginning today, in a bank account that will pay 7% interest, compounded annually. You expect to receive annual raises of 3%, so you will increase the amount you deposit each year by 3%. (That is, your second deposit will be 3% greater than your first, the third will be 3% greater than the second, etc.) How much must your first deposit be if you are to meet your goal? a. $11,144.03 b. $11,754.31 c. $12,491.25 d. $12,346.35 29. Merchants Bank offers to lend you $50,000 at a nominal rate of 5.8%, simple interest, with interest paid quarterly. Gold Coast Bank offers to lend you the $50,000, but it will charge 6.5%, 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. 0.48% b. 0.57% c. 0.62% d. 0.79% 30. Which investment will have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same. a. Investment A pays $200 at the beginning of every year for the next 10 years (a total of 10 payments). b. Investment B pays $100 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $100 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,000 at the end of 10 years (a total of only one payment).

31. Which of the following bank accounts has the highest effective annual return? a. an account that pays 9% nominal interest with monthly compounding b. an account that pays 8% nominal interest with daily (365-day) compounding c. an account that pays 9% nominal interest with daily (365-day) compounding d. an account that pays 8% nominal interest with monthly compounding

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Chap 04_4ce 32. Which of the following statements is NOT correct? a. The present value of a 5-year, $100 ordinary annuity will be less than the present value of a 5-year, $100 annuity due. b. If a loan has a nominal annual rate of 12%, then the effective rate can never be less than 12%. c. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be the same. d. An investment that has a nominal rate of 8% with quarterly payments will have an effective rate that is less than 8%.

33. You have a chance to buy an annuity that pays $1,100 at the end of each year for 5 years. You could earn 5.9% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $3,775.77 b. $3,921.86 c. $4,075.64 d. $4,646.23 34. Your bank account pays a 10% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is correct? a. The periodic rate of interest is 2.5% and the effective rate of interest is greater than 10%. b. The periodic rate of interest is 6% and the effective rate of interest is greater than 6%. c. The periodic rate of interest is 2.5% and the effective rate of interest is 10%. d. The periodic rate of interest is 6% and the effective rate of interest is 10%.

35. You just deposited $2,600 in a bank account that pays a 16% nominal interest rate, compounded quarterly. If you also add another $5,500 to the account 1 year (12 months) from now and another $7,200 to the account 2 years from now, how much will be in the account 3 years (12 quarters) from now? a. $20,422.75 b. $20,339.98 c. $20,256.61 d. $20,112.79 36. Your uncle has $465,000 and wants to retire. He expects to live for another 28 years and to be able to earn 8.3% on his invested funds. How much could he withdraw at the end of each of the next 28 years and end up with zero in the account? a. $40,843.38 b. $41,361.46 c. $42,959.43 d. $43,231.66

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Chap 04_4ce 37. You agree to make 36 deposits of $600 at the beginning of each month into a bank account. At the end of the 36th month, you will have $25,000 in your account. If the bank compounds interest monthly, what nominal annual interest rate will you be earning? a. 8.79% b. 8.62% c. 9.40% d. 9.31% 38. East Coast Bank offers to lend you $27,000 at a nominal rate of 8.5%, compounded monthly. The loan (principal plus interest) must be repaid at the end of the year. Midwest Bank also offers to lend you the $27,000, but it will charge an annual rate of 9.3%, with no interest due until the end of the year. What is the difference in the effective annual rates charged by the two banks? a. 0.39% b. 0.46% c. 0.64% d. 0.54% 39. Your child’s orthodontist offers you two alternative payment plans. The first plan requires a $4,600 immediate up-front payment. The second plan requires you to make monthly payments of $126.30, payable at the end of each month for 4 years. What nominal annual interest rate is built into the monthly payment plan? a. 14.26% b. 14.95% c. 15.07% d. 15.33% 40. You plan to make annual deposits into a bank account that pays a 6% nominal annual rate. You think inflation will amount to 2.80% per year. What is the expected annual real rate at which your money will grow? a. 2.98% b. 3.11% c. 3.24% d. 3.68% 41. Suppose you have $1,800 and plan to purchase a 6-year certificate of deposit (CD) that pays 8.5% interest, compounded annually. How much will you have when the CD matures? a. $2,936.64 b. $2,870.61 c. $3,065.14 d. $3,145.34

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Chap 04_4ce 42. Which of the following statements regarding the present value of an annuity is correct? a. All other factors held constant, the present value of a given annual annuity decreases as the number of discounting periods per year decreases. b. All other factors held constant, the future value of a given annual annuity decreases as the number of discounting periods per year increases. c. All other factors held constant, the present value of a given annual annuity increases as the number of discounting periods per year decreases. d. All other factors held constant, the future value of a given annual annuity increases as the number of discounting periods per year decreases.

43. Your sister wants to attend university. She is 14 years old and expects to begin university the year she turns 18.

If university tuition is currently $12,000 annually, and inflation is 3.5%, what is the expected tuition cost of your sister’s first year? a. $12,093 b. $13,770 c. $14,286 d. $15,000 44. A Canada government bond promises to pay a lump sum of $3,000 exactly 5 years from today. The nominal interest rate is 10%, semiannual compounding. Which of the following statements is correct? a. The periodic interest rate is greater than 5%. b. The periodic rate is less than 5%. c. The present value would be smaller if the lump sum were discounted back for fewer periods. d. The present value of the $3,000 would be smaller if interest were compounded quarterly rather than semiannually.

45. What is the present value of $1,800 discounted back 6 years if the appropriate interest rate is 5%, compounded semiannually? a. $1,338.40 b. $1,307.32 c. $1,360.33 d. $1,316.14 46. Your father now has $1,500,000 invested in an account that pays 8.5%. He expects inflation to average 2.8%, and he wants to make annual constant dollar (real) end-of-year withdrawals over each of the next 25 years and end up with a zero balance after the 25th year. How large will his initial withdrawal (and thus constant dollar [real] withdrawals) be? a. $108,621.49 b. $108,527.44 c. $109,392.08 d. $109,657.08

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Chap 04_4ce 47. Suppose the Government of Canada offers to sell you a bond for $850.25. No payments will be made until the bond matures 6 years from now, at which time it will be redeemed for $1,000. What interest rate would you earn if you bought this bond at the offer price? a. 2.57% b. 2.86% c. 2.60% d. 2.74% 48. What’s the future value of $1,300 after 6 years if the appropriate interest rate is 7.2%, compounded monthly? a. $1,999.85 b. $2,023.28 c. $2,104.44 d. $2,230.66 49. What is the PV of an ordinary annuity with 9 payments of $2,900 if the appropriate interest rate is 6.7%? a. $17,641.51 b. $18,517.38 c. $19,439.35 d. $19,137.68 50. Pace Co. borrowed $30,000 at a rate of 8.5%, simple interest, with interest paid at the end of each month. The bank uses a 360-day year. How much interest would Pace have to pay in a 30-day month? a. $206.32 b. $209.49 c. $212.50 d. $214.37 51. How much would $1, growing at 4% per year, be worth after 65 years? a. $12.54 b. $12.80 c. $13.62 d. $13.85 52. Suppose you inherited $288,000 and invested it at 8.6% per year. How much could you withdraw at the end of each of the next 25 years? a. $28,375.42 b. $29,959.08 c. $30,457.03 d. $31,029.88

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Chap 04_4ce 53. You deposit $1,000 today in a savings account that pays 2.5% interest, compounded annually. How much will your account be worth at the end of 40 years? a. $2,545.08 b. $2,685.06 c. $2,681.41 d. $2,705.48 54. Your uncle has $400,000 invested at 8.5%, and he now wants to retire. He wants to withdraw $39,000 at the end of each year, beginning at the end of this year. He also wants to have $32,000 left to give you when he ceases to withdraw funds from the account. For how many years can he make the $39,000 withdrawals and still have $32,000 left in the end? a. 25.96 b. 26.01 c. 26.49 d. 27.32 55. Your sister turned 37 today, and she is planning to save $6,000 per year for retirement, with the first deposit to be made 1 year from today. She will invest in a mutual fund that will provide a return of 9% per year. She plans to retire 28 years from today, when she turns 65, and she expects to live for 23 years after retirement, to age 88. Under these assumptions, how much can she spend in each year after she retires? Her first withdrawal will be made at the end of her first retirement year. a. $57,623 b. $60,408 c. $70,751 d. $75,714 56. An investment costs $725 and is expected to produce cash flows of $83 at the end of Year 1, $120 at the end of Year 2, $92 at the end of Year 3, and $680 at the end of Year 4. What rate of return would you earn if you bought this investment? a. 8.19% b. 9.22% c. 9.75% d. 10.05% 57. A $100,000 loan is to be amortized over 6 years, with annual end-of-year payments. Which of these statements is correct? a. The annual payments would be less if the interest rate were higher. b. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher. c. If the loan were amortized over 8 years rather than 6 years, and if the interest rate were the same in either case, the first payment would include fewer dollars of interest under the 6-year amortization plan. d. The last payment would have a smaller proportion of principal than the first payment.

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Chap 04_4ce 58. Which of the following statements is correct? a. 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 requires a computer or financial calculator. b. If you have an uneven cash flow stream, you can still solve for I using a financial calculator’s TVM registers and pressing the I/YR key. c. If you have a series of cash flows, all of which are 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. d. If CF0 is positive and all the other CFs are negative, then you cannot solve for I. 59. Which of the following statements is NOT correct? a. A time line can be meaningful if all cash flows occur quarterly. b. Time lines can be constructed even in situations where some of the cash flows occur annually but others occur monthly. c. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of periods. d. The cash flows shown on a time line must be in the form of annuity payments, and they cannot be uneven amounts.

60. You want to buy a new sports car 5 years from now, and you plan to save $3,900 per year, beginning immediately. You will make 5 deposits in an account that pays 4.2% interest. Under these assumptions, how much will you have 5 years from today? a. $22,099.00 b. $22,654.24 c. $23,386.95 d. $23,156.30 61. Your uncle has $400,000 invested at 8.5%, and he now wants to retire. He wants to withdraw $43,000 at the beginning of each year, beginning immediately. He also wants to have $32,000 left to give you when he ceases to withdraw funds from the account. For how many years can he make the $43,000 withdrawals and still have $32,000 left in the end? a. 14.72 b. 15.91 c. 16.69 d. 17.43 62. Suppose you borrowed $14,000 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 interest would you have to pay in the first year? a. $1,025.97 b. $1,190.00 c. $1,126.00 d. $1,080.00

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Chap 04_4ce 63. Suppose a Government of Canada bond promises to pay $10,000 10 years from now. If the going interest rate on 10-year government bonds is 6%, how much is the bond worth today? a. $5,583.95 b. $5,603.39 c. $5,543.56 d. $5,685.74 64. Last year Toto Corporation’s sales were $650 million. If sales grow at 4.5% per year, how large (in millions) will they be 7 years later? a. $891.74 million b. $856.05 million c. $884.56 million d. $916.16 million 65. Your aunt is about to retire, and she wants to buy an annuity that will provide her with $72,000 of income a year for 23 years, with the first payment coming immediately. The going rate on such annuities is 5.75%. How much would it cost her to buy the annuity today? a. $859,281.38 b. $878,190.93 c. $919,148.35 d. $958,161.02 66. At a rate of 6.5%, what is the present value of the following cash flow stream: $0 at Time 0; $95 at the end of Year 1; $255 at the end of Year 2; $100 at the end of Year 3; and $150 at the end of Year 4? a. $493.23 b. $496.21 c. $508.04 d. $513.41 67. Steve and Ed are cousins who were both born on the same day. Both turned 26 today. Their grandfather began putting $2,700 per year into a trust fund for Steve on his 20th birthday, and he just made a seventh payment into the fund. The grandfather (or his estate’s trustee) will continue with these $2,700 payments until a 51st and final payment is made on Steve’s 70th birthday. The grandfather set things up this way because he wants Steve to work, not to be a “trust fund baby,” but he also wants to ensure that Steve is provided for in his old age.

Until now, the grandfather has been disappointed with Ed, hence has not given him anything. However, they recently reconciled, and the grandfather decided to make an equivalent provision for Ed. He will make the first payment to a trust for Ed later today, and he has instructed his trustee to make additional equal annual payments each year until Ed turns 70, when the 45th and final payment will be made. If both trusts earn an annual return of 9%, how much must the grandfather put into Ed’s trust today and each subsequent year to enable him to have the same retirement nest egg as Steve after the last payment is made on their 70th birthday? a. $4,026 b. $4,312 c. $4,567 d. $4,713 Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 68. A homeowner just obtained a 25-year amortized mortgage loan for $120,000 at a nominal annual rate of 7%, with 360 end-of-month payments. What percentage of the total payments made during the first 3 months will go toward payment of interest? a. 79.25% b. 80.62% c. 81.90% d. 82.43% 69. Assume that you own an annuity that will pay you $16,000 per year for 14 years, with the first payment being made today. Your uncle offers to give you $130,000 for the annuity. If you sell it, what rate of return would your uncle earn on his investment? a. 7.85% b. 8.21% c. 8.59% d. 9.94% 70. Your company has just taken out a 2-year installment loan for $95,000. The nominal rate is 18%, but with equal end-of-month payments. What percentage of the second monthly payment will go toward the repayment of principal? a. 70.85% b. 71.00% c. 72.15% d. 73.89% 71. You just won the lottery, and you have a choice between receiving $3,600,000 today or a 9-year annuity of $510,000, with the first payment coming 1 year from today. What rate of return is built into the annuity? a. 5.02% b. 5.16% c. 6.43% d. 6.80% 72. An investment costs $1,200 and is expected to produce cash flows of $80 at the end of each of the next 5 years, then an additional lump sum payment of $1,400 at the end of the 5th year. What is the expected rate of return on this investment? a. 8.77% b. 9.43% c. 9.50% d. 9.88%

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Chap 04_4ce 73. An investment promises the following cash flow stream: $800 at Time 0; $2,660 at the end of Year 1; $3,425 at the end of Year 2; and $4,500 at the end of Year 3. At a discount rate of 9%, what is the present value of the cash flow stream? a. $9,616.51 b. $9,333.17 c. $9,597.95 d. $804.26 74. What’s the present value of a perpetuity that pays $300 per year if the appropriate interest rate is 5.5%? a. $4,950.00 b. $5,454.55 c. $5,250.00 d. $5,512.50 75. Your aunt is about to retire, and she wants to buy an annuity that will supplement her income by $66,000 per year for 28 years, beginning a year from today. The going rate on such annuities is 5.75%. How much would it cost her to buy such an annuity today? a. $970,963.15 b. $907,928.68 c. $952,117.17 d. $934,723.02 76. Suppose a Government of Canada bond will pay $3,000 five years from now. If the going interest rate on 5-year Treasury bonds is 6.25%, how much is the bond worth today? a. $2,128.78 b. $2,215.52 c. $2,131.81 d. $2,238.40 77. Which of the following is true regarding the present value of a future sum? a. There is no relationship between present and future value. b. The present value of a future sum remains the same as either the discount rate or the number of periods per year decreases. c. The present value of a future sum increases as either the discount rate or the number of periods per year increases. d. The present value of a future sum increases as either the discount rate or the number of periods per year decreases.

78. What annual payment would you have to receive in order to earn a 7% rate of return on a perpetuity that has a cost of $1,660? a. $116.20 b. $103.75 c. $98.44 d. $109.36 Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 79. Your friend just won the lottery. She has the choice of $16,000,000 today or a 23-year annuity of $1,180,000, with the first payment coming 1 year from today. What rate of return is built into the annuity? a. 3.79% b. 3.18% c. 4.94% d. 4.79% 80. Your subscription to Investing Wisely Weekly is about to expire. You plan to subscribe to the magazine for the rest of your life, and you can renew it by paying $80 annually, beginning immediately, or you can get a lifetime subscription for $820, also payable immediately. Assuming you can earn 6% on your funds and the annual renewal rate will remain constant, how many years must you live to make the lifetime subscription the better buy? Round fractional years up. (Hint: Be sure to remember that you are solving for how many years you must live, not for how many payments must be made.) a. 12 b. 13 c. 14 d. 15 81. Suppose you deposited $3,000 in a bank account that pays 6.25% with daily compounding and a 360-day year.

How much could you withdraw after 6 months, assuming each month has 30 days? a. $2,978.09 b. $2,936.99 c. $3,108.84 d. $3,095.22 82. Your father now has $1,500,000 invested in an account that pays 8%. He expects inflation to average 2.70%, and he wants to make annual constant dollar (real) beginning-of-year withdrawals over each of the next 30 years and end up with a zero balance after the 30th year. How large will his initial withdrawal (and thus constant dollar [real] withdrawals) be? a. $83,525.60 b. $86,301.47 c. $94,494.88 d. $95,220.17 83. How many years would it take $60 to double if it were invested in a bank that pays 3.3% per year? a. 22.26 b. 22.58 c. 21.98 d. 21.35

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Chap 04_4ce 84. You are considering two equally risky annuities, each of which pays $6,000 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. The present value of ORD exceeds the present value of DUE, while the future value of ORD is less than the future value of DUE. b. 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. c. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. d. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. 85. Suppose you are buying your first house for $260,000, and are making a $30,000 down payment. You have arranged to finance the remaining amount with a 35-year, monthly payment, amortized mortgage at a 6.25% nominal interest rate. What will your equal monthly payments be? a. $1,283.84 b. $1,240.88 c. $1,350.28 d. $1,360.98 86. Which of the following statements regarding a 10-year (120-month), $100,000 fixed-rate mortgage is correct?

(Ignore all taxes and transaction costs.) a. The remaining balance after 2 years will be $100,000 less the total amount of interest paid during the first 24 months. b. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. c. The proportion of the monthly payment that goes toward repayment of principal will be lower 6 years from now than it will be the first year. d. The outstanding balance gets paid off at a faster rate in the earlier years of a loan’s life.

87. What is the present value of a 6-year ordinary annuity of $1,950 per year plus an additional $2,700 at the end of Year 6 if the interest rate is 4.75%? a. $10,956.56 b. $12,427.96 c. $11,924.17 d. $12,021.03 88. What is the present value of the following cash flow stream at an interest rate of 11% per year: $0 at Time 0; $1,400 at the end of Year 1; $2,900 at the end of Year 2; $4,600 at the end of Year 3; and $6,100 at the end of Year 4? a. $10,809.64 b. $10,996.71 c. $11,024.34 d. $11,548.55 Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 89. What is the PV of an annuity due with 12 payments of $2,900 at an interest rate of 6.8%? a. $24,864.45 b. $25,705.06 c. $22,790.31 d. $23,929.82 90. You plan to invest in securities that pay 8.5%, compounded annually. If you invest $6,000 today, how many years will it take for your investment account to grow to $10,240.20? a. 5.59 b. 7.10 c. 7.30 d. 6.55 91. At a rate of 7.2%, what is the future value of the following cash flow stream: $0 at Time 0; $80 at the end of Year 1; $245 at the end of Year 2; $0 at the end of Year 3; and $280 at the end of Year 4? a. $626.01 b. $653.69 c. $660.10 d. $665.80 92. Eight years ago, Levin Inc. earned $0.60 per share. Its earnings this year were $2.40 per share. What was the growth rate in Levin’s earnings per share (EPS) over the 8-year period? a. 18.92% b. 18.77% c. 17.61% d. 17.49% 93. What would the future value of $150 be after 7 years at 9% compound interest? a. $206.53 b. $214.67 c. $258.07 d. $274.21 94. You are considering investing in a developing-country bank account that pays a nominal annual rate of 24%, compounded monthly. If you invest $7,000 at the beginning of each month, how many months will it take for your account to grow to $280,000? Round fractional years up. a. 29 b. 30 c. 31 d. 32

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Chap 04_4ce 95. Which of the following is a benefit that derives from beginning to save for retirement early? a. Fewer hassles from borrowing in retirement. b. More total hours spent at work. c. Greater compounding of interest. d. Less money to spend after retirement.

96. Suppose a bank offers to lend you $20,000 for one year at a nominal annual rate of 11.55%, but you must make interest payments at the end of each quarter and then pay off the $20,000 principal amount at the end of the year. What is the effective annual rate on the loan? a. 12.06% b. 12.63% c. 11.59% d. 10.65% 97. Which of the following is true regarding the discounting process? a. The present value of a sum to be received in the future increases as the payment date is extended further and further. b. For the same cash flows to be received in the future, the present value falls faster when the interest rate is lower. c. For the same cash flows to be received in the future, the present value falls faster when the interest rate is higher. d. At relatively high rates, funds due in the future are worth much more today.

98. You want to go to Europe 7 years from now, and you can save $4,300 per year, beginning 1 year from today.

You plan to deposit the funds in a mutual fund that you expect to return 7.5% per year. Under these conditions, how much will you have just after you make the seventh deposit, 7 years from now? a. $37,785.48 b. $38,287.09 c. $39,251.44 d. $40,264.02 99. You plan to borrow $24,000 at a 7.5% annual interest rate. The terms require you to amortize the loan with five equal end-of-year payments. How much interest would you be paying in Year 2? a. $1,347.79 b. $1,380.30 c. $1,416.11 d. $1,490.10

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Chap 04_4ce 100. John and Daphne are saving for their daughter Ellen’s university education. Ellen is now 10 years old and will be entering university 8 years from now (t = 8). University tuition and expenses at City U are currently $15,000 a year, but they are expected to increase at a rate of 4% a year. John and Daphne expect Ellen to graduate in 4 years. (If Ellen 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, John and Daphne have accumulated $14,000 in the university savings account. Their long-run financial plan is to add an additional $6,000 at the beginning of each of the next 4 years (at t = 0, 1, 2, and 3). Then they plan to make four equal annual contributions at the end of each of the following five years (t = 4, 5, 6, 7, and 8). They expect their investment account to earn 8.5%.

How large must the annual payments be at t = 4, 5, 6, 7, and 8 to meet Ellen’s anticipated university costs? a. $1,398.37 b. $1,472.01 c. $1,569.82 d. $1,627.16 101. Suppose you borrowed $15,000 at a rate of 10% and must repay it in 5 equal installments at the end of each of the next 5 years. How much would your payments be? a. $3,804.02 b. $3,956.96 c. $4,083.69 d. $4,187.87 102. By law, credit card issuers must print the annual percentage rate (APR) on their monthly statements. If the APR is stated to be 24%, with interest paid monthly, what is the card’s EFF percentage? a. 26.82% b. 27.56% c. 28.54% d. 29.73% 103. Which of the following statements is correct regarding time value of money? a. The present value of a series of fixed payments will be equal to its expected future value. b. The present value of a series of fixed payments will be less than its expected future value. c. The future value of a series of fixed payments will be less than its expected future value. d. The present value of an annuity will be equal to its future value.

104. Last year, Mason Corp.’s earnings per share was $3.50, and its growth rate during the prior 5 years was 11% per year. If that growth rate were maintained, how many years would it take for Mason’s EPS to triple? a. 9.86 b. 9.92 c. 10.24 d. 10.53

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Chap 04_4ce 105. Which of the following are annuities due? a. payments on mortgages that come out of a chequing account at the end of each month b. payments on car loans that are made at the end of each month c. rental payments for an apartment that are made at the beginning of each month d. payments on student loans that come out of a chequing account at the end of each month 106. You are considering investing in a bank account that pays a nominal annual rate of 7.2%, compounded monthly.

If you invest $6,000 at the end of each month, how many months will it take for your account to grow to $230,000? Round fractional years up. a. 33 b. 35 c. 38 d. 40 107. Suppose you borrowed $15,000 at a rate of 8% 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. $12,443.15 b. $12,673.24 c. $13,461.82 d. $13,375.98 108. Suppose you take out a $20,000 loan at a 7.2% nominal annual rate. The terms of the loan require you to make 12 equal end-of-month payments each year for 5 years, and then an additional final (balloon) payment of $6,000 at the end of the last month. What will your equal monthly payments be? a. $314.54 b. $317.22 c. $320.86 d. $325.91 109. You are analyzing the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which circumstance would increase the calculated value of the investment? a. The discount rate increases. b. The riskiness of the investment’s cash flows increases. c. 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. d. The discount rate decreases.

110. Suppose you borrowed $15,000 at a rate of 8% 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. $2,292.81 b. $2,379.02 c. $2,455.23 d. $2,556.85 Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 111. How much would $8,000 due in 70 years be worth today if the discount rate were 6.5%? a. $99.51 b. $95.27 c. $97.72 d. $97.41 112. Which statement best describes time lines? a. A time line is meaningful only if all cash flows occur annually. b. Time lines are useful for visualizing complex problems after doing actual calculations. c. Time lines can be constructed to deal with situations where some of the cash flows occur annually but others occur monthly. d. Time lines can be constructed only for annuities where the payments occur at the beginning of the periods, i.e., for annuities due.

113. Your uncle has $395,000 invested at 7.6%, and he now wants to retire. He wants to withdraw $33,000 at the end of each year, beginning at the end of this year. How many years will it take to exhaust his funds; that is, run the account down to zero? a. 32.83 b. 33.63 c. 34.81 d. 35.05 114. Which of the following statements is correct, assuming positive interest rates and other things held constant? a. A 6-year, $1,000 ordinary annuity will have a higher present value than a similar annuity due. b. A 30-year, $100,000 amortized mortgage will have larger monthly payments than an otherwise similar 20year mortgage. c. A typical investment’s nominal interest rate will always be equal to or less than its effective annual rate. d. If an investment pays 10% interest, compounded annually, its effective annual rate will be greater than 10%.

115. Your uncle has $425,000 and wants to retire. He expects to live for another 26 years, and he also expects to earn 7.8% on his invested funds. How much could he withdraw at the beginning of each of the next 26 years and end up with zero in the account? a. $33,243.21 b. $34,729.70 c. $35,835.65 d. $36,859.14 116. Suppose your credit card issuer states that it charges a 16% nominal annual rate. If you must make monthly payments, which amounts to monthly compounding, what is the effective annual rate? a. 16.27% b. 16.08% c. 17.52% d. 17.23% Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 117. What’s the present value of $2,025 discounted back 6 years if the appropriate interest rate is 7.2%, compounded monthly? a. $1,169.34 b. $1,274.36 c. $1,316.35 d. $1,330.59 118. What is the future value of $1,600 after 4 years if the appropriate interest rate is 8%, compounded semiannually? a. $2,219.33 b. $2,189.71 c. $2,015.87 d. $2,116.67 119. You have a chance to buy an annuity that pays $480 at the beginning of each year for 4 years. You could earn 5.25% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $1,512.84 b. $1,587.20 c. $1,781.06 d. $1,643.75 120. You want to go to Europe 6 years from now, and you can save $3,800 per year, beginning immediately. You plan to deposit the funds in a mutual fund that you expect to return 8.3% per year. Under these conditions, how much will you have just after you make the sixth deposit, 6 years from now? a. $29,986.82 b. $28,933.49 c. $30,419.58 d. $30,926.49 121. You want to buy a new sports car 4 years from now, and you plan to save $5,100 per year, beginning 1 year from today. You will deposit your savings in an account that pays 6.3% interest. How much will you have just after you make the fourth deposit, 4 years from now? a. $21,973.07 b. $22,603.23 c. $22,410.04 d. $23,929.88

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Chap 04_4ce Answer Key 1. False 2. True 3. False 4. True 5. False 6. False 7. False 8. False 9. True 10. True 11. False 12. c 13. b 14. d 15. b 16. b 17. d 18. b 19. d 20. d 21. c 22. d 23. c 24. d 25. b 26. d

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Chap 04_4ce 27. d 28. a 29. b 30. a 31. c 32. d 33. d 34. a 35. d 36. d 37. d 38. b 39. a 40. b 41. a 42. c 43. b 44. d 45. a 46. c 47. d 48. a 49. d 50. c 51. b 52. a 53. b 54. b Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 55. c 56. b 57. b 58. a 59. d 60. a 61. c 62. b 63. a 64. c 65. d 66. d 67. c 68. d 69. d 70. b 71. b 72. b 73. c 74. b 75. b 76. b 77. d 78. a 79. c 80. c 81. d 82. c Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 83. d 84. d 85. c 86. b 87. d 88. b 89. a 90. d 91. c 92. a 93. d 94. b 95. c 96. a 97. c 98. a 99. d 100. c 101. b 102. a 103. b 104. d 105. c 106. b 107. a 108. a 109. d 110. d Copyright Cengage Learning. Powered by Cognero.

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Chap 04_4ce 111. d 112. c 113. a 114. c 115. c 116. d 117. c 118. b 119. c 120. c 121. c

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Chap 05_4ce Indicate whether the statement is true or false.

1. The term “spontaneously generated funds” generally refers to increases in the equity account that result from a growth in sales, assuming the firm is operating with a positive profit margin. a. True b. False 2. To determine the amount of additional funds needed, you subtract the expected increase in liabilities, which represents a source of funds, and the expected increases in retained earnings, from the required increase in assets. a. True b. False 3. The AFN method assumes that the forecasted items could be estimated as a percentage of sales. This implies, for example, that if you plotted a graph of inventories versus sales, the regression line would be linear or curvilinear. a. True b. False 4. One of the key steps in the development of pro forma financial statements is to identify those assets and retained earnings that increase spontaneously with sales. a. True b. False 5. Managers use pro forma financial statements to evaluate whether the firm’s historical performance is in line with the firm’s own general targets and with investors’ expectations. a. True b. False 6. A better way to look at past growth is to use a regression approach, where a curve is fitted to the historic sales data and then the slope of that curve is used to measure historic growth. a. True b. False 7. A firm’s additional funds needed (AFN) must come from external sources. Typical sources include accruals, long-term bonds, preferred stock, and common stock. a. True b. False 8. A rapid build-up of inventories normally does not require additional financing since the increase is always matched by an equally large decrease in some other asset. a. True b. False

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Chap 05_4ce 9. The AFN formula would be appropriate if, in a regression of each asset and spontaneous liability on sales, the regression line was linear and passed through the origin. a. True b. False 10. When one or more ratios change for certain assets and liabilities, the forecasted financial statement method is a better choice. Three conditions where constant ratios cannot hold are economies of scale, lumpy assets, and excess capacity. a. True b. False 11. If a firm’s capital intensity ratio (A*/S0) increases as sales increase, use of the AFN formula is likely to overstate the amount of additional funds required, other things held constant. a. True b. False 12. In typical financial policies, most mature companies rarely issue new common shares and most firms do not use preferred shares. However, forecasting equity depends on a firm’s financial policies, which vary widely from firm to firm. a. True b. False 13. Suppose that a firm’s profit margin is 7%, its debt-to-assets ratio is 62%, and its dividend payout ratio is 51%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds; however, 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 14. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating below capacity, while Firm B is operating at full 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 15. As a firm’s sales increase, it usually has to purchase assets (inventories, machines, etc.) in order to support the increased level of sales. To purchase the projected increase in assets, the firm can use part of the profit from the new sales. a. True b. False

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Chap 05_4ce 16. Suppose a firm with a positive net worth is operating its fixed assets at full capacity and its dividend payout ratio is 100%, and 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 Indicate the answer choice that best completes the statement or answers the question.

17. Which of the following statements is correct? a. 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. b. 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. c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. d. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are nonspontaneous in the sense that they require explicit financing decisions to obtain them.

18. What is the first and most critical step in constructing a set of pro forma financial statements? a. forecasting cash flows b. forecasting industry average c. forecasting sales d. forecasting equity 19. Which of the following statements is correct? a. The self-supporting growth rate is the maximum growth rate the firm could achieve if it had limited access to external capital. b. The self-supporting growth rate can be found as the value of g that, when used in the AFN equation, results in a specific positive AFN. c. We can obtain the self-supporting growth rate g by multiplying M(RR)S0 by [A* – L* – M(RR)S0]. d. We can obtain the self-supporting growth rate g by dividing M(RR)S0 by [A* – L* – M(RR)S0].

20. Which of the following statements is correct? a. If the sales forecast is not accurate, the consequences are not serious and will not influence the firm’s well-being dramatically. b. A firm can use an arithmetic average procedure or point-to-point procedure to forecast the future sales growth rate, both of which are superior to the regression approach. c. The AFN equation method produces better predictions than the forecasted financial statement method, especially if fixed assets are lumpy. d. The first step in forecasting financial statements is to forecast future sales, which generally starts with a review of sales during the past 5 years.

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Chap 05_4ce 21. Which of the following best defines the term “spontaneously generated funds”? a. 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. b. The amount of assets required per dollar of sales, or A*/S0. c. Funds that a firm needs to obtain externally through bank loans, issuing bonds, or issuing stock. d. Funds that are generated automatically from normal operations, which include spontaneous increases in accounts payable and accruals, plus the increase of retained earnings.

22. 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 decrease? a. The company increases its dividend payout ratio. b. The company begins to pay employees monthly bonuses instead of quarterly. c. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. d. The company’s profit margin decreases.

23. Last year, Handorf-Zhu Inc. had $920 million of sales, and it had $560 million of fixed assets that were used at only 70% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets? a. 40.16% b. 42.83% c. 45.02% d. 48.10% 24. ABC Co. is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm’s additional funds needed (AFN). 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.

Last year’s sales = S0 Sales growth rate = g Last year’s total assets = A0 Last year’s profit margin = M a. $105.20 b. $110.05

$420 25% $600 6%

Last year’s accounts payable $50 Last year’s notes payable (to bank) $80 Last year’s accruals $40 Target payout ratio 55%

c. $113.33 d. $118.40 25. Which assumption is embodied in the AFN formula forecasting method? a. All liability and equity accounts are tied directly to sales. b. New plant and equipment are tied directly to sales. c. Accounts payable and accruals are tied directly to sales. d. Bank loans and bonds are tied directly to sales.

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Chap 05_4ce 26. Which of the following statements is correct? a. The statement of corporate objectives sets out broad approaches rather than detailed plans. b. Corporate scope defines a firm’s lines of business and geographic area of operations. c. Corporate strategies set forth specific goals to guide management. d. Strategic plans usually end with a company’s mission statement.

27. Fairchild Garden Supply expects $700 million of sales this year, and it forecasts a 10% increase for next year.

The CFO uses this equation to forecast inventory requirements at different levels of sales: Inventories = $29 + 0.31(Sales). All dollars are in millions. What is the projected inventory turnover ratio, using the sales number, for the coming year? a. 2.20 b. 2.65 c. 2.88 d. 3.00 28. Last year, Wei Guan Inc. had $490 million of sales, and it had $350 million of fixed assets that were used at 72% of capacity. In millions, by how much could Wei Guan’s sales increase before it is required to increase its fixed assets? a. $179.04 b. $182.21 c. $187.35 d. $190.56 29. Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm’s additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year?

Last year’s sales = S0 $300,000 Last year’s accounts payable $65,000 Sales growth rate = g 30% Last year’s notes payable (to bank) $49,000 Last year’s total assets = A0 $160,000 Last year’s accruals $30,000 Last year’s profit margin = M

25%

Target payout ratio

30%

a. –$45,000 b. –$48,750 c. –$50,250 d. –$54,080

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Chap 05_4ce 30. Last year, Canada Master Corp. had $20 million of sales and $16 million of fixed assets, so its FA/Sales ratio was 80%. 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. 55% b. 60% c. 64% d. 70% 31. Which of the following best defines the term “additional funds needed (AFN)”? a. funds that a firm must raise externally from nonspontaneous sources, i.e., by borrowing or by issuing new shares to support increased sales b. a forecasting approach that forecasts the complete set of financial statements c. funds that are obtained internally from spontaneous liabilities and retained earnings d. the amount of internally generated cash in a given year minus the increase of retained earnings 32. Suppose that Kamath-Meier Corporation’s CFO uses this equation, which was developed by regressing inventories on sales over the past 5 years, to forecast inventory requirements: Inventories = $19 + 0.23(Sales).

The company expects sales of $500 million during the current year, and it expects sales to grow by 28% next year. All dollars are in millions. What is the inventory forecast for next year? a. $163.0 b. $166.2 c. $167.5 d. $169.0 33. Which term best describes a ratio relationship in which increases in sales sometimes require no additions to fixed assets? a. lumpiness b. curvilinear c. constant ratio d. economies of scale 34. Which of the following statements is correct? a. The mission statement states specific goals to guide management. Most organizations only have quantitative goals. b. The operating plans can be developed for any time horizon, but many companies use a 5-year horizon. A 5-year plan is detailed for the first year, with each succeeding year’s plan becoming less specific. c. The statement of corporate objectives shows broad approaches rather than detailed plans. Any such statement must be compatible with the firm’s purpose, scope, and objectives. d. A firm’s corporate scope states the general philosophy of the business, but it does not provide managers with operational objectives.

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Chap 05_4ce 35. A Canadian firm has net income of $15,000 on sales of $70,000, fixed assets of $92,000, and total assets of $145,000. The firm retains 65% of its earnings. If the firm is operating at 80% capacity, what are the full capacity sales? a. $80,000 b. $83,000 c. $87,500 d. $90,000 36. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm’s additional funds needed (AFN). 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 20% that was used in the past to 60%, 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 20% to the new and higher level? All dollars are in millions.

Last year’s sales = S0

$400

Last year’s accounts payable

$60

Sales growth rate = g

35%

Last year’s notes payable (to bank)

$49

Last year’s total assets = A0

$600

Last year’s accruals

$30

Last year’s profit margin = M

30%

Initial payout ratio

20%

New payout ratio

60%

a. $60.0 b. $62.5 c. $64.8 d. $67.0 37. Last year, Emery Industries had $600 million of sales and $350 million of fixed assets, so its FA/Sales ratio was 58.33%. However, its fixed assets were used at only 40% 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 $600 million, how much cash (in millions) would it have generated? a. $210.02 b. $213.51 c. $215.90 d. $219.04 38. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which factor is most likely to lead to an increase of the additional funds needed? a. a sharp increase in its forecasted sales b. an insufficient capacity of fixed assets c. a sharp increase in its dividend payout ratio d. a sharp decrease in its dividend payout ratio

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Chap 05_4ce 39. Last year, Canada Corp. had $300 million of sales and $180 million of fixed assets, so its FA/Sales ratio was 60%. However, its fixed assets were used at only 70% 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. 37.50% b. 41.96% c. 46.25% d. 50.00% 40. Which of the following is NOT one of the steps taken in the financial planning process? a. Forecast financial statements and use these projections to analyze the likely effects of the operating plan on profits and various financial ratios. b. Forecast the funds that will be needed to support the 5-year plan. c. Develop a cash budget for use in determining when funds will be needed or when surplus funds will be available for investment. 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.

41. Canada Manufacturing has net income of $24,000 on sales of $80,000, fixed assets of $139,000, and total assets of $220,000. The firm retains 65% of its earnings. If the firm is operating at 65% capacity, what are the full capacity sales? a. $110,000 b. $115,000 c. $120,000 d. $123,000 42. Which of the following statements is correct? a. When we use the AFN formula, we assume that the ratios of assets and liabilities to sales (A*/S0 and L*/S0) vary from year to year in a stable, predictable manner. 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. 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.

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Chap 05_4ce 43. Which of the following statements is correct? a. To get the full capacity sales, we can multiply the actual sales by the percentage of capacity at which fixed assets were operated. b. To get the target fixed assets/sales ratio, we can multiply the actual fixed assets by the full capacity sales. c. To get the required level of fixed assets, we can divide the target fixed assets/sales ratio by the projected sales. d. To get the required level of fixed assets, we can multiply the target fixed assets/sales ratio by the projected sales.

44. Last year, Godinho Corp. had $310 million of sales, and it had $84 million of fixed assets that were being operated at 90% of capacity. In millions, how large could sales have been if the company had operated at full capacity? a. $344.44 b. $350.20 c. $361.05 d. $368.79 45. Which of the following best defines the term “capital intensity ratio”? a. the amount of current liabilities required per dollar of sales, or CL*/S0 b. amount of spontaneous liabilities generated per dollar of sales, or L*/S0 c. the amount of assets required per dollar of sales, or A*/S0 d. the amount of current assets required per dollar of sales, or CA*/S0 46. Which of the following statements is correct? a. High-performance companies focus on the links among forecasting, planning, and business strategy rather than on just cost management and cost accounting. b. High-performance companies focus on cost management and cost accounting rather than the links among forecasting, planning, and business strategy. c. To improve business planning and forecasting, companies can adopt activity-based budgeting, which means allocating costs and revenues by traditional departments rather than by products and services. d. To improve business planning and forecasting, companies can use rolling forecasting, in which companies make a 1-year forecast and then modify the 1-year forecast each year as new operating results become available.

47. Which of the following situations does NOT require a forecasting adjustment? a. Economies of scale exist in the use of assets. b. Excess capacity exists. c. The ratios are constant and the growth rates are identical. d. The growth must occur in large increments (lumpy assets).

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Chap 05_4ce 48. Which factors are used to determine the level of sales that a firm can generate without having to raise any external funds (self-supporting growth rate)? a. total profit from sales, and liabilities tied to sales b. profits retained from sales, and assets and liabilities tied to sales c. profits retained from sales, and liabilities tied to sales d. total profit from sales, and assets and liabilities tied to sales 49. Last year, Jain Technologies had $330 million of sales and $160 million of fixed assets, so its FA/Sales ratio was 48.48%. However, its fixed assets were used at only 81% 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. 39.27% b. 41.50% c. 43.06% d. 44.85% 50. Which of the following is NOT a step of the FFS method? a. forecast the statement of cash flows b. forecast the income statement c. forecast the balance sheet d. analyze the forecast 51. Suppose a firm has net income of $12,000 on sales of $60,000, fixed assets of $94,000, and total assets of $120,000. The firm retains 60% of its earnings. If the firm is operating at 75% capacity, what are the full capacity sales? a. $70,000 b. $73,000 c. $78,000 d. $80,000

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Chap 05_4ce Answer Key 1. False 2. True 3. False 4. False 5. False 6. True 7. False 8. False 9. True 10. True 11. False 12. True 13. False 14. False 15. True 16. True 17. d 18. c 19. d 20. d 21. d 22. c 23. b 24. c 25. c 26. b

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Chap 05_4ce 27. c 28. d 29. b 30. b 31. a 32. b 33. a 34. b 35. c 36. c 37. a 38. d 39. b 40. d 41. d 42. b 43. d 44. a 45. c 46. a 47. c 48. b 49. a 50. a 51. d

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Chap 06_4ce Indicate whether the statement is true or false.

1. Warrants are options that permit the holder to buy stock at a fixed price, thereby providing a gain if the price of the stock rises. So, bonds with warrants have higher coupon rates than straight bonds. a. True b. False 2. Floating-rate debt stabilizes the market value of the debt and provides institutional buyers with income that is better geared to their own obligations. However, floating-rate debt doesn’t appeal to corporations that want to issue long-term debt since the corporations have to take more risk over the entire life of the loan. a. True b. False 3. The Canada call feature calculates the buy-back price based on the equivalent-maturity Government of Canada bond minus a premium, which makes it cheap to call a bond before maturity. a. True b. False 4. If the required rate of return on a bond (rd) is less than its coupon interest rate and will remain below that rate, then the market value of the bond will always be above 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 5. For bonds with the same coupons, they have differential sensitivity to changes in interest. That is, the shorter the maturity of the bond, the more its price changes in response to a given change in interest rates. a. True b. False 6. The value of any financial asset, like a lease, or even a physical asset such as an apartment building is the future value of the cash flows the asset is expected to produce. a. True b. False 7. The required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False 8. The risk in bond prices due to fluctuations in interest rates is called interest rate risk. a. True b. False

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Chap 06_4ce 9. A bond rating agency will rely on both quantitative data and qualitative factors to determine the risk that a firm may default on its debt servicing obligations. a. True b. False 10. Other things being equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its first mortgage bonds. a. True b. False 11. Retractable bonds protect investors against a rise in interest rates. When interest rates increase, investors have more incentive to sell their retractable bonds back to the issuer at a preset price. a. True b. False 12. The prices of high-coupon bonds tend to be more sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False 13. Zero coupon bonds pay no coupons at all but are offered at their par values and hence provide capital appreciation rather than interest income. a. True b. False 14. A call provision gives the issuing corporation the right to call bonds for redemption. The call provision generally states that the company must pay the bondholders an amount less than the par value if they are called. a. True b. False 15. Real return bonds (RRBs) are indexed bonds issued by the Canadian government that have no default risk.

RRBs can protect bondholders against inflation and interest rate risk. a. True b. False 16. Only retractable bonds can be turned in or “put” back to the issuer by the bondholders. a. True b. False 17. Floating-rate debt is popular with investors who are worried about the risk of rising interest rates, since the interest paid on such bonds increases whenever market rates rise. Corporate issues can be tied to government bond rates and other rates, such as LIBOR. a. True b. False

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Chap 06_4ce 18. Junk bonds are bonds rated less than BBB and are noninvestment-grade debt. They are often issued by companies with a high credit risk. However, “fallen angels” are junk bonds that were originally highly rated when issued, but whose ratings have declined because the issuing corporation has fallen on hard times. a. True b. False 19. A bond that is callable has a chance of being retired earlier than its stated term to maturity, which is valuable to the firm but potentially detrimental to investors. So, an outstanding callable bond should always have a higher yield to maturity than an otherwise identical noncallable bond. a. True b. False 20. Suppose you are considering two bonds that will be issued tomorrow. Both are rated double A (AA), both mature in 15 years, both have an 8% 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 7% of the bonds at par each year. The yield curve at the time is upward sloping. The bond’s prices, being equal, are likely in equilibrium, as Bond SF would generally be expected to have the same yield as Bond NSF. a. True b. False 21. Sinking funds are devices that facilitate the orderly retirement of a bond issue. Usually, though, the sinking fund is used to buy back a certain percentage of the issue each year. A failure to meet the sinking fund requirement causes the bond to be thrown into default, which may force the company into bankruptcy. a. True b. False 22. Maple bonds are issued by the government of Canada in the U.S. market, and they are sold only to U.S. investors. a. True b. False 23. All other things being equal, the bond with the longer maturity is exposed to more risk from a rise in interest rates. So, interest rate risk reflects the length of time one is committed to a given investment. a. True b. False

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Chap 06_4ce Indicate the answer choice that best completes the statement or answers the question.

24. Three $1,000 face value bonds that mature in 20 years have the same level of risk, hence their YTMs are equal. Bond A has a 15% annual coupon, Bond B has a 13% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 20 years, which statement about these bonds is true? a. The required return on all these bonds is 15%. b. Bond A sells at a premium (its price is greater than par), and its price is expected to decrease over the next year. c. Bond C sells at a discount (its price is less than par), and its price is expected to decrease over the next year. d. Over the next year, the prices of Bonds A, B, and C are expected to remain at their current levels until maturity since they have the same YTM. 25. A 20-year bond with a face value of $1,000 currently sells for $1,200. Which statement regarding the bond’s yield is true? a. The bond’s yield to maturity is less than its coupon rate. b. The bond’s coupon rate is equal to its current yield. c. The bond’s coupon rate is less than its current yield. d. If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $1,200.

26. The spread between a debenture and a junior mortgage bond is the premium in interest rate that must be paid on the debenture. Why? a. It is a secured bond and thus has a lower level of risk of loss. b. It is an unsecured bond with a higher level of risk of loss. c. It is a secured debenture with a higher level of risk of loss. d. It is an unsecured bond with a lower level of risk of loss.

27. Cosmic Communications Inc. is planning two new issues of 20-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 12% semiannual coupon. Bond OID will be an original issue discount bond, and it will also have a 20-year maturity and a $1,000 par value, but its semiannual coupon will be only 7%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Cosmic issue to raise $4,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds. a. 6,105 b. 6,412 c. 6,680 d. 6,931

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Chap 06_4ce 28. Taussig Corp.’s bonds currently sell for $1,280. They have a 7.5% annual coupon rate and a 20-year maturity, but they can be called in 9 years at $1,175. 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 into the future. Under these conditions, what rate of return should investors expect to earn if they purchase these bonds? a. 4.83% b. 5.12% c. 5.40% d. 5.95% 29. Garvin Enterprises’ bonds currently sell for $1,230. They have a 7-year maturity, an annual coupon of $92, and a par value of $1,000. What is their current yield? a. 6.32% b. 6.80% c. 7.15% d. 7.48% 30. A 20-year corporate bond has an annual coupon of 15%. The bond is currently selling at par ($1,000). Which of the following statements is correct? a. The bond’s current yield is less than its capital gains yield. b. The bond’s current yield is less than 15%. c. The bond’s yield to maturity is 15%. d. If the bond’s yield to maturity remains constant, the bond will sell at a discount.

31. Crockett Corporation’s 6-year bonds yield 7.95%, and 6-year government bonds yield 5.45%. The real risk-free rate is r* = 3.10%, the default risk premium for Crockett’s bonds is DRP = 1.10% versus zero for T-bonds, the liquidity premium on Crockett’s bonds is LP = 1.4%, 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 6-year bonds? a. 1.35% b. 1.50% c. 1.70% d. 1.85% 32. Which of the following best describes a normal yield curve? a. downward sloping to the right b. upward sloping to the right c. first flat and then upward sloping to the left d. first flat and then downward sloping to the right

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Chap 06_4ce 33. A bond has a $1,000 par value, makes annual interest payments of $200, has 7 years to maturity, cannot be called, and is not expected to default. What should we generally expect of the price of this bond if interest rates change? a. If interest rates on similar bonds rise, the price of this bond may remain unchanged. b. If interest rates on similar bonds decline, the price of this bond should also decline. c. If interest rates on similar bonds decline, the price of this bond should rise. d. If interest rates on similar bonds rise, the price of this bond should also rise.

34. Where are bonds mainly sold? a. in commercial banks b. in the New York stock exchange c. in the Toronto stock exchange d. in the over-the-counter market 35. Which of the following best describes a convertible bond issue? a. A bond that offers the bondholders the option of converting their bonds into a fixed number of common shares within a predetermined period of time. b. A bond that offers the bondholders the obligation of converting their bonds into a fixed number of common shares within a predetermined period of time. c. A bond that offers the bondholders the option of converting their fixed-rate bonds into a floating-rate bond within a predetermined period of time. d. A bond that offers the bondholders the obligation of converting their coupon bonds into a zero coupon bond within a predetermined period of time.

36. Which event would make it more likely that a company would choose to call its outstanding callable bonds? a. The company’s cash flows are worse now. b. The company’s net income plummeted. c. Market interest rates have decreased dramatically. d. The market experiences higher inflation.

37. Which of the following statements is correct? a. In general, the quoted interest rate on a debt security is equal to the quoted risk-free rate plus inflation premium, default risk premium, liquidity premium, and maturity risk premium. b. In general, the quoted interest rate on a debt security is equal to the real risk-free rate plus inflation premium, default risk premium, liquidity premium, and maturity risk premium. c. In general, the quoted interest rate on a debt security is equal to the quoted risk-free rate plus inflation premium and default risk premium, minus liquidity premium and maturity risk premium. d. In general, the quoted interest rate on a debt security is equal to the real risk-free rate plus inflation premium and default risk premium, minus liquidity premium and maturity risk premium.

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Chap 06_4ce 38. Which of the following best describes a bond’s annual or semiannual interest payment? a. the annual or semiannual payment made by the debtor to the creditor, which is calculated by dividing the coupon rate into the issuing price of the bond b. the annual or semiannual payment made by the creditor to the debtor, which is calculated by multiplying the coupon rate by the market value of the bond c. the annual or semiannual payment made by the debtor to the creditor, which is calculated by dividing the coupon rate into the market value of the bond d. the annual or semiannual payment made by the debtor to the creditor, which is calculated by multiplying the coupon rate by the par value of the bond 39. If Risky Inc. has an outstanding bond with an annual coupon payment of $140 and is currently priced at $872, what is this bond’s current yield? a. 15.39% b. 16.06% c. 16.50% d. 17.22% 40. Company A has a bond outstanding that pays a 9% coupon. The interest is paid annually, and the bond matures in 15 years. The market rate of interest on bonds of similar risk is 6.5% and the bond is selling for $1,235.07.

One year from today, the bond is expected to be selling for $1,225.35. What is the current yield on the bond? a. 7.2870% b. 7.3448% c. 7.4500% d. 7.5832% 41. Assuming all else is constant, which of the following statements is correct? a. For a bond of any maturity, a 100 basis point increase in the market interest rate would cause a smaller dollar capital loss than the capital gain stemming from a 100 basis point decrease in the interest rate. b. For any given maturity, a 100 basis point increase in the market interest rate would cause a larger dollar capital loss than the capital gain stemming from a 100 basis point decrease in the interest rate. c. Price sensitivity as measured by the percentage change in price due to a given change in the required rate of return increases as a bond’s maturity decreases. d. A 20-year zero coupon bond has less interest rate risk than a 20-year coupon bond.

42. Under normal conditions, which action would be most likely to increase the coupon rate required to enable a bond to be issued at par? a. making the bond a first mortgage bond rather than a debenture b. making the bond a convertible bond rather than a nonconvertible bond c. the rating agencies changing the bond’s rating from BBB to A d. adding a call provision to the bond

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Chap 06_4ce 43. McCue Inc.’s bonds currently sell for $1,360. They pay a $130 annual coupon, have a 17-year maturity and a $1,000 par value, but they can be called in 6 years at $1,100. 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 into the future. What is the difference between this bond’s YTM and its YTC? (Subtract the YTC from the YTM.) a. 1.25% b. 1.50% c. 1.73% d. 1.95% 44. What is the main purpose of restrictive covenants? a. They protect bond issuers by constraining the actions of managers. Such covenants are not spelled out in bond indentures. b. They protect bond issuers by transferring the power from managers to shareholders. Such covenants are not spelled out in bond indentures. c. They protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. d. They protect bondholders by transferring the power from managers to bondholders. Such covenants are spelled out in bond indentures.

45. Consider some bonds with one annual coupon payment of 8.65%. The bonds have a par value of $1,000, a current price of $1,160, and they will mature in 17 years. What is the yield to maturity on these bonds? a. 6.02% b. 6.50% c. 6.84% d. 7.01% 46. Which of the following statements is correct? a. A bond is likely to be called if current interest rates are well below its YTM. b. A bond is likely to be called if its market price is no higher than its par value. c. When a bond’s YTC exceeds its YTM, an investor with an investment horizon longer than the bond’s maturity would be better off if the bond were called. d. A bond is likely to be called if it sells at a discount below par.

47. Which statement regarding bond yields is true? a. All else being equal, if a bond’s yield to maturity decreases, its price will increase. b. A zero coupon bond’s current yield is greater than its yield to maturity. c. If a bond’s yield to maturity is less than its coupon rate, the bond will sell at par. d. If a bond’s yield to maturity is less than its coupon rate, the bond will sell at a discount.

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Chap 06_4ce 48. Which of the following is NOT true regarding bonds? a. As interest rates (yield to maturity) rise, the price of bonds with similar risks will decline. b. If the market interest is higher than the coupon rate of a bond, the price of the bond will be greater than its par value. c. Assuming no bankruptcy, as the maturity date of a premium bond approaches, the premium bond’s price will keep decreasing. d. A bond that is trading at a price below its par value is often referred to as a discount bond.

49. If 15-year T-bonds have a yield of 7.3%, 15-year corporate bonds yield 9.9%, the maturity risk premium on all 15-year bonds is 2.1%, and corporate bonds have a 0.6% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? a. 1.75% b. 1.90% c. 2.00% d. 2.36% 50. A Government of Canada bond that was issued with a term to maturity of 16 years ago and is expected to mature in 4 years has a coupon of 7%. If other Government of Canada bonds that are scheduled to mature in 4 years are currently paying a coupon of 7%, what can we reasonably expect that these Government of Canada bonds are currently priced at? a. a discount to their par value b. equal to their par value c. a premium to their par value d. a premium or a discount to their par value 51. Which of the following statements about bond yields is true? a. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity. b. 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. c. If a coupon bond is selling at par, its current yield equals its yield to maturity. 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. 52. Company A has two 9% coupon bonds outstanding. Each of the bonds pays interest annually. Bond A has 15 years to maturity and Bond B has 12 years to maturity. The current market rate of return is 7%. What will happen if the market rate of return decreases to 6%? a. The percentage change in the price of Bond A will be the same as the percentage change in the price of Bond B. b. The percentage change in the price of Bond A will be less than the percentage change in the price of Bond B. c. The percentage change in the price of Bond A will be greater than the percentage change in the price of Bond B. d. The price of the bonds will not change as the market rate of return has no effect on the value of the bond.

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Chap 06_4ce 53. Which statement regarding bonds is true? a. A $1,000 bond with $100 annual interest payments that has 10 years to maturity and is not expected to default would sell at a premium if interest rates were below 8% and at a discount if interest rates were greater than 12%. b. A 20-year, 13% coupon bond has less reinvestment rate risk than a 20-year, 7% coupon bond (assuming all else is equal). c. 15-year zero coupon bonds have higher reinvestment rate risk than 15-year, 9% coupon bonds. d. The price of a 30-year, 8% bond is less sensitive to changes in interest rates than the price of a 10-year, 8% bond.

54. Which of the following statements is correct? a. All else being equal, senior debt generally has a lower yield to maturity than subordinated debt. 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 Canadian bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

55. Which statement regarding bonds is true? a. If a coupon bond is selling at par, its current yield is greater than its yield to maturity. b. If rates fall after its issue, a zero coupon bond could trade at a price above its par value. c. Unlike the yield to maturity, the current yield does not represent the rate of return that investors should expect on the bond. d. If a firm moves from a position of financial distress toward strength, its bonds’ yield to maturity would probably increase.

56. Tucker Corporation is planning to issue new 30-year bonds. Initially, the plan was to make the bonds noncallable. If the bonds were made callable after 10 years at an 8% call premium, how would this affect their required rate of return? a. The required rate of return would increase because the bond would then be riskier to a bondholder. b. The required rate of return would decrease because the bond would then be less risky to a bondholder. c. The required rate of return would remain the same because the corporation’s default risk remains the same. d. The required rate of return would decrease because the call premium would fall each year after the bond is called.

57. Risky Inc. issued a bond 6 years ago with a term to maturity of 10 years. The bond pays a coupon of 14% (stated annually, paid semiannually). If Risky Inc.’s bond is currently priced at $810, what is this bond’s yield to maturity? a. 18.20% b. 19.34% c. 21.29% d. 22.60%

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Chap 06_4ce 58. A bond pays a 4% coupon (stated annually, paid semiannually). Its price is currently $890 and its term to maturity is 11 years. What is the expected yield for an investor who buys the bond and holds it to maturity? a. 4.41% b. 4.75% c. 5.33% d. 5.80% 59. Assume that a 15-year Treasury bond has a 17% annual coupon, while a 20-year T-bond has a 9% annual coupon. Assume also that the yield curve is flat, and all Treasury securities have a 13% yield to maturity. Which of the following statements is correct? a. The 15-year bond would sell at a premium, while the 20-year bond would sell at par. b. The 15-year bond would sell at a discount, while the 20-year bond would sell at a premium. c. If interest rates increase, the prices of both bonds will decrease, but the 15-year bond would have a larger percentage decrease in price. d. If interest rates increase, the prices of both bonds will decrease, but the 20-year bond would have a larger percentage decrease in price.

60. Which statement regarding the yield curve is true? a. 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. b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. c. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. d. The yield curve can never be downward sloping.

61. Which statement regarding yield is true? a. A bond’s current yield must always be greater than its yield to maturity and its coupon rate. b. If a bond sells at par, then its current yield will be equal to its yield to maturity. c. If a bond sells for more than par, then its yield to maturity is greater than its coupon rate. d. A premium bond’s price increases each year until it matures, when its value equals its par value.

62. Zumwalt Corporation’s Class S bonds have an 11-year maturity, a $1,000 par value, and a 6.5% coupon paid semiannually (3.25% each 6 months), and those bonds sell at their par value. Zumwalt’s Class A bonds have the same risk, maturity, and par value, but the A bonds pay a 6.5% annual coupon. Neither bond is callable. At what price should the annual payment bond sell? a. $991.89 b. $1,015.23 c. $1,106.50 d. $1,249.10

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Chap 06_4ce 63. Which of the following statements is correct? a. Liquidity premiums are generally higher on small companies than large companies. b. Default risk premiums are generally higher on government bonds than on corporate bonds. c. 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. d. Reinvestment rate risk is higher, other things held constant, on long-term than on short-term bonds.

64. Which statement regarding bonds is true? a. A bond that has just been issued is called a seasoned bond. b. The market value of a discount bond will always increase and approach its par value as its maturity date approaches, provided the bond’s required return remains constant. c. Bonds issued by smaller companies always have higher yields to maturity (more risk) than bonds issued by larger companies. d. The total yield on a bond equals current yield minus capital gains yield of the bond.

65. A 12-year Treasury bond has a 9% coupon, and a 9-year Treasury bond has a 12% coupon. Both bonds have the same yield to maturity. If the yield to maturity of both bonds decreases by the same amount, which of the following statements would be correct? a. The prices of both bonds would increase by the same amount. b. The prices of both bonds would decrease by the same amount. c. Both bonds would increase in price, but the 12-year bond would have the greater percentage increase in price. d. One bond’s price would decrease, while the other bond’s price would increase.

66. A 25-year bond with a 9% annual coupon has a yield to maturity of 11%. Which statement about this bond is correct? a. The bond is selling above its par value. b. The bond is selling at a premium to its par value. c. The bond is priced to sell at its par value. d. The bond is selling at a discount to its par value.

67. Which statement regarding reinvestment rate risk is true? a. All else equal, high-coupon bonds have more reinvestment rate risk than low-coupon bonds. b. All else equal, low-coupon bonds have more reinvestment rate risk than high-coupon bonds. c. All else equal, short-term bonds have more reinvestment rate risk than long-term bonds. d. All else equal, long-term bonds have more reinvestment rate risk than short-term bonds.

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Chap 06_4ce 68. Bonds A, B, and C all have a maturity of 10 years and a yield to maturity of 9%. Bond A’s price is less than its par value, Bond B’s price equals its par value, and Bond C’s price is greater than its par value. Which statement regarding bonds is true? a. If the yield to maturity on each bond decreases to 8%, the prices of all three bonds will increase. b. If the yield to maturity on each bond increases to 10%, Bond C will have the largest percentage decrease in its price. c. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain unchanged over the next year. d. Bond C has the most interest rate risk.

69. A 28-year corporate bond was issued 20 years ago. What is it today? a. a long-term bond with 8 years to maturity b. a long-term bond with 28 years to maturity c. a medium-term bond with 8 years to maturity d. a medium-term bond with 28 years to maturity 70. A 13-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 10%. Which statement regarding the bond’s price is true? a. If market interest rates increase, the price of the bond will also increase. b. The bond is currently selling at a price above its par value. c. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today. d. The bond should currently be selling at its par value.

71. Company A has a bond outstanding that pays a 9% coupon. The interest is paid semiannually, and the bond matures in 13 years. If the market rate of interest on bonds of similar risk is 12%, what should company A’s bond be selling for, approximately? a. $741.60 b. $770.35 c. $801.50 d. $804.95 72. Quigley Inc.’s bonds currently sell for $1,290 and have a par value of $1,000. They pay a $110 annual coupon and have a 13-year maturity, but they can be called in 5 years at $1,186. What is their yield to maturity (YTM)? a. 7.44% b. 7.70% c. 8.03% d. 8.28%

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Chap 06_4ce 73. Niendorf Corporation’s 5-year bonds yield 7.15%, and 5-year T-bonds yield 5%. The real risk-free rate is r* = 2.85%, the inflation premium for 5-year bonds is IP = 1.75%, the default risk premium for Niendorf’s bonds is DRP = 1.3% 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 Niendorf’s bonds? a. 0.85% b. 0.95% c. 1.00% d. 1.20% 74. D.J. Masson Inc. recently issued noncallable bonds that mature in 15 years. They have a par value of $1,000 and an annual coupon of 6.4%. If the current market interest rate is 9%, at what price should the bonds sell? a. $784.39 b. $790.42 c. $815.00 d. $827.61 75. What is the semiannual coupon payment for a 14% bond with a $1,000 par? a. $1,400 b. $700 c. $140 d. $70 76. Moerdyk Corporation’s bonds have a 12-year maturity, an 8.50% semiannual coupon, and a par value of $1,000.

The going interest rate (rd) is 6.4%, based on semiannual compounding. What is the bond’s price? a. $1,174.05 b. $1,190.25 c. $1,226.10 d. $1,250.08 77. Which statement regarding interest rate risk is true? a. The higher the coupon rate, the higher the interest rate risk. b. The higher the coupon rate, the lower the interest rate risk c. If the market interest rate for a bond is less than the bond’s coupon rate, the bond will sell at a discount. d. If the market interest rate for a bond is greater than the bond’s coupon rate, the bond will sell at a premium.

78. An 18-year corporate bond was issued 11 years ago. What is it today? a. a medium-term bond with 7 years to maturity b. a medium-term bond with 18 years to maturity c. a long-term bond with 7 years to maturity d. a long-term bond with 18 years to maturity

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Chap 06_4ce 79. Which statement regarding bond yields is true? a. If a coupon bond is selling at a discount, then the bond’s current yield is zero. b. If a coupon bond is selling at par, its current yield equals its yield to maturity. c. If a bond is selling at a premium, the yield to call is a better measure of the expected return than the yield to maturity. d. The current yield on Bond A is less than the current yield on Bond B. Therefore, Bond A must have a lower coupon rate than Bond B. 80. In corporate bonds, what is a “Canada call” used for calculating? a. the buy-back price b. the credit rating c. the expected cash flow d. the market rate 81. Which of the following are criteria for a bond to be labelled a Maple bond? a. The bond must be sold by a foreign company or government in Canadian dollars, in the Canadian bond market. b. The bond must be sold by a Canadian company, or the Government of Canada, in Canadian dollars, in the U.S. bond market. c. The bond must be sold by a U.S. company, or the Government of the U.S., in U.S. dollars, in the Canadian bond market. d. The bond must be sold by a foreign company or government in Canadian dollars, in the worldwide bond market.

82. You are considering two bonds. Bond A has a 5% annual coupon while Bond B has an 11% annual coupon.

Both bonds have an 8% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is correct? a. The price of Bond B will decrease over time, but the price of Bond A will increase over time. 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 remain unchanged. d. The prices of both bonds will decrease over time, but the price of Bond B will decrease by more.

83. Which statements regarding bond ratings are true?

I. They include quantitative analysis of financial ratios.

II. They include the effects of sinking fund provisions and whether the bond is subordinated to other debt.

III. They include qualitative analysis of potential environmental problems and potential antitrust problems.

IV. They do not adjust immediately as the factors in the market or in the company change. a. I, II, and IV only b. I, II, and III only c. II, III, and IV only d. I, II, III, and IV

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Chap 06_4ce 84. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which statement about this bond 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 1 year from now will be lower than its current price. d. The bond’s current yield is greater than 9%.

85. Which of the following statements is correct? a. A company’s bond rating is affected by the provisions in its indenture rather than its financial ratios. b. The promised return on a corporate bond equals its expected return if the probability of default is greater than zero and the bond can be called. c. There are two acts that address bankruptcy and reorganization in Canada, the Bankruptcy and Insolvency Act (BIA) and the Companies’ Creditors Arrangement Act (CCAA). The CCAA is used when a company has liabilities exceeding $5 million. d. All else being equal, senior debt has more default risk than junior debt.

86. A 12-year bond pays an annual coupon, its YTM is 10%, and it currently trades at a discount. Which statement regarding the bond’s yield is true? a. The bond’s current yield is greater than 10%. b. If the yield to maturity remains at 10%, then the bond’s price will decline over the next year. c. The bond’s coupon rate is greater than 10%. d. If the yield to maturity remains at 10%, then the bond’s price will increase over the next year.

87. Company A has a bond outstanding that pays a 9% coupon. The interest is paid semiannually, and the bond matures in 13 years. If the market rate of interest on bonds of similar risk is 12%, what should Company A’s bond be selling for, approximately, one year from today? a. $749.30 b. $780.50 c. $811.74 d. $835.21 88. Which statement regarding bond yields is true? a. The yield to maturity for a coupon bond that sells at a discount consists entirely of a negative capital gains yield; it has a zero current interest yield. b. 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. 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. Declining inflation makes the actual yield to maturity on a bond less than a quoted yield to maturity that is based on market prices.

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Chap 06_4ce 89. Short Corp. just issued bonds that will mature in 15 years, and Long Corp. issued bonds that will mature in 30 years. Both bonds promise to pay an annual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the yield curve is based only on expectations about future inflation; that is, that the maturity risk premium is zero for government bonds. Under these conditions, which of the following statements is correct? a. If the yield curve is upward sloping, Short’s bonds must have the lower yield under all conditions. b. If the yield curve is downward sloping, Short’s bonds must have the higher yield under all conditions. c. If the yield curve is upward sloping and Short has higher default risk than Long, then Long’s bonds must have the higher yield under all conditions. d. If the yield curve is upward sloping and Short has less default risk than Long, then Long’s bonds must have the higher yield under all conditions.

90. Which statement regarding bond maturity is true? a. The par value of the bond can be repaid after the maturity date. b. The longest term of maturity for corporate bonds is 100 years. c. The effective maturity of a bond remains unchanged after it has been issued. d. Most bonds have original maturities ranging from 10 to 40 years, but any maturity is legally permissible.

91. Which statement regarding types of debt is true? a. In the event of liquidation, the holders of senior mortgage bonds would receive payments only after the junior mortgage bondholders are paid off in full. b. Subordinated debt has higher default risk than senior debt. c. Investment-grade bonds typically provide a higher yield to maturity than speculative bonds. d. Convertible bonds have higher coupon rates than nonconvertible bonds of similar default risk because they offer the possibility of capital gains.

92. Bond A has a 7% annual coupon, while Bond B has a 13% annual coupon. Both bonds have the same maturity, a face value of $1,000, and a 10% yield to maturity. Which of the following statements is correct? a. If the yield to maturity for both bonds immediately decreases to 8%, Bond A’s bond will have a larger percentage increase in value. b. Bond A trades at a premium, whereas Bond B trades at a discount. c. Bond A’s current yield is greater than that of Bond B. d. Bond A’s capital gains yield is less than Bond B’s capital gains yield.

93. An investor is considering buying one of two 10-year, $1,000 face value bonds: Bond A has a 15% annual coupon, while Bond B has a 10% annual coupon. Both bonds have a yield to maturity of 13%, which is expected to remain constant for the next 10 years. Which statement regarding these bonds is correct? a. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. b. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. c. Bond B’s current yield is greater than 13%. d. Two years from now, Bond A’s price will be lower than it is today.

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Chap 06_4ce 94. What does the yield to maturity on bonds refer to? a. the expected rate of return on the bonds if purchased at the current price and held to maturity b. the promised rate of return on the bonds if purchased at the current price and held to maturity c. the ratio of the annual interest payment divided by the bond’s current price d. the rate of return due to the interest payment plus the rate of return due to the price change 95. Which statement regarding bond prices is true? a. If a coupon bond is selling at a discount, its current yield equals its yield to maturity. b. If a coupon bond is selling at a premium, its price will continue to increase until it reaches its par value at maturity. c. If interest rates decrease, the price of a 20-year coupon bond will increase by a greater percentage than the price of a 20-year zero coupon bond. d. If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a discount.

96. An investor has two bonds in their investment portfolio. Bond A matures in 8 years and Bond B matures in 20 years. All else equal, which bond would have a greater price sensitivity to a given change in interest rates? a. Bond A would have a greater sensitivity to a given change in interest rates due to its relative shorter term to maturity. b. Bond A and Bond B would have the same price sensitivity since term to maturity would not affect bond price. c. Bond B would have a greater sensitivity to a given change in interest rates as it has a longer term to maturity. d. Bond A and Bond B would have no price sensitivity since a given change in interest rates would not affect bond price.

97. O’Brien Ltd.’s outstanding bonds have a $1,000 par value, and they mature in 20 years. Their nominal yield to maturity is 8.9%, they pay interest semiannually, and they sell at a price of $870. What is the bond’s nominal (annual) coupon interest rate? a. 7.25% b. 7.50% c. 7.85% d. 8.10% 98. Assume that the current corporate bond yield curve is upward sloping. Under this condition, what could we be sure of? a. Inflation is expected to decrease in the future. b. Inflation is expected to remain unchanged in the future. c. Short-term bonds are less risky than long-term bonds. d. The maturity risk premium is an important reason for the yield curve’s upward slope.

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Chap 06_4ce 99. Which of the following is an example of reinvestment risk when investing in the bond market? a. The coupon rate on a bond is 10% and interest rates on similar bonds have risen by 2%. b. The coupon rate on a bond is 10% and interest rates on similar bonds have fallen by 3% c. The coupon rate on a bond is 10% and interest rates on similar bonds are also 10%. d. Reinvestment risk is not a factor in bond investing because bonds offer investors a risk free investment.

100. Which of the following statements regarding the real risk-free rate of interest is correct? a. The real risk-free rate of interest is the interest rate of a riskless security if inflation were expected, and it may be thought of as the rate of interest on long-term Government of Canada T-bonds in an inflation world. b. The real risk-free rate of interest is the interest rate of a riskless security if no inflation were expected, and it may be thought of as the rate of interest on long-term Government of Canada T-bonds in an inflation-free world. c. The real risk-free rate of interest is the interest rate of a riskless security if inflation were expected, and it may be thought of as the rate of interest on short-term Government of Canada T-bills in an inflation world. d. The real risk-free rate of interest is the interest rate of a riskless security if no inflation were expected, and it may be thought of as the rate of interest on short-term Government of Canada T-bills in an inflation-free world.

101. Which of the following explains why mortgage bonds have lower required interest rates than debentures? a. Debentures pay higher coupon payments given their relative higher risk profile since they are debts for which a corporation pledges a particular asset that may be claimed by the secured debtholder in the event of default. b. Mortgage bonds are secured by property, but debentures are unsecured bonds. c. Mortgage bonds have greater potential of loss due to a lack of collateral and thus offer lower coupon payments. d. Debentures pay higher coupon payments given their relative higher risk profile since they provide a lien against specific property as security for the obligation.

102. Wachowicz Corporation issued 20-year, noncallable, 8.6% annual coupon bonds at their par value of $1,000 four years ago. Today, the market interest rate on these bonds is 6.3%. What is the current price of the bonds, given that they now have 16 years to maturity? a. $1,227.72 b. $1,248.05 c. $1,271.00 d. $1,295.60

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Chap 06_4ce 103. Which of the following statements regarding junk bonds is correct? a. The large default variability combined with an appropriate risk-adjusted return make it possible for junk bonds to have attractive returns. b. The bonds rated less than BB are noninvestment-grade debt, also called junk bonds or high-yield debt. c. Since there is a high risk with junk bonds, there are no portfolio managers who specialize in junk bond investing. d. Although the Canadian market has some notable junk bond names such as Air Canada, Bombardier, and Quebecor Media, that market is large—more than 4% of the comparable U.S. market.

104. Which statement regarding bonds is true? a. If a 20-year, $1,000 par, 9% coupon bond was issued at par, and if interest rates then dropped to the point where rd = YTM = 6%, we could be sure that the bond would sell at a discount below its $1,000 par value. b. If a 20-year, $1,000 par, zero coupon bond was issued at a price that gave investors a 9% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 6%, the bond would sell at a premium above its $1,000 par value. c. Other things held constant, a callable bond would have a higher required rate of return than a noncallable bond. d. People often call a downward-sloping yield curve a normal yield curve and a yield curve that slopes upward an inverted, or abnormal, yield curve.

105. A downward-sloping yield curve is often referred to as which of the following? a. pure expectation curve b. flat curve c. normal curve d. inverted curve 106. Which of the following statements is correct? a. One advantage of zero coupon bonds is there is no reinvestment risk since zero coupon bonds don’t make regular interest payments. b. Other things held constant, a noncallable bond should have a higher yield to maturity than a callable bond. c. Once a firm declares bankruptcy, it must then be liquidated by the trustee, which uses the proceeds to pay suppliers, bondholders, trustee expenses, and unpaid wages. d. Indexed bonds must pay interest only if the company has sufficient earnings. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them riskier to the issuing corporation than “regular” bonds.

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Chap 06_4ce 107. Which of the following statements regarding zero coupon bonds is correct? a. Zero coupon bonds pay no coupons at all but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income. b. Zero coupon bonds pay no coupons at all but are offered at a substantial premium above their par values and hence provide capital appreciation rather than interest income. c. Although no regular interest payments are made, zero coupon bonds have risk of having to reinvest interest payments. d. The return of zero coupon bonds is the sum of the coupon payments and the gain (loss) on the price of the bond.

108. Keenan Industries has a bond outstanding with 18 years to maturity, a 9.5% coupon paid semiannually, and a $1,000 par value. The bond has a 7.2% nominal yield to maturity, but it can be called in 10 years at a price of $1,090. What is the bond’s nominal yield to call? a. 5.51% b. 5.70% c. 6.05% d. 6.92% 109. What effect would a 200-basis-point increase in yield have on bond prices? a. It would cause bond prices to increase in general. b. It would have the same impact on bond prices regardless of whether yields are high or low. c. It would have a larger impact on bond prices when yields are high. d. It would have a larger impact on bond prices when yields are low.

110. Company A has a bond outstanding that pays a 9% coupon. The interest is paid annually, and the bond matures in 13 years. If the market rate of interest on bonds of similar risk is 12%, what should company A’s bond be selling for, approximately? a. $807.29 b. $850.33 c. $872.50 d. $895.41 111. Which statement regarding sinking funds is true? a. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price. b. Most sinking funds require the issuer to provide funds to a trustee, which saves the money so that it will be available to pay off bondholders when the bonds mature. c. On balance, bonds that have a sinking fund are risker than those without such a provision, so sinking fund bonds are issued with higher coupon rates. d. Sinking fund provisions sometimes can work to the detriment of bondholders, and this is most likely to occur if the yields on similar bonds decrease after the bond has been issued.

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Chap 06_4ce 112. A bond is currently priced at $910 on a par value of $1,000. Its term to maturity is 7 years and its coupon rate is 12% (stated annually, paid annually). If you buy the bond, and hold it to maturity, what would be the yield to maturity? a. 12.85% b. 13.30% c. 13.71% d. 14.11% 113. Which of the following statements is correct? a. If two bonds have the same coupon rates, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of the bonds’ maturities. b. All else being equal, an increase in interest rates will have a smaller effect on the prices of long-term bonds than short-term bonds. c. All else being equal, an increase in interest rates will have a greater effect on lower-coupon bonds than it will have on higher-coupon bonds. d. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be greater than its maturity value.

114. A company is planning to raise $2 million to finance a new plant. Which statement regarding the cost of debt is true? a. The company would prefer to issue a bond without a call provision if its management thinks that interest rates are almost certain to decrease in the foreseeable future. b. If two tiers of debt are used (with one senior and one subordinated debt class) to raise the $2 million, the senior debt will carry a higher interest rate. c. If debt is used to raise the $2 million, with $0.7 million as first mortgage bonds on the new plant and $1.3 million as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $2 million were raised by selling first mortgage bonds. d. If debt is used to raise the $2 million, the cost of the debt would be lower if the debt were in the form of an unsecured term loan rather than a mortgage bond.

115. If the yield to maturity is 6%, what is the price of a 12-year, zero coupon bond with a par value of $1,000? a. $460.11 b. $473.02 c. $487.50 d. $496.97 116. Which of the following best describes zero coupon bonds? a. bonds that are issued with no coupon payment and whose price fluctuates above and below its par value b. bonds that are issued with one coupon payment on the issuing day and whose price is generally below the bond’s par value c. bonds that are issued with no coupon payment and whose price is generally at the bond’s par value d. bonds that are issued with no coupon payment and do not retain the creditworthiness of the original bonds on which they were based

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Chap 06_4ce 117. Which statement regarding interest rate risk is true? a. Short-term bonds have less interest rate price risk and less reinvestment rate risk than long-term bonds. b. If interest rates decrease, all bond prices will decrease, but the decrease will be greater for bonds that have less interest rate risk. c. Short-term bonds have less interest rate price risk but more reinvestment rate risk than long-term bonds. d. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has less interest rate price risk but more reinvestment rate risk.

118. Which statement regarding callable bonds is true? a. 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 smaller if the current market interest rate is below the coupon rate than if it is above the coupon rate. b. Corporate treasurers like issuing callable bonds because the company could sell a new issue of highyielding securities if and when interest rates increase. 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 smaller 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.

119. Which of the following is a correct statement regarding Maple bonds? a. Maple bonds are issued by the Canadian Government in January of each year. b. Maple bonds are foreign bonds and have currency risk. c. Maple bonds are domestic bonds and have no currency risk. d. The number of Maple bonds has grown substantially since first introduced, although they are still a relatively small part of the overall bond market.

120. In which of these countries did indexed bonds first become popular? a. Canada b. United States c. Israel d. United Kingdom

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Chap 06_4ce 121. Which of the following statements best describes interest rates? a. You hold two bonds. One is a 15-year, zero coupon issue, and the other is a 15-year bond that pays a 7% annual coupon. The same market rate, 7%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline. b. You hold two bonds. One is a 15-year, zero coupon issue, and the other is a 15-year bond that pays a 7% annual coupon. The same market rate, 7%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the same percentage decline. c. An increase in interest rates will cause the prices of outstanding bonds to rise, whereas a decrease in rates will cause bond prices to fall. d. An increase in interest rates will cause the prices of outstanding bonds to fall, whereas a decrease in rates will cause bond prices to rise.

122. Suppose a new company decides to raise a total of $350 million, with $200 million as common equity and $150 million as long-term debt. The debt can be mortgage bonds or debentures, but by an ironclad provision in its charter, the company can never raise any additional debt beyond the original $150 million. Given these conditions, which of the following statements is correct? a. 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. b. In this situation, we cannot tell for sure how, or whether, the firm’s total interest expense on the $150 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. If the debt were raised by issuing $75 million of debentures and $75 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 $150 million of debentures. d. If the debt were raised by issuing $75 million of debentures and $75 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 $150 million of first mortgage bonds.

123. In the bond market, what is a firm that raises capital by selling new bonds? a. indenture b. issuing firm c. trustee d. bondholder 124. A $10,000 strip bond is priced at $8,730. If its term to maturity is 9 years, what is the yield to maturity on this bond, to the nearest percent? a. 0.85% b. 1.10% c. 1.52% d. 2.38%

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Chap 06_4ce 125. ABC Inc. issued at par value a 15-year, 7% semiannual coupon bond with a par value of $1,000. At the end of 3 years the market interest increases to 9%. One year later, the market interest is 10%. If an investor purchases the bond at the end of year 3 and sells it 1 year later, how much is the capital gain or loss? a. –$49.00 b. –$50.31 c. –$52.50 d. –$55.60 126. Ezzell Enterprises’ noncallable bonds currently sell for $1,370. They have an 18-year maturity, an annual coupon of $98, and a par value of $1,000. What is their yield to maturity? a. 5.94% b. 6.10% c. 6.30% d. 6.53% 127. Assume that you are considering the purchase of a 13-year bond with an annual coupon rate of 12%. The bond has face value of $1,000 and makes semiannual interest payments. If you require a 13% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $895.26 b. $912.50 c. $938.04 d. $960.81 128. Company A has a bond outstanding that pays a 9% coupon. The interest is paid annually, and the bond matures in 13 years. If the market rate of interest on bonds of similar risk is 12%, what should Company A’s bond be selling for, approximately, one year from today? a. $790.25 b. $814.17 c. $842.10 d. $875.03 129. In which way do income bonds pay interest? a. annually or semiannually b. when earnings are higher than the interest expense c. when earnings are lower than the interest expense d. at predetermined dates

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Chap 06_4ce 130. Which of the following statements is correct? a. A 15-year coupon bond would have more reinvestment rate risk than an 11-year coupon bond, but will have less interest rate risk than an 11-year coupon bond. b. A 15-year coupon bond would have less reinvestment rate risk and interest rate risk than an 11-year coupon bond. c. If their maturities and other characteristics were the same, a 12% coupon bond would have more interest rate price risk than a 9% coupon bond. d. If their maturities and other characteristics were the same, a 12% coupon bond would have less interest rate price risk than a 9% coupon bond.

131. The following are some provisions that are often found in a bond indenture. Which of these provisions would probably NOT reduce the yield to maturity that investors would otherwise require on a newly issued bond? a. The bond is subordinated to certain bank loans. b. The bond has a sinking fund. c. Real estate is used as security for the bond. d. The indenture contains covenants that keep the company’s debt ratio below a given level.

132. Ten-year Treasury bonds yield 7.6%. The inflation premium (IP) is 2.8%, and the maturity risk premium (MRP) on 10-year bonds is 1.4%. What is the real risk-free rate, r*? a. 3.15% b. 3.40% c. 3.65% d. 3.80% 133. Current yield is calculated by dividing a bond’s coupon payment by which of the following? a. its par value b. its current price c. its maturity value d. its purchase price

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Chap 06_4ce 134. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. KJM Corporation’s balance sheet as of today is as follows: Long-term debt (bonds, at par) Preferred shares Common shares ($10 par) Retained earnings Total debt and equity

$9,000,000 2,000,000 13,000,000 4,000,000 $28,000,000

The bonds have a 5% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 11 years from today. The yield to maturity is 14%, so the bonds now sell below par. What is the current market value of the firm’s debt? a. $6,076,050 b. $6,300,485 c. $6,529,120 d. $6,750,510 135. Keys Corporation’s 7-year bonds yield 8%, and 7-year T-bonds yield 6.2%. The real risk-free rate is r* = 3.6%, the inflation premium for 7-year bonds is IP = 2%, the liquidity premium for Keys’s bonds is LP = 0.9% 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 Keys’s bonds? a. 0.5% b. 0.8% c. 0.9% d. 1.1% 136. Which bond would have the greatest percentage decrease in value if all interest rates increase by 1%? a. 30-year, 14% coupon bond b. 30-year, 8% coupon bond c. 30-year, zero coupon bond d. 5-year, zero coupon bond 137. Morrissey Company’s bonds mature in 8 years, have a par value of $1,000, and make an annual coupon payment of $90. The market interest rate for the bonds is 11%. What is the bond’s price? a. $860.33 b. $882.15 c. $897.08 d. $912.40

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Chap 06_4ce 138. Amram Inc. can issue a 30-year bond with a 9% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Amram could issue a 30-year bond that is convertible into common equity, may be called, and has a sinking fund. What is the coupon rate that Amram would have to pay on the convertible, callable bond? a. It is less than 9%. b. It is exactly equal to 9%. c. It is greater than 9%. d. It could be less than, equal to, or greater than 9%.

139. Sadik Inc.’s bonds currently sell for $1,400 and have a par value of $1,000. They pay a $150 annual coupon and have an 18-year maturity, but they can be called in 8 years at $1,200. What is their yield to call (YTC)? a. 9.15% b. 9.44% c. 9.68% d. 9.91% 140. Assume that interest rates on 30-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 8.85% AAA = 9.31%

A = 10.50% BBB = 11.64%

What most probably caused the differences in rates among these issues? a. default risk differences b. real risk-free rate differences c. interest rate risk differences d. inflation differences 141. A bond’s price decreases from par value to $925 due to a change in interest rates. All other things equal, this a good example of which of the following? a. interest rate risk b. default risk c. liquidity risk d. reinvestment risk 142. Suppose a Korean company issues a bond in Canada that is denominated in Canadian dollars. What is this an example of? a. a global bond b. a Maple bond c. a domestic bond d. a Yankee bond

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Chap 06_4ce 143. Which of the following is NOT an action or consequence of the activities of bond rating agencies? a. In assessing the rating, the agency examines both qualitative and quantitative factors. b. When a material change is identified in any of the factors used to measure a bond’s default risk the agency will not adjust immediately to changes in credit quality, and in some cases there can be a considerable lag between a change in credit quality and a change in rating. c. With respect to qualitative factors, the agency will pay particular attention to important provisions, including whether the bond is secured by a mortgage on specific assets, whether the bond is subordinated to other debt, or any sinking fund provisions. d. Rating agencies review outstanding bonds on a periodic basis and re-rate if necessary.

144. Which of the following statements is correct? a. For a given firm, its mortgage bonds are likely to have a higher yield to maturity than its debentures. b. A company may file for a bankruptcy order, or a creditor may go to court to force it into bankruptcy through a voluntary assignment in bankruptcy. c. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. d. The price of a premium bond will decrease over time, assuming that the bond’s yield to maturity remains constant.

145. Which of the following statements is a description of “refunding operation”? a. Provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates drop. It could then use the proceeds of the new issue to retire the high-rate issue and thus reduce its interest expense. b. Provided the issue is callable, the company could sell a new issue of high-yielding securities if and when interest rates drop. It could then use the proceeds of the new issue to retire the low-rate issue and thus reduce its interest expense. c. Provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates increase. It could then use the proceeds of the new issue to retire the high-rate issue and thus reduce its interest expense. d. Provided the issue is callable, the company could sell a new issue of high-yielding securities if and when interest rates increase. It could then use the proceeds of the new issue to retire the low-rate issue and thus reduce its interest expense.

146. A zero coupon bond with a nominal $1,000 face value has 18 years to maturity and is issued with a price of $302.50. What is the implicit interest you earn on the bond in the first year of the bond’s life, keeping all other factors constant? a. $68.68 b. $60.05 c. $20.78 d. $17.54

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Chap 06_4ce 147. A government bond has a 9% annual coupon and a 10% yield to maturity. Which statement regarding this bond is correct? a. The bond sells at a price above par. b. The bond has a current yield greater than 9%. c. The bond’s required rate of return is less than 10%. d. If the yield to maturity remains constant, the price of the bond will decrease over time.

148. Assume that all interest rates in the economy decline from 12% to 11%. Which bond would have the largest percentage increase in price? a. a 25-year zero coupon bond b. a 20-year bond with a 6% coupon c. a 10-year bond with a 12% coupon d. a 7-year bond with a 16% coupon 149. A bond with a par value of $1,000 has an annual interest payment of $93. The bond currently sells for $930 and has 7 years to maturity. Which of the following is true? a. The coupon rate must be 9.3%. b. The investor’s required rate of return must be 9.3%. c. The current yield on the bond must be 9.3%. d. The yield to maturity must be 9.3%.

150. Which bond has the greatest interest rate price risk? a. a 20-year, $1,000 face value, zero coupon bond b. a 20-year, $1,000 face value, 14% coupon bond with annual interest payments c. a 20-year, $1,000 face value, 14% coupon bond with semiannual interest payments d. All 20-year bonds have the same interest rate price risk due to the same maturity.

151. If a bond’s par value is less than its market price, which of the following can we reasonably state about the general direction of interest rates in the recent past? a. Interest rates have risen. b. Interest rates have declined. c. Interest rates have remained relatively stable. d. None of the above are correct.

152. Which of the following statements is correct? a. A trustee (for bond indenture) is an official (usually a bank) who represents the bond issuer and makes sure the terms of the indenture are carried out. b. Canada Housing Trust, an agency holding residential mortgages, is not a large issuer of agency bonds. c. The purchaser of a credit default swap (CDS) agrees to make annual payments to a counterparty that agrees to pay if a particular bond defaults. d. During the 2000s, investment banks often would purchase mortgage-backed securities (MBS) for the CDS they were creating in order to make the securities more attractive to investors.

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Chap 06_4ce 153. If its yield to maturity increased by 1%, which bond would have the largest percentage decrease in value? a. a 3-year zero coupon bond b. a 15-year zero coupon bond c. a 3-year bond with a 9% coupon d. a 15-year bond with a 9% coupon 154. What is a bond that offers investors a variable rate coupon payment? a. coupon bond b. convertible bond c. stripped bond d. floating rate bond 155. Company A has a bond outstanding that pays a 9% coupon. The interest is paid annually, and the bond matures in 15 years. The market rate of interest on bonds of similar risk is 6.5% and the bond is selling for $1,235.07.

One year from today, the bond is expected to be selling for $1,225.35. What is the rate of return for the bondholder? a. –0.0787% b. 5.2300% c. 6.0000% d. 6.5000% 156. Which statement regarding bonds is FALSE? a. Any maturity is legally permissible. b. A make-whole provision refers to the Canada call provision that has been adopted by U.S. corporate bond issuers and is now widely used in the United States. c. A super poison put enables an issuing corporation to turn in, or “put,” a bond to the bondholder at par in the event of a takeover, merger, or major recapitalization. d. Real return bonds are indexed bonds issued by the Canadian government, which can protect bondholders against inflation.

157. Which of the following is considered the dominant law when a firm with liabilities exceeding $5 million is declaring bankruptcy? a. Companies’ Creditors Arrangements Act b. Bankruptcy and Insolvency Act c. Federal Bankruptcy Code d. International Financial Reporting Standards

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Chap 06_4ce 158. Which of the following statements regarding bond current yields is correct? a. If a bond is selling at a premium, then its current yield will decrease as the bond’s term to maturity changes. b. If a bond is selling at a discount, then its current yield will increase as the bond’s term to maturity changes. c. If a bond is selling at par, then its current yield will remain unchanged as the bond’s term to maturity changes. d. If a bond is selling at a discount, then its current yield will be less than its yield to maturity.

159. Bond X has a 13% annual coupon, Bond Y has a 9% annual coupon, and Bond Z has a 6% annual coupon.

Each of the bonds has a maturity of 10 years and a yield to maturity of 9%. Which statement regarding bonds is true? a. If the bonds’ market interest rate remains at 9%, Bond Z’s price will be lower 2 years from now than it is today. b. If market interest rates remain at 9%, Bond X’s price will be 9% higher 1 year from today. c. If market interest rates increase, Bond X’s price will decrease, Bond Z’s price will increase, and Bond Y’s price will remain the same. d. If market interest rates decline, the prices of all three bonds will increase, but Bond Z’s price will have the largest percentage increase.

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Chap 06_4ce Answer Key 1. False 2. False 3. False 4. True 5. False 6. False 7. True 8. True 9. True 10. True 11. True 12. False 13. False 14. False 15. False 16. False 17. True 18. True 19. True 20. False 21. True 22. False 23. True 24. b 25. a 26. b

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Chap 06_4ce 27. b 28. b 29. d 30. c 31. d 32. b 33. c 34. d 35. a 36. c 37. b 38. d 39. b 40. a 41. a 42. d 43. d 44. c 45. d 46. a 47. a 48. b 49. c 50. b 51. c 52. c 53. a 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 06_4ce 55. c 56. a 57. c 58. c 59. d 60. a 61. b 62. a 63. a 64. b 65. c 66. d 67. c 68. a 69. c 70. c 71. d 72. a 73. a 74. b 75. d 76. a 77. b 78. a 79. b 80. a 81. a 82. a Copyright Cengage Learning. Powered by Cognero.

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Chap 06_4ce 83. d 84. c 85. c 86. d 87. c 88. c 89. d 90. d 91. b 92. a 93. d 94. b 95. d 96. c 97. b 98. d 99. b 100. d 101. b 102. a 103. a 104. c 105. d 106. a 107. a 108. d 109. d 110. a Copyright Cengage Learning. Powered by Cognero.

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Chap 06_4ce 111. d 112. d 113. c 114. c 115. d 116. a 117. c 118. c 119. d 120. c 121. d 122. b 123. b 124. c 125. c 126. c 127. c 128. b 129. b 130. d 131. a 132. b 133. b 134. c 135. c 136. c 137. c

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Chap 06_4ce 138. d 139. b 140. a 141. a 142. b 143. c 144. d 145. a 146. c 147. b 148. a 149. a 150. a 151. b 152. c 153. b 154. d 155. d 156. c 157. a 158. c 159. d

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Chap 07_4ce Indicate whether the statement is true or false.

1. Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A’s portfolio has a beta of minus 3.0, while Investor B’s portfolio has a beta of plus 3.0. 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. By adding some “normal” stocks with beta = 1.0, the holders of either portfolio could lower their risks, but the risk reduction effect in Investor B’s portfolio would be larger. a. True b. False 2. A firm’s beta can be changed through managerial decisions such as changes in the composition of its assets, but does not change because of external factors such as the expiration of basic patents. a. True b. False 3. 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 4. If any two assets are perfectly positively correlated, an equal weighted portfolio of these two assets will always result in a positive portfolio return. a. True b. False 5. No investment should be undertaken unless the expected rate of return is high enough to compensate the investor for the perceived risk of the investment. So, in equilibrium, the expected rate of return on a stock must equal its required return. a. True b. False 6. The slope of the SML reflects the degree of risk aversion in the economy. The smaller the average investor’s aversion to risk, the steeper the slope of the line. a. True b. False 7. The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be close to the expected value, and, consequently, the less likely it is that the actual return will end up far below the expected return. a. True b. False 8. The part of a stock’s risk that can be eliminated is called diversifiable risk, which is caused by factors that systematically affect most firms such as war, inflation, recessions, and high interest rates. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 07_4ce 9. If an investor buys “index” mutual funds that hold the same stocks that make up major indices such as the S&P/TSX 60, diversification can eliminate stock market risk even in a market crash. a. True b. False 10. Risky assets often generate their expected rates of return. a. True b. False 11. Diversification can effectively reduce risk if the portfolio consists of perfectly positively correlated stocks. a. True b. False 12. Efficient portfolios are defined as those portfolios that provide the lowest expected return for any degree of risk, or the highest degree of risk for any expected return. a. True b. False 13. 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, the change in the risk-free rate will cause a change in the required market return, resulting in a relatively stable market risk premium (rM – rRF). However, if there is no change in stocks’ betas, then the required rate of return on each stock as measured by the CAPM will increase more than the increase in expected inflation. a. True b. False 14. The primary conclusion of the CAPM is that the relevant risk of an individual stock is the amount of risk the stock contributes to a well-diversified portfolio. The benchmark for a well-diversified stock portfolio is the market portfolio, which is a portfolio containing all stocks. a. True b. False 15. Market risk is caused by random events such as lawsuits and strikes. Because these events are random, their effects on a portfolio can be eliminated by diversification. a. True b. False 16. 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

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Chap 07_4ce 17. If we plot the actual historical returns for a company on the vertical axis and plot the market portfolio’s returns on the horizontal axis, a regression line then can be fitted through the points. The slope of the regression line provides an estimate of the stock’s beta. a. True b. False 18. A portfolio’s risk can be measured by the standard deviation of the portfolio. In general, the risk of a portfolio decreases as the number of stocks in the portfolio increases. a. True b. False 19. We will generally find that the beta of a single security is less stable over time than the beta of a diversified portfolio. a. True b. False 20. Since a stock’s beta coefficient determines how the stock affects the risk of a diversified portfolio, beta is the most relevant measure of any stock’s risk. a. True b. False 21. In a market dominated by risk-averse investors, riskier securities must have lower expected returns than less risky securities according to the estimates of marginal investors. If this situation does not exist, buying and selling in the market will force it to occur. a. True b. False 22. Risk aversion means investors like returns and dislike risk. So, other things held constant, the higher a security’s risk, the lower its price and the higher its required return. a. True b. False 23. The CAPM can be considered as a special case of the arbitrage pricing theory where there is only one risk factor, the market portfolio. a. True b. False 24. The beta coefficient used by investors should reflect the expected volatility of a given stock’s return versus the return on the market during some future period. So, people generally calculate betas using predicted data for future periods. a. True b. False

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Chap 07_4ce 25. The distributions of rates of return for Companies AA and BB are given below: State of Economy Boom Normal Recession

Probability of State Occurring 0.3 0.5 0.2

AA 30% 10% –5%

BB –10% 6% 65%

We can conclude from the above information that any rational risk-averse investor will add Security AA to a well-diversified portfolio over Security BB. a. True b. False 26. The expected return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. a. True b. False 27. The coefficient of variation provides a more meaningful basis for comparison than the standard deviation when the expected returns on two alternatives are not the same. a. True b. False 28. If a portfolio consists of perfectly related stocks—that is, the correlation between the returns of the two stocks is +1.0—this diversification does nothing to reduce risk. a. True b. False 29. Theoretically, it’s impossible to construct a portfolio such that the portfolio was riskless and the net investment in it was zero. a. True b. False 30. Investors prefer diversification based on only one asset class rather than diversification among different asset classes (e.g., stocks, bonds, money market securities). a. True b. False 31. Portfolio A has only one security, whereas Portfolio B has 200. Because of the diversification effect, the risk of Portfolio B must be lower than that of Portfolio A. a. True b. False

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Chap 07_4ce 32. The stock’s stand-alone risk is its contribution to a well-diversified portfolio’s risk, which is much smaller than the stock’s relevant risk. a. True b. False 33. The market risk premium (RPM ) is the extra rate of return that investors require to invest in the stock market rather than purchase risk-free securities. The size of the market risk premium depends on the degree of risk aversion that investors have on average. a. True b. False 34. In cases where two or more investments have significantly different expected returns, the coefficient of variation is a better measure than just standard deviation for evaluating stand-alone risk since it measures the impacts of both risk and return. a. True b. False 35. If an investor buys enough stocks they 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 company-specific risk. a. True b. False 36. In the graph of SML, the returns on individual stocks are plotted on the vertical axis and returns on the market index are shown on the horizontal axis. a. True b. False 37. 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 riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

38. Stock A’s beta is 1.1 and Stock B’s beta is 2. 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. In equilibrium, the expected return on Stock A will be greater than that on Stock B. c. Stock B would be a more desirable addition to a portfolio than Stock A. d. Stock A would be a more desirable addition to a portfolio than Stock B.

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Chap 07_4ce 39. Which of the following statements regarding beta coefficient is correct? a. According to the definition of beta coefficient, a stock with a high standard deviation will tend to have a high beta, which means that it contributes a relatively large amount of risk to a well-diversified portfolio. b. The stand-alone risk of an individual stock, which is called its beta coefficient, b, is defined under the CAPM as the amount of risk that the stock contributes to the market portfolio. c. According to the definition of beta coefficient, a stock with a high correlation with the market will also have a small beta, and hence be less risky. d. We cannot obtain the beta coefficient based on the covariance between a stock and the market and the standard deviation of the market’s return.

40. By definition, which of the following is correct regarding the beta of the market? a. The market beta will depend on the composition of the market portfolio and could be any value. b. The market beta will be equal to 1 given that it is a well-diversified portfolio containing all assets. c. The market beta will be equal to 1 as the market portfolio diversification is generally the same as an individual’s portfolio diversification. d. The market beta will be less than 1 as the market portfolio is generally less diversified than an individual’s portfolio.

41. An investment has an average return of 9.5%. The standard deviation of returns on this investment is 23.69%.

Given this information, what is the range of return 99% of the time? a. 14.19% to 33.19% b. 14.19% to 80.57% c. –61.57% to 80.57% d. –61.57% to 33.19% 42. Which of the following statements is correct? a. 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. b. If an investor buys enough stocks, they can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would still be exposed to market risk. c. Portfolio diversification reduces the stand-alone risk of each individual stock held in a portfolio. d. A security’s beta measures its diversifiable, or market, risk relative to that of an average stock.

43. Which of the following is the best measure of risk for a single 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. beta; beta d. coefficient of variation; beta

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Chap 07_4ce 44. Stock A has a beta of 1.6, Stock B has a beta of 1.0, and Stock C has a beta of 0.5. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 32%. 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 of all stocks will remain unchanged since there was no change in their betas. b. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock A) will increase while the returns of safer stocks (such as Stock C) will decrease. c. The required return on Stock A will increase by more than the increase in the market risk premium, while the required return on Stock C will increase by less than the increase in the market risk premium. d. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock A) will decrease while the returns on safer stocks (such as Stock C) will increase.

45. What happens to the amount of market risk as the number of assets in a portfolio increases? a. It decreases. b. It increases. c. It remains constant. d. It changes randomly.

46. Which of the following statements is correct? a. A graph of the SML as applied to individual stocks would show standard deviations of return on the vertical axis and betas of returns on the horizontal axis. b. The CAPM has been thoroughly tested, so there are no limitations when using it in practice. c. If investors become less risk averse, then (1) the slope of the SML would decrease and (2) the required rate of return on low-beta stocks would decrease by less 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 the increase in the required return on a riskless asset less than the increase on an average stock, other things held constant.

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Chap 07_4ce 47. Consider the following information for three stocks, A, B, and C, and portfolios of these stocks. The stocks’ returns are positively but not perfectly positively correlated with one another, i.e., the correlation coefficients are all between 0 and 1.

Stock Stock A Stock B Stock C

Expected Return 10% 10 14

Standard Deviation 30% 20 14

Beta 1.0 1.0 1.6

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 6%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is correct? a. Portfolio AB has a standard deviation of 30%. b. Portfolio AB’s coefficient of variation is greater than 3.0. c. Portfolio AB’s required return is equal to the required return on Stock A. d. Portfolio ABC’s expected return is 12%.

48. What is the effect on portfolio beta of a smaller number of assets in a portfolio and a shorter time period? a. It is less stable. b. It is more stable. c. It is more consistent. d. It is less consistent.

49. Rodriguez Roofing’s stock has a beta of 1.45, its required return is 12.8%, and the risk-free rate is 5.2%. What is the required rate of return on the stock market? (Hint: First find the market risk premium.) a. 10.10% b. 10.44% c. 10.75% d. 10.90% 50. A stock has an expected return of 17.8%. Its beta is 1.52 and the risk-free rate is 6%. What is the market risk premium? a. 7.21% b. 7.50% c. 7.76% d. 7.94%

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Chap 07_4ce 51. Suppose you hold a diversified portfolio consisting of a $10,000 investment in each of 13 different common stocks. The portfolio’s beta is 1.6. Now suppose you decided to sell one of your stocks that has a beta of 1.1 and use the proceeds to buy a replacement stock with a beta of 1.55. What would be the portfolio’s new beta? a. 1.01 b. 1.25 c. 1.48 d. 1.63 52. Assume that you manage an $11.25 million mutual fund that has a beta of 1.3 and an 11% required return. The risk-free rate is 5.1%. You now receive another $6.75 million, which you invest in stocks with an average beta of 0.72. 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. 9.50% b. 9.85% c. 10.01% d. 10.27% 53. A payoff matrix considers the possible rates of return along with which other factor? a. the correlation of rates of return b. the standard deviation of rates of return c. the variance of each occurrence d. the probabilities of occurrence 54. Other things held constant, in which way would the Security Market Line shift if the expected inflation rate increases and investors also become less risk averse? a. It would shift down and keep the same slope. b. It would shift down and have a steeper slope. c. It would shift up and keep the same slope. d. It would shift up and have a less steep slope.

55. An investment’s expected rate of return is found by multiplying which of the following? a. each possible outcome or “state” by its probability of occurrence b. each possible outcome or “state” by its standard deviation of return c. the average return of each occurrence by its probability d. each possible outcome by its standard deviation of occurrence probability

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Chap 07_4ce 56. Ripken Iron Works believes the following probability distribution exists for its stock. What is the coefficient of variation on the company’s stock?

State of the Economy Boom Normal Recession

Probability of State Occurring 0.20 0.60 0.20

Stock’s Expected Return 30% 18% 6%

a. 0.3502 b. 0.3860 c. 0.4015 d. 0.4217 57. An investor has $200,000 to invest. If she invests 20% in Stock A, 45% in Stock B, and the remainder in a market index exchange-traded fund (ETF), calculate the investor’s portfolio beta.

Betas Stock A 0.91 Stock B 1.58 a. 1.24 b. 1.05 c. 1.00 d. 0.73 58. Stocks A, B, and C all have an expected return of 12% and a standard deviation of 30%. Stocks A and C have returns that are independent of one another; that is, their correlation coefficient equals zero. Stocks A and B have returns that are negatively correlated with one another; that is, their correlation coefficient 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 AB has a standard deviation that is less than 30%. b. Portfolio AC has a standard deviation that is greater than 30%. c. Portfolio AB has an expected return that is greater than 12%. d. Portfolio AC has an expected return that is less than 12%.

59. Yonan Corporation’s stock had a required return of 12.8% last year, when the risk-free rate was 6.3% and the market risk premium was 5.7%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 3%. The risk-free rate and Yonan’s beta remain unchanged. What is Yonan’s new required return? (Hint: First calculate the beta, then find the required return.) a. 15.64% b. 15.80% c. 16.22% d. 16.58%

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Chap 07_4ce 60. Stock A has an expected return of 11%, a beta of 1.5, and a standard deviation of 22%. Stock B also has a beta of 1.5, an expected return of 17%, and a standard deviation of 13%. Portfolio AB has $300,000 invested in Stock A and $200,000 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. Portfolio AB’s beta is less than 1.5. b. Portfolio AB’s expected return is 14%. c. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. d. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.

61. The appropriate measure of risk for all investors is how the return on an individual stock moves with the returns of other assets in the portfolio. Which of the following best describes this relationship? a. correlation b. covariance c. beta d. coefficient of variation 62. What happens to portfolios that cannot be dominated? a. They have low covariances. b. They have minimum standard deviations. c. They lie on the efficient frontier. d. They have maximum expected returns.

63. Currently, the risk-free rate is 7% and the market risk premium is 8%. Given this information, which of the following statements is correct? a. If a stock’s beta triples, its required return must also triple. b. An index fund with beta = 1.0 should have a required return less than 15%. c. An index fund with beta = 1.0 should have a required return of 15%. d. An index fund with beta = 1.0 should have a required return greater than 15%.

64. Stock A has a beta of 0.4, whereas Stock B has a beta of 1.6. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium decreased by 1%? (Assume that the risk-free rate remains constant.) a. The required return on both stocks would decrease by 1%. b. The required return on Portfolio P would decrease by 1%. c. The required return on Portfolio P would decrease by less than 1%. d. The required return on Stock A would decrease by more than 1%, while the return on Stock B would decrease by less than 1%.

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Chap 07_4ce 65. Which of the following statements is correct? a. GGG Inc. is in the business of selling gold. GGG’s revenues, profits, and stock price tend to rise during recessions. This suggests that GGG Inc.’s beta should be quite high, say 3.0, because it does so much better than most other companies when the economy is weak. b. You think that investor sentiment is about to change, and investors are about to become more risk seeking. This suggests that you should rebalance your portfolio to include more low-beta stocks. c. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very weak in the immediate future. That is, you are convinced that the market is about to fall sharply. You should buy high-beta stocks and sell your low-beta stocks in order to take advantage of the expected market move. d. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.5 as determined in a regression analysis using data for the past 10 years, while the other has a beta of –0.7. The returns on the stock with the negative beta will be negatively correlated with returns on most other stocks in the market during that 10-year period.

66. Which statement best characterizes economic events such as war, recession, and high interest rates? a. They are market risk factors that can be totally diversified. b. They are systematic risks that cannot be eliminated by diversification. c. They are unsystematic risk factors that cannot be totally diversified. d. They are random events whose impact on a portfolio can be eliminated by diversification since bad events in one firm will be offset by good events in another.

67. Market risk refers to the tendency of a stock to move with the general stock market. Which of the following best describes a stock with a below-average market risk? a. it will tend to be less volatile than an average stock and its beta will be less than 1.0 b. it will tend to be less volatile than an average stock and its beta will be greater than 1.0 c. it will tend to be less volatile than an average stock and its beta will be equal to 1.0 d. it will tend to be less volatile than an average stock and its beta will be greater than 1.0 and less than 1.5 68. Assume that the risk-free rate is 5%. Which statement about a stock’s beta is correct? a. If a stock’s beta tripled, its required return under the CAPM would also triple. b. If a stock has a negative beta, its required return under the CAPM would be less than 6%. c. If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 6%. d. If a stock’s beta were 1.0, its required return under the CAPM would be 6%.

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Chap 07_4ce 69. You observe the following information regarding Companies X and Y: – Company X has a lower expected return than Company Y. – Company X has a higher standard deviation of returns than Company Y. – Company X has a lower beta than Company Y. Given this information, which of the following statements is correct? a. Company X has less unsystematic risk than Company Y. b. Company X has more market risk than Company Y. c. Company X’s returns will be positive when Y’s returns are negative. d. Company X has a higher coefficient of variation than Company Y. 70. Which of the following statements is correct? a. 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 is not always the same as the beta that exists in the future. b. If you found a stock with a negative historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. c. The beta of a portfolio of stocks is always larger than the beta 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 smaller than the risk-free (default-free) rate of return, rRF. 71. Suppose you have an asset with a return that rises as GDP increases. How will the asset’s return be affected if the government announces that GDP is unexpectedly lower than was previously thought? a. The return will increase. b. The return will remain unchanged. c. The return will decrease. d. It is undetermined and more information is needed.

72. Millar Co. has a beta of 1.4 and an expected dividend growth rate of 8% per year. The T-bill rate is 4%, and the T-bond rate is 7.5%. The annual return on the stock market during the past three years was 16%. Investors expect the annual future stock market return to be 13%. Using the SML, what is Millar’s required return? a. 14.5% b. 14.9% c. 15.2% d. 15.7%

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Chap 07_4ce 73. Stock A has a beta of 0.9 and Stock B has a beta of 1.1. 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 decrease but the risk-free rate (rRF) remained constant, which of the following would occur? a. The required return on Portfolio P will remain unchanged since the beta of Portfolio P is 1. b. The required return will decrease by the same amount for both Stock A and Stock B. c. The required return will increase for Stock A but will decrease for Stock B. d. The required return will decrease for both stocks but the decrease will be greater for Stock B than for Stock A. 74. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of five average stocks? a. The expected return of your portfolio is likely to decline. b. The unsystematic risk will remain the same, but the systematic risk will likely decline. c. The unsystematic risk of your portfolio will likely decline, but the market risk should not be expected to change. d. The total risk of your portfolio will remain the same, but the expected rate of return on the portfolio should decline.

75. What is implied when an asset has a negative beta value? a. It implies that the asset is a risk-reducing property when added to a portfolio. b. It implies that the asset doesn’t exist theoretically and practically. c. It implies that the asset’s return always decreases whenever the overall stock market decreases. d. It implies that the asset has a lower standard deviation.

76. Which of the following statements is correct? a. Higher beta stocks have lower required returns. b. The slope of the security market line is equal to the market risk premium. c. A stock’s beta indicates its unsystematic risk. d. Company-specific risk cannot be completely diversified away.

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Chap 07_4ce 77. Assume that you are the portfolio manager of the Coastal Fund, a $4 million hedge fund that contains the following stocks. The required rate of return on the market is 15% and the risk-free rate is 5.8%. What rate of return should investors expect (and require) on this fund?

Stock A Stock B Stock C Stock D

Amount $1,010,000 1,560,000 830,000 600,000 $4,000,000

Beta 1.30 0.65 1.70 0.80

a. 14.52% b. 14.88% c. 15.14% d. 15.46% 78. Which of the following is correct regarding a change in beta and its potential impact on a stock’s price? a. Any change in beta is not likely to affect the required rate of return on a stock, which implies that a change in beta will not likely have an impact on the stock’s price. b. Any change in beta is not likely to affect the required rate of return on a stock, which implies that a change in beta will always have an impact on the stock’s price. c. Any change in beta is likely to affect the required rate of return on a stock, which implies that a change in beta will never have an impact on the stock’s price. d. Any change in 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.

79. Which of the following best describes the beta coefficient? a. A stock’s beta measures its diversifiable (or company-specific) risk relative to the nondiversifiable risks of its bond issues. b. A stock’s beta measures its systematic risk relative to the market portfolio. c. A stock’s beta measures its market risk relative to the unsystematic risks of other firms. d. A stock’s beta measures its unsystematic risk relative to the market portfolio.

80. Which type of investor prefers lower returns with known risks rather than higher returns with unknown risks? a. ordinary investor b. risk-neutral investor c. risk-seeking investor d. risk-averse investor

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Chap 07_4ce 81. Which of the following is correct regarding anchoring bias? a. When the market is performing better than average, anchoring bias makes people tend to think it will perform worse than average. b. Anchoring bias is a phenomenon where many people focus too closely on recent events when predicting future events. c. When anchoring bias is coupled with overconfidence, investors can become convinced that their prediction of an increasing market is wrong, thus creating even less demand for stocks. d. Anchoring bias and overconfidence will drag down stock prices.

82. Stocks A and B both have an expected return of 13% and a standard deviation of returns of 22%. Stock A has a beta of 1.5 and Stock B has a beta of 0.7. The correlation coefficient, r, between the two stocks is 0.7.

Portfolio P is a portfolio with 50% invested in Stock A and 50% invested in B. Which of the following statements is correct? a. Portfolio P has more market risk than Stock B but less market risk than Stock A. b. Portfolio P has a coefficient of variation of 1.69. c. Portfolio P has a standard deviation of 22% and a beta of 1.1. d. Stock A should have a lower expected return than Stock B as viewed by the marginal investor.

83. Vera Paper’s stock has a beta of 1.5, and its required return is 13.2%. Dell Dairy’s stock has a beta of 0.9. If the risk-free rate is 5.6%, what is the required rate of return on Dell’s stock? a. 10.16% b. 10.45% c. 10.72% d. 10.99% 84. Stock A has a beta = 0.5, while Stock B has a beta = 1.5. Which of the following statements is correct? a. Stock B’s required return is three times that of Stock A’s. b. If the marginal investor becomes more risk averse, the required return on Stock B will increase by less than the required return on Stock A. c. An equally weighted portfolio of Stocks A and B will have a beta higher than 1. d. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by as much as that on Stock B. 85. Which of the following is correct regarding combining two negatively correlated assets into a portfolio? a. it will reduce portfolio risk b. it will not affect portfolio risk c. it will increase portfolio standard deviation d. it will keep portfolio returns unchanged

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Chap 07_4ce 86. Rosenberg Inc. is considering a capital budgeting project that has an expected return of 18% and a standard deviation of 30%. What is the project’s coefficient of variation? a. 1.52 b. 1.67 c. 1.80 d. 1.95 87. Your portfolio consists of $100,000 invested in Stock X and $100,000 invested in Stock Y. Both stocks have an expected return of 18%, betas of 1.7, and standard deviations of 29%. The returns of the two stocks are independent, so the correlation coefficient between them is zero. Which statement best describes the characteristics of your two-stock portfolio? a. Your portfolio has a standard deviation greater than 29%, and its beta is equal to 1.7. b. Your portfolio has a beta equal to 1.7, and its expected return is 18%. c. Your portfolio has a standard deviation less than 29%, and its beta is greater than 1.7. d. Your portfolio has a beta greater than 1.7, and its expected return is greater than 18%.

88. Which of the following statements is correct? a. If a company with a high-beta stock merges with a low-beta company, the best estimate of the new merged company’s beta is zero. b. The beta of the “average stock” or “market” always changes slightly over time, but the average beta is always equal to 1. c. 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 not be close to the “true” or “expected future” beta. d. If a newly issued stock does not have a past history that can be used as a basis for calculating beta, then we should always estimate that its beta will turn out to be zero. This is especially true if the company finances with more debt than the average firm.

89. Stocks A, B, and C have betas of 0.7, 1.0, and 1.3, respectively. Portfolio P has one-third of its value invested in each stock. Each stock has a standard deviation of 31%, and their returns are independent of one another; that is, the correlation coefficient between each pair of stock is zero. If the market is in equilibrium, which of the following is correct regarding Portfolio P’s expected return? a. it is greater than the expected return on Stock B b. it is equal to the expected return on Stock B c. it is less than the expected return on Stock B d. it is greater than the expected return on Stock C

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Chap 07_4ce 90. Bob has a $100,000 stock portfolio with a beta of 1.5, an expected return of 14%, and a standard deviation of 22%. Becky also has a $100,000 portfolio, but it has a beta of 0.9, an expected return of 8%, and a standard deviation that is also 22%. The correlation coefficient, r, between Bob’s and Becky’s portfolios is zero. If Bob and Becky marry and combine their portfolios, which statement about their combined $200,000 portfolio is true? a. The combined portfolio’s beta will be equal to a simple average of the betas of the two individual portfolios, 1.2; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 11%; and its standard deviation will be less than the simple average of the two portfolios’ standard deviations, 22%. b. The combined portfolio’s expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 11%. c. The combined portfolio’s standard deviation will be equal to the simple average of the two portfolios’ standard deviations, 22%. d. The combined portfolio’s standard deviation will be greater than the simple average of the two portfolios’ standard deviations, 22%.

91. J. Harper Inc.’s stock has a 60% chance of producing a 40% return, a 25% chance of producing a 12% return, and a 15% chance of producing a –26% return. What is Harper’s expected return? a. 23.10% b. 24.55% c. 25.40% d. 27.00% 92. Bertin Bicycles has a beta of 0.92 and an expected dividend growth rate of 5.1% per year. The T-bill rate is 4.5%, and the T-bond rate is 6.3%. The annual return on the stock market during the past 4 years was 11.7%.

Investors expect the average annual future return on the market to be 13.8%. Using the SML, what is Bertin’s required rate of return? a. 13.05% b. 13.20% c. 13.56% d. 13.89% 93. Which of the following is correct regarding the SML? a. The X-axis intercept of the SML represents the required return of a portfolio with a beta of 1, or the market portfolio rate. b. The X-axis intercept of the SML represents the required return of a portfolio with a beta of greater than 0, or risk-free rate. c. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of 0, or the riskfree rate. d. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of greater than 1, or the 10-year Government of Canada bond yield.

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Chap 07_4ce 94. 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 would have fallen, but the fall would have been greater for stocks with higher betas. b. The required returns on all stocks would have fallen, but the decline would have been greater for stocks with lower betas. c. Required returns would have decreased for stocks with betas greater than 1.0, but would have increased for stocks with betas less than 1.0. d. 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.

95. Jane has a portfolio of 3 average stocks, and Dick has a portfolio of 30 average stocks. Assuming the market is in equilibrium, which of the following statements is correct? a. Jane’s portfolio will have more diversifiable risk and also more market risk than Dick’s portfolio. b. The required return on Jane’s portfolio will be higher than that on Dick’s portfolio because Jane’s portfolio will have more total risk. c. If the two portfolios have the same beta, their required returns will be the same, but Jane’s portfolio will have more market risk than Dick’s. d. Dick’s portfolio will have less diversifiable risk, the same market risk, and thus less total risk than Jane’s portfolio, but the required (and expected) returns will be the same on both portfolios.

96. Which of the following statements is correct? a. A large portfolio of randomly selected stocks may have a standard deviation of returns that is greater than the standard deviation of a portfolio with fewer stocks. b. Company-specific (or diversifiable) risk can be reduced by forming a large portfolio, and market (or systematic) risk may be reduced by forming a highly diversified portfolio. 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 = 0.7. d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the systematic risk from the portfolio.

97. Which of the following is true regarding dollar returns? a. Dollar returns are equal to the amount invested minus the amount received. b. Dollar returns fail to take into account the size of the investment. c. Dollar returns take into account the timing of the investment. d. The concept of returns provides investors with a complex way to express the financial performance of an investment.

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Chap 07_4ce 98. Nile Foods’ stock has a beta of 1.5, while Elba Eateries’ stock has a beta of 0.5. Assume that the risk-free rate, rRF, is 6.2% and the market risk premium, (rM – rRF), equals 7%. Which of the following statements is correct? a. If the risk-free rate decreases but the market risk premium remains unchanged, the required return will decrease for both stocks, but the decrease will be larger for Nile since it has a higher beta. b. If the market risk premium decreases but the risk-free rate remains unchanged, Nile’s required return will decrease because it has a beta greater than 1.0 but Elba’s will increase because it has a beta less than 1.0. c. Since Nile’s beta is three times that of Elba’s, its required rate of return will also be three times that of Elba’s. d. If the risk-free rate decreases while the market risk premium remains constant, then the required return on an average stock will decrease.

99. As investors become risk averse, the market risk premium a. more, increases, flatter b. more, decreases, steeper c. less, increases, steeper d. less, decreases, flatter

and SML becomes

.

100. Returns for Shields Company over the past 3 years are shown below. What is the standard deviation of Shields’ returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.)

Year 2019 2020 2021 a. 26.95% b. 29.45% c. 30.02%

Return 30% –18.6% 25.9%

d. 33.60% 101. A mutual fund manager has a $26 million portfolio with a beta of 1.1. The risk-free rate is 5.3%, and the market risk premium is 7%. The manager expects to receive an additional $29 million, which they plan to invest in additional stocks. After investing the additional funds, they want the fund’s required and expected return to be 16%. What must the average beta of the new stocks be to achieve the target required rate of return? a. 1.65 b. 1.72 c. 1.80 d. 1.91

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Chap 07_4ce 102. Which of the following statements is correct? a. 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 in the market expect the observed relationship to continue on into the future. b. The SML shows the relationship between companies’ required returns and their unsystematic risks. The slope and intercept of this line can be influenced by a firm’s managers, but the position of the company on the line cannot be influenced by managers. c. The slope of the SML is determined by the risk-free rate. 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.

103. Which of the following is correct regarding the SML? a. The greater the marginal investor’s risk aversion, the flatter the SML. b. The lower the marginal investor’s risk aversion, the more positive the SML slope. c. The lower the marginal investor’s risk aversion, the steeper the SML. d. The lower the marginal investor’s risk aversion, the flatter the SML. 104. According to the SML, the 91-day Government of Canada T-bill is which of the following? a. a less risky asset used to determine the market’s return b. a risky asset used to price a stock c. a risk-free asset used to determine the required rate of return on a stock d. a risk-free asset used to determine the beta coefficient of a stock 105. Stock X has a beta of 0.7, while Stock Y has a beta of 1.3. Which of the following statements is correct? a. A portfolio consisting of $80,000 invested in Stock X and $80,000 invested in Stock Y will have a lower required return than that of the overall market. b. Stock Y must have a higher expected return and a higher standard deviation than Stock X. c. If the market risk premium decreases but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be smaller for Stock X. d. If expected inflation decreases but the market risk premium is unchanged, the required return on both stocks will increase by the same amount.

106. You are given the following returns on the market and on Stock A. Calculate Stock A’s beta coefficient.

Year 2019 2020 2021

Market –7% 15% 28%

Stock A –12% 14% 50%

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Chap 07_4ce 107. Stock A has a beta of 1.6 and a standard deviation of 22%. Stock B has a beta of 1.2 and a standard deviation of 27%. Portfolio AB was created by investing in a combination of Stocks A and B. Portfolio AB has a beta of 1.3 and a standard deviation of 20%. Which of the following statements is correct? a. Portfolio AB has less money invested in Stock A than in Stock B. b. Stock A has less market risk than Stock B but more stand-alone risk. c. Stock A has less market risk than Portfolio AB. d. Portfolio AB has the same amount of money invested in each of the two stocks.

108. Hocking Manufacturing Company has a beta of 0.72, while Levine Industries has a beta of 1.55. The required return on the stock market is 12%, and the risk-free rate is 5.5%. What is the difference between Hocking’s and Levine’s required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.) a. 5.15% b. 5.40% c. 5.72% d. 5.90% 109. An investment has an average return of 10.28%. The standard deviation of returns on this investment is 19.35%. Given this information, what is the range of return 68% of the time? a. 28.42% to 29.63% b. –28.42% to 29.63% c. –9.07% to 29.63% d. 9.07% to 29.63% 110. The risk-free rate is 7% and the market risk premium is 8%. Your $1 million portfolio consists of $600,000 invested in a stock that has a beta of 1.5 and $400,000 invested in a stock that has a beta of 0.9. Which of the following statements is correct? a. If the stock market is efficient, your portfolio’s expected return should equal the expected return on the market, which is 15%. b. The required return on the market is 12%. c. The portfolio’s required return is greater than 15%. d. If the risk-free rate remains unchanged but the market risk premium increases by 3%, your portfolio’s required return will increase by less than 3%.

111. Standard deviation is a measure of which of the following types of risk? a. nondiversifiable risk b. market risk c. combination risk d. stand-alone risk

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Chap 07_4ce 112. Your firm’s analyst believes that economic conditions during the next year will be either strong, normal, or weak, and they think that Crary Inc.’s returns will have the probability distribution shown below. What’s the standard deviation of Crary’s returns as estimated by your analyst? (Hint: Use the formula for the standard deviation of a population, not a sample.)

Economic Conditions Strong Normal Weak

Prob.

25% 55% 20%

Return 34.1% 12% –16.3%

a. 16.80% b. 17.15% c. 17.60% d. 17.92% 113. For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true? a. The riskiness of the portfolio is equal to the riskiness of each of the stocks if each was held in isolation. b. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks. c. The beta of the portfolio is less than the weighted average of the betas of the individual stocks. d. The beta of the portfolio greater than the weighted average of the betas of the individual stocks.

114. Which type of correlation will a completely diversified portfolio have with the market portfolio? a. less than 1, because it carries only market risk b. less than 1, because it carries only diversifiable risk c. equal to 1, because it carries only diversifiable risk d. equal to 1, because it carries only market risk 115. Which of the following statements is correct? a. The slope of the security market line is equal to the market risk premium, (rM – rRF). b. If a company’s beta is halved, then its required return will also be halved. c. If the risk-free rate decreases, then the market risk premium will also decrease. d. Market risk premium is measured by the intercept of the security market line.

116. During the next year, the market risk premium, (rM – rRF), is expected to increase, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is correct? a. 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. b. The required return for all stocks will increase by the same amount. c. The required return will increase for all stocks, but it will increase more for stocks with higher betas. d. The required return will increase for all stocks, but it will increase less for stocks with higher betas.

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Chap 07_4ce 117. Which of the following statements is correct? (Assume that the risk-free rate is a constant.) a. If the market risk premium increases by 2% 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. b. The effect of a change in the market risk premium depends on the level of the risk-free rate. c. If the market risk premium increases by 2% then the required return will increase by 2% for a stock that has a beta of 1.0. d. If the market risk premium increases by 2% then the required return on all stocks will rise by 2%.

118. Which of the following statements is correct? a. If investors become less risk averse but rRF does not change, then the required rate of return on highbeta stocks will decline and the required return on low-beta stocks will increase, but the required return on an average-risk stock will not change. b. An investor who holds just one stock will generally be exposed to less risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. c. Assume that the required rate of return on the market, rM, is given and fixed at 16%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a flatter slope if 50-year Treasury bonds were used as the risk-free rate than if 1-year Treasury bills were used for rRF. d. The effect of a change in the market risk premium depends on the slope of the yield curve.

119. Which statement about a stock’s beta is correct? a. If a stock has a negative beta, its required rate of return will be unaffected by changes in the market risk premium. b. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative. c. If a stock’s beta triples, its required rate of return must also triple. d. A stock with a negative beta in theory cannot have a positive required rate of return.

120. Which statement about risk is true? a. An investor can eliminate all market risk if they hold a very large and well-diversified portfolio of stocks. b. The lower the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. c. The market risk of a single stock is always higher than that of a portfolio that includes the stock. d. Almost half of the risk inherent in an average individual stock can be eliminated if the stock is held in a reasonably well diversified portfolio, which is one containing 20 or more stocks in a number of different industries.

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Chap 07_4ce 121. Over the past 75 years, we have observed 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 options correctly ranks investments from lowest to highest risk (and return), where the security with the lowest risk is shown first, and the one with the highest risk last? a. Treasury bills, long-term government bonds, large-company stocks, long-term corporate bonds, smallcompany stocks b. long-term government bonds, Treasury bills, large-company stocks, long-term corporate bonds, smallcompany stocks c. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, largecompany stocks d. Treasury bills, long-term government bonds, long-term corporate bonds, large-company stocks, smallcompany stocks 122. Which of the following is correct? a. Market risk, which is measured by the stock’s coefficient of variation, can be lowered by adding more stocks to the portfolio in which the stock is held. b. Systematic risk, which is measured by the stock’s beta, cannot be diversified away by adding more stocks to the portfolio in which the stock is held. c. Unsystematic risk, which is measured by the standard deviation, can be lowered by adding more stocks to the portfolio in which the stock is held. d. Company-specific risk, which is measured by the stock’s expected return, cannot be lowered by adding more stocks to the portfolio in which the stock is held.

123. Which of the following statements regarding Ponzi schemes is correct? a. A Ponzi scheme is an investment fraud that pays existing investors with funds collected from new investors. b. All Ponzi schemes crash when something occurs that causes some investors to seek to withdraw funds in amounts less than the incoming funds from new investors. c. The risk of Ponzi schemes can be explained by the CAPM. d. A Ponzi scheme is premised on using old investors’ funds to pay the new backers.

124. Stock X has a beta of 1.2 and Stock Y has a beta of 0.8. The standard deviation of each stock’s returns is 19%.

The stocks’ returns are independent of each other; that is, the correlation coefficient between them is zero.

Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is correct? a. Portfolio P has the same required return as the market (rM). b. Portfolio P has a beta of 0.8. c. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. d. The required return on Portfolio P is equal to the market risk premium (rM – rRF).

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Chap 07_4ce 125. What should you expect to happen if you randomly select stocks and add them to your portfolio? a. This will maximize the portfolio’s expected rate of return. b. This will reduce the portfolio’s market risk but not its unsystematic risk. c. This will reduce the portfolio’s unsystematic risk. d. This will reduce the portfolio’s beta coefficient and thus its market risk.

126. Assume that investors have recently become less risk averse, so the market risk premium has decreased. 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 increase for stocks whose betas are less than 1.0. b. The required rate of return for an average stock will decrease by an amount equal to the decrease in the market risk premium. c. The required rate of return on a riskless bond will increase. d. The required rate of return for each individual stock in the market will decrease by an amount greater than the decrease in the market risk premium.

127. Rick Kish has a $100,000 stock portfolio; $28,000 is invested in a stock with a beta of 0.68 and the remainder is invested in a stock with a beta of 1.45. These are the only two investments in his portfolio. What is his portfolio’s beta? a. 0.85 b. 0.98 c. 1.10 d. 1.23 128. You are given the following returns on the market and on Stock A. Calculate Stock A’s beta coefficient.

Year 1 2 3

Market –18% 16% 29%

Stock A –23% 25% 19%

a. 0.82 b. 0.90 c. 1.00 d. 1.15 129. Stocks A and B each have an expected return of 19%, a standard deviation of 25%, and a beta of 1.6. The returns on the two stocks have a correlation coefficient of +0.8. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is correct regarding this portfolio? a. its beta is less than 1.6 b. its expected return is less than 19% c. its beta is 1.6 d. its standard deviation is greater than 25%

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Chap 07_4ce 130. Which of the following statements is correct? a. If the risk-free rate rises by 0.8% but the market risk premium declines by that same amount, then the required rates of return on an average stock will remain unchanged, but required returns on stocks with betas greater than 1.0 will decrease. b. Other things held constant, if investors suddenly became convinced that there would be inflation in the economy, then the required returns on all stocks should decrease. c. If a company’s beta were cut in half, then its required rate of return would also be halved. d. If a company’s beta triples, then its required rate of return will also triple.

131. Which of the following statements is correct? a. 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. b. A stock with a beta of –1.0 has zero market risk if held in a one-stock portfolio. c. Risk refers to the chance that some unfavourable event will occur, but a probability distribution is completely described by a listing of the likelihoods of favourable events. d. When market risk has been diversified away, the inherent risk that remains is company-specific risk, which is different for all stocks in the market.

132. Which asset mix would be the best representation of the true market portfolio? a. bonds, stocks, foreign securities, derivatives, and real estate b. bonds, stocks, foreign securities, and derivatives c. bonds, stocks, and foreign securities d. bonds and stocks 133. Assume that the risk-free rate remains constant, but the market risk premium increases. Which of the following is most likely to occur? a. The required return on a stock with beta less than 1.0 will increase. b. The return on the market will remain unchanged. c. The return on the market will decrease. d. The required return on a stock with beta greater than 1.0 will decrease.

134. Which of the following statements is correct? a. Even if you add enough randomly selected stocks to a portfolio, you can never eliminate all of the company-specific risk from the portfolio. b. 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 100,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. c. If you formed a portfolio that consisted of all stocks with betas less than 0.9, 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. d. A portfolio that consists of all stocks in the market would have a required return that is less than the riskfree rate.

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Chap 07_4ce 135. Assume that the risk-free rate, rRF, declines but the market risk premium, (rM – rRF) increases, 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 of all stocks will decrease by the amount of the decrease in the risk-free rate. b. The required return will increase for stocks that have a beta less than 1.0 but will decline for stocks that have a beta greater than 1.0. c. The required return will decline for stocks that have a beta less than 1.0 but increase for stocks that have a beta greater than 1.0. d. Since the overall return on the market stays constant, the required return on each individual stock will remain constant.

136. Which of the following statements is correct? a. A three-stock portfolio will always have a lower standard deviation than a one-stock portfolio. b. A one-stock portfolio will always have a higher beta than a 100-stock portfolio. c. 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. d. A stock with a low standard deviation must also have a low beta.

137. An investor purchased 200 shares of Suncor at $56.90 and later sold his investment at $54.20. If he received $1.30 in dividends, what was his total dollar return? a. $280 b. $800 c. –$280 d. –$800 138. Which of the following statements regarding behavioural finance is correct? a. The field of behavioural finance focuses on rational, but unpredictable, financial decisions. b. Loss aversion means losses are so painful that people will make rational choices to suffer possible losses. c. Behavioural finance—mixing finance with sociological economics—tries to explain the occurrence and persistence of accurate debt securities mispricing. d. Herding behaviour occurs when groups of investors emulate other successful investors and chase asset classes that are doing well. Thus, herding behaviour can inflate rising markets.

139. Ritter Company’s stock has a beta of 1.50, the risk-free rate is 4.6%, and the market risk premium is 6.2%.

What is Ritter’s required rate of return? a. 13.90% b. 14.25% c. 11.60% d. 12.73%

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Chap 07_4ce 140. Stock HB has a beta of 1.7 and Stock LB has a beta of 0.9. The market is in equilibrium, with required returns equalling expected returns. Which of the following statements is correct? a. If expected inflation remains constant but the market risk premium (rM – rRF) increases, the required return of Stock LB will increase but the required return of Stock HB will decrease. b. If expected inflation remains constant but the market risk premium (rM – rRF) increases, the required return on Stock HB will increase but the required return of Stock LB will decrease. c. If both expected inflation and the market risk premium (rM – rRF) decrease, the required returns of both stocks will decrease by the same amount. d. If both expected inflation and the market risk premium (rM – rRF) decrease, the required return on Stock HB will decrease by more than that of Stock LB. 141. In the absence of a risk-free rate, what is the minimum variance portfolio? a. It is seldom efficient. b. It is never efficient. c. It is always efficient. d. It is usually the optimal portfolio.

142. The real risk-free rate is 1.8%, the expected inflation rate is 3.7%, the market risk premium is 5.3%, and Kohers Enterprises has a beta of 1.2. What is the required rate of return on Kohers’ stock? a. 11.28% b. 11.50% c. 11.86% d. 12.04% 143. A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio, to form a fourstock portfolio. The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market. Potential new Stocks A and B both have expected returns of 20%, and both are equally correlated with the market, with r = 0.80. However, Stock A’s standard deviation of returns is 11% versus 15% for Stock B. Which stock should this investor add to their portfolio, or does the choice matter? a. either A or B, i.e., the investor should be indifferent as to which of the two b. Stock A c. Stock B d. neither A nor B, as neither has a return sufficient to compensate for risk 144. Which of the following statements is an assumption of the CAPM? a. All investors focus on multiple holding periods, and they seek to maximize the expected utility of their terminal wealth by choosing among alternative portfolios based on each portfolio’s expected return and standard deviation. b. All investors have different estimates of the expected returns, variances, and covariances among all assets (i.e., investors have heterogeneous expectations). c. All investors can borrow or lend an unlimited amount at a given risk-free rate of interest, rRF, but there are some restrictions on short sales of any asset. d. All assets are perfectly divisible and perfectly liquid (i.e., marketable at the going price).

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Chap 07_4ce 145. Stock A has an expected return of 12% and a standard deviation of 23%. Stock B has an expected return of 16% and a standard deviation of 31%. The risk-free rate is 6% and the market risk premium, rM – rRF, is 7%.

Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another; that is, 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 A’s beta is 0.8571. c. Stock B’s beta is 1.2510. d. Portfolio AB’s required return is 13%.

146. Stock X has a beta of 1.8 and Stock Y has a beta of 0.6. Which of the following statements must be true, according to the CAPM? a. Stock X’s return during the coming year will be higher than Stock Y’s return. b. If expected inflation increases but the market risk premium is unchanged, Stock X will have a larger increase in its required return than will Stock Y. c. Stock X’s return has a higher standard deviation than Stock Y. 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. 147. Campbell’s father holds just one stock, East Coast Bank (ECB), which he thinks is a very low-risk security.

Campbell agrees that the stock is relatively safe, but he wants to demonstrate that his father’s risk would be even lower if he were more diversified. Campbell obtained the following returns data shown for West Coast Bank (WCB). Both have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would his father’s historical risk have been reduced if he had held a portfolio consisting of 70% ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Year 2017 2018 2019 2020 2021 Average return = Standard deviation =

ECB 35% –12% 40% –8% 16% 14.2% 23.88%

WCB 45% 10% –6% –13% 33% 13.8% 24.83%

a. 3.05% b. 3.24% c. 3.50% d. 3.79%

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Chap 07_4ce 148. Stocks A and B each have an expected return of 15%, a beta of 1.4, and a standard deviation of 31%. The returns on the two stocks have a correlation of 0.7. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is correct? a. Portfolio P has a beta that is greater than 1.4. b. Portfolio P has a standard deviation that is less than 31%. c. Portfolio P has a standard deviation that is equal to 31%. d. Portfolio P has a beta that is less than 1.4.

149. Which of the following statements is correct? a. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.4. b. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.4, assuming that the stock’s beta was correctly calculated and is stable. c. If a stock has a negative beta, its expected return cannot be positive. d. According to the CAPM, stocks with lower standard deviations of returns must also have lower expected returns.

150. Keith Johnson has $100,000 invested in a two-stock portfolio: $40,000 is invested in Potts Manufacturing and the remainder is invested in Stohs Corporation. Potts’s beta is 1.70 and Stohs’s beta is 0.50. What is the portfolio’s beta? a. 0.74 b. 0.98 c. 1.12 d. 1.35 151. Stock A has a beta of 1.5 and a standard deviation of 19%. Stock B has a beta of 0.5 and a standard deviation of 27%. Portfolio P has $300,000 consisting of $150,000 invested in Stock A and $150,000 in Stock B. Which of the following statements is correct? (Assume that stocks are in equilibrium.) a. Stock A’s returns are less highly correlated with the returns on most other stocks than are B’s returns. b. Portfolio P has a beta equal to 1.0. c. Portfolio P has a standard deviation of 23%. d. Stock B has a higher required rate of return than Stock A. 152. In a two-asset portfolio, Stock A and Stock B have a measured correlationship of –0.60. Which of the following best describes the impact on the portfolio of having “A” and “B” in the portfolio? a. A and B are perfectly negatively correlated, which reduces diversification. b. A and B are negatively correlated, which reduces diversification in the portfolio. c. A and B are negatively correlated, which improves diversification in the portfolio. d. A and B are perfectly negatively correlated, which improves diversification.

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Chap 07_4ce Answer Key 1. False 2. False 3. True 4. False 5. True 6. False 7. True 8. False 9. False 10. False 11. False 12. False 13. False 14. True 15. False 16. False 17. True 18. True 19. True 20. True 21. False 22. True 23. True 24. False 25. False 26. True

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Chap 07_4ce 27. True 28. True 29. False 30. False 31. False 32. False 33. True 34. True 35. False 36. False 37. True 38. a 39. a 40. b 41. c 42. b 43. d 44. c 45. c 46. c 47. c 48. a 49. b 50. c 51. d 52. c 53. d 54. d Copyright Cengage Learning. Powered by Cognero.

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Chap 07_4ce 55. a 56. d 57. a 58. a 59. c 60. d 61. a 62. c 63. c 64. b 65. d 66. b 67. a 68. b 69. d 70. a 71. c 72. c 73. d 74. c 75. a 76. b 77. d 78. d 79. b 80. d 81. b 82. a Copyright Cengage Learning. Powered by Cognero.

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Chap 07_4ce 83. a 84. d 85. a 86. b 87. b 88. c 89. b 90. a 91. a 92. b 93. c 94. a 95. d 96. a 97. b 98. d 99. d 100. a 101. d 102. a 103. d 104. c 105. c 106. b 107. a 108. b 109. c 110. c Copyright Cengage Learning. Powered by Cognero.

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Chap 07_4ce 111. d 112. a 113. b 114. d 115. a 116. c 117. c 118. c 119. b 120. b 121. d 122. b 123. a 124. a 125. c 126. b 127. d 128. c 129. c 130. a 131. a 132. a 133. a 134. c 135. c 136. c 137. c

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Chap 07_4ce 138. d 139. a 140. d 141. c 142. c 143. b 144. d 145. b 146. d 147. b 148. b 149. b 150. b 151. b 152. c

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Chap 08_4ce Indicate whether the statement is true or false.

1. Ready availability of information and how investors interpret such information causes stock prices to be volatile.

Since in our economy timely information is readily available, stocks, especially those of large companies, adjust rapidly to new information. a. True b. False 2. According to the nonconstant growth model, the stock’s intrinsic value today is the present value of the dividends during the nonconstant growth period minus the present value of the horizon value. a. True b. False 3. Market equilibrium ordinarily exists for any given stock, and required and expected returns are generally equal.

However, in equilibrium, stock prices remain unchanged. a. True b. False 4. A significant difference between a stock’s market value and its intrinsic value may exist in efficient financial markets. a. True b. False 5. The preemptive right enables current shareholders to buy additional shares in the same proportion they currently hold in the firm. This right helps protect current shareholders against both dilution of control and dilution of value. a. True b. False 6. Dual-class shares differentiate different classes of common share. Some shares with either no voting rights or very limited ones are referred to as multiple or super-voting shares; others, called restricted or subordinate voting shares, come with many votes per share. a. True b. False 7. The expected future cash flows provided by common stocks include the dividends expected in each year and the price investors expect to receive when they sell the stock. a. True b. False 8. If security markets were strong-form efficient, current market prices would reflect all pertinent information but it would still be possible for insiders to earn consistently abnormal returns in the stock market. a. True b. False

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Chap 08_4ce 9. Dual-class shares are issued for two basic reasons: they allow (family) owners to obtain additional equity capital without giving up voting control of their firm; and they prevent takeover attempts. a. True b. False 10. According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the risk-free rate. a. True b. False 11. A proxy fight is an unfriendly contest for control over an organization. The event usually occurs when the firm’s earnings are poor and shareholders are dissatisfied. An outside group may solicit shareholders’ proxies in an effort to overthrow management and take control of the business. a. True b. False 12. Stock price quotes are readily available from internet sources such as TMX Money, Yahoo!, and the Globe and Mail, but investors can’t determine the dividend yield and the price/earnings ratio from the stock quotes. a. True b. False 13. The Gordon model used to evaluate the prices of common shares is essentially the same as the model used to find the price of perpetual preferred stock or any other perpetuity. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

14. Stock X has a required return of 18%, while Stock Y has a required return of 15%. Which of the following statements is correct? a. Stock Y must have a lower dividend 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 lower price. c. The stocks must sell for the same price. d. If the market is in equilibrium, and if Stock Y has the higher expected dividend yield, then it must have the lower expected growth rate.

15. Upton Company’s last dividend was $1.96. Its dividend growth rate is expected to be constant at 20% for 2 years, after which dividends are expected to grow at a rate of 8% forever. Upton’s required return (r s) is 14%.

What is Upton’s current stock price? a. $43.32 b. $43.75 c. $43.90 d. $44.26

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Chap 08_4ce 16. Gary Wells Inc. plans to issue perpetual preferred stock with an annual dividend of $7.30 per share. If the required return on this preferred stock is 7.6%, at what price should the stock sell? a. $90.02 b. $92.38 c. $94.50 d. $96.05 17. Which of the following statements is correct? a. The dividend yield on a constant growth stock must be equal to the stock’s expected total return plus its expected capital gains return. b. A stock’s dividend yield can exceed its expected growth rate when the expected rate of return is positive and the dividend growth rate is negative. c. A required condition for one to use the constant growth model is that the stock’s expected growth rate should be equal to its required rate of return. d. Other things held constant, the lower a company’s beta coefficient, the higher its required rate of return.

18. Alberta Inc. (AI) pays an annual dividend of $5.60 per share. If AI’s stock is currently trading at $81 per share, and AI’s expected growth rate is 6.2%, what is AI’s expected return? a. 12.24% b. 12.60% c. 13.10% d. 14.00% 19. Assume that markets are semistrong-form efficient, but not strong-form efficient. Which of the following statements is correct? a. Each common stock has a required return equal to that of the overall market. b. Investors may be able to earn returns above those predicted by the SML if they have access to information contained in past price movements. c. Investors can expect to earn returns above those predicted by the SML if they have access to private information. d. Investors may be able to earn returns above those predicted by the SML if they have access to some public information in newspapers.

20. E.M. Roussakis Inc.’s stock currently sells for $49 per share. The stock’s dividend is projected to increase at a constant rate of 4.62% per year. The required rate of return on the stock, rs, is 17.8%. What is Roussakis’ expected price 6 years from now? a. $64.25 b. $66.50 c. $69.35 d. $72.00

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Chap 08_4ce 21. Companies can issue different classes of common shares. Which of the following statements concerning share classes is correct? a. All common shares, regardless of class, must follow the premise “one share, one vote.” b. All firms fall into one of three classes: A, B, or C. c. Some class or classes of common share may be entitled to more votes per share than other classes. d. All firms have dual-class common shares.

22. Canada Inc. pays an annual dividend of $1.70 per share. If your required rate of return on an equity investment is 13%, and Canada Inc.’s expected growth rate is 5%, what should Canada Inc.’s price be? a. $21.78 b. $22.04 c. $22.31 d. $22.75 23. Which of the following best describes the reason preemptive rights are granted? a. Preemptive rights protect new shareholders against dilution of control and minimize existing shareholders’ value. b. Preemptive rights maximize new shareholders’ control and minimize new bondholders’ value. c. Preemptive rights protect existing shareholders against dilution of control and minimize new shareholder value. d. Preemptive rights protect existing shareholders against dilution of control and dilution of shareholder value.

24. Alberta Oil Inc. (AOI) pays an annual dividend of $3.50 per share. If AOI’s stock is currently trading at $64 per share, and AOI’s expected growth rate is 5.5%, what is AOI’s expected return? a. 9.50% b. 9.88% c. 10.40% d. 11% 25. Prock Petroleum’s stock has a required return of 14%, and the stock sells for $68 per share. The firm just paid a dividend of $1.50, and the dividend is expected to grow by 40% per year for the next 4 years, so D4 = $1.50(1.40)4 = $5.7624. 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; that is, what is X? a. 7.39% b. 7.64% c. 7.85% d. 8.10%

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Chap 08_4ce 26. The expected return on Northeast Corporation’s stock is 17%. The stock’s dividend is expected to grow at a constant rate of 5%, and it currently sells for $60 a share. Which of the following statements is correct? a. The stock price is expected to be $63 a share 1 year from now. b. The stock’s dividend yield is 11%. c. The current dividend per share is $8. d. The stock’s dividend yield is 13%.

27. Which of the following statements is correct? a. The price of a stock is the present value of all expected future dividends, discounted at the sum of the required rate of return and the dividend growth rate. b. The stock valuation model, P0 = D1/(rs – g), cannot be used for firms that have expected negative, but constant, growth rates. c. A necessary condition for the validity of the constant dividend growth model is that rs should be greater than g. d. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time.

28. You have been assigned the task of using the free cash flow model to estimate Petry Corporation’s intrinsic value. Petry’s WACC is 11.5%, its end-of-year free cash flow (FCF) is expected to be $176 million, the FCFs are expected to grow at a constant rate of 7% a year in the future, the company has $240 million of long-term debt plus preferred stock, and it has 61 million common shares outstanding. What is Petry’s estimated intrinsic value per common share? a. $59.20 b. $60.18 c. $60.95 d. $71.32 29. McDonnell Manufacturing is expected to pay a dividend of $1.80 per share at the end of the year (D1 = $1.80).

The stock sells for $38.60 per share, and its required rate of return is 12.4%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 7.33% b. 7.74% c. 7.97% d. 8.20% 30. Wei Company’s last dividend was $1.98. The dividend growth rate is expected to be constant at 2% for 2 years, after which dividends are expected to grow at a rate of 9% forever. Wei’s required return (rs) is 13%. What is Wei’s current share price? a. $47.05 b. $47.37 c. $47.88 d. $48.10

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Chap 08_4ce 31. Stock A has a required return of 15% and a price of $32, and its dividend is expected to grow at a constant rate of 8% per year. Stock B has a required return of 19% and a price of $45, and its dividend is expected to grow at a constant rate of 10% per year. Which of the following statements is correct? a. If the stock market were efficient, these two stocks would have the same price. b. The two stocks have the same expected capital gains yield. c. If the stock market were efficient, Stock A is expected to pay more dividends in the coming year than Stock B. d. The dividend yield of Stock A is lower than that of Stock B. 32. Ewert Enterprises’ stock currently sells for $35.20 per share. The stock’s dividend is projected to increase at a constant rate of 5.1% per year. The required rate of return on the stock, rs, is 12.9%. What is Ewert’s expected price 4 years from today? a. $37.82 b. $40.05 c. $42.95 d. $45.10 33. Stock X has a required return of 13% and a dividend yield of 4%, and its dividend is expected to grow at a constant rate forever. Stock Y has a required return of 16%, a dividend yield of 7%, and its dividend is expected to grow at a constant rate forever. Both stocks currently sell for $30 per share. Which of the following statements is correct? a. Stock Y pays a lower dividend per share than Stock X. b. Stock Y has a lower expected growth rate than Stock X. c. Stock X pays a lower dividend per share than Stock Y. d. Stock Y has the higher expected capital gains yield.

34. You are considering buying a zero growth stock. If the firm pays a $6 annual dividend, and your required rate of return is 6%, what is the maximum price you would pay for this stock? a. $100 b. $105 c. $110 d. $115 35. If a stock’s dividend is expected to grow at a constant rate of 8% a year, which of the following statements is correct? a. The expected return on the stock is 8% a year. b. The stock’s price 1 year from now is expected to be 8% above the current price. c. The stock’s required return cannot be greater than 8%. d. The stock’s dividend yield is 8%.

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Chap 08_4ce 36. Stock A has a beta of 0.8 and Stock B’s beta is 1.2. The market risk premium is 8%, and the risk-free rate is 5.5%. Both stocks have a constant dividend growth rate of 9%. If the market is in equilibrium, which of the following statements is correct? a. Stock A must have a lower stock price than Stock B. b. Stock B could have the lower expected return. c. Stock B must have the lower required return. d. Stock A must have a lower dividend yield than Stock B. 37. Stocks A and B have the same required return of 20% and the same price, $30. Stock A’s dividend is expected to grow at a constant rate of 4% per year, while Stock B’s dividend is expected to grow at a constant rate of 16% per year. Which of the following statements is correct? a. Since Stock B’s growth rate is four times that of Stock A, Stock A’s future dividends will always be four times as high as Stock B’s. b. Stock A has a lower dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock A’s price will pass that of Stock B. d. Stock A’s expected dividend at t = 1 is four times that of Stock B. 38. If D0 = $3.65, g (which is constant) = 4.2%, and P0 = $60, what is the stock’s expected dividend yield for the coming year? a. 6.34% b. 6.65% c. 6.90% d. 7.21% 39. Canada Inc. pays an annual dividend of $0.80 per share. If your required rate of return on an equity investment is 18%, and Canada Inc.’s expected growth rate is 2%, what should Canada Inc.’s price be? a. $4.50 b. $5.10 c. $5.80 d. $6.40 40. Which of the following statements regarding market multiple analysis is correct? a. While the market multiple analysis applies valuation concepts in a precise manner, focusing on expected cash flows, the discounted dividend method is more judgmental. b. Market multiple analysis applies a market-determined multiple to net income, earnings per share, sales, book value, or, for businesses such as cable TV or cellular telephone systems, the number of subscribers. c. The EBIT multiple is based on total value since EBIT measures the entire firm’s performance. So, it is called an entity multiple. d. We can estimate a company’s total value by dividing the company’s EBITDA by its market multiple.

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Chap 08_4ce 41. Why is the preemptive right important to shareholders? a. It helps the current shareholders to oversee management. b. It helps the current shareholders to maintain their proportionate interest in the company and not suffer any dilution if the company issues more shares. c. helps the current shareholders to obtain a higher expected rate of return. d. It helps the current shareholders to receive more dividends per share.

42. Which of the following best describes a closely held corporation? a. The corporation’s shares are owned by many individuals who can buy and sell their interest in the stock market b. The corporation’s shares are owned by a few individuals who are associated with the firm’s management. c. The corporation’s shares are owned by many individuals who are associated with the firm’s management. d. Closely held corporations are not legally allowed to form in Canada.

43. If D1 = $2.40, g (which is constant) = 7.3%, and P0 = $68, what is the stock’s expected capital gains yield for the coming year? a. 6.40% b. 6.72% c. 7.05% d. 7.30% 44. B.C. Inc. (BCI) pays an annual dividend of $3.10 per share. If BCI’s stock is currently trading at $58 per share, and BCI’s expected growth rate is 4.2%, what is BCI’s expected return? a. 9.50% b. 9.90% c. 10.27% d. 10.80% 45. Which of the following statements regarding market multiple analysis is correct? a. The assumption of market multiple analysis is that the relative value of certain financial ratios cannot be used to rank or value a company within a similar group. b. The EBITDA multiple is the total value of a company (the market value of equity plus debt) multiplied by EBITDA. c. To estimate the company’s stock value using the market P/E multiple approach, simply multiply its EPS by the market multiple to obtain the estimated stock price per share. d. To estimate the company’s stock value using the market P/E multiple approach, simply divide its market multiple by EPS to obtain the estimated stock price per share.

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Chap 08_4ce 46. WWW Servers just paid a dividend of D0 = $1.00. Analysts expect the company’s dividend to grow by 28% this year, by 13% in Year 2, and at a constant rate of 6% in Year 3 and thereafter. The required return on WWW’s stock is 10%. What is the best estimate of the stock’s current intrinsic value? a. $34.04 b. $34.45 c. $34.70 d. $34.99 47. McLaughlin Inc.’s stock has a required rate of return of 11.8%, and it sells for $72.50 per share. McLaughlin’s dividend is expected to grow at a constant rate of 7.9% per year. What is the expected year-end dividend, D1? a. $2.83 b. $3.15 c. $3.39 d. $3.62 48. Schnusenberg Corporation just paid a dividend of $0.86 per share, and that dividend is expected to grow at a constant rate of 8% per year in the future. The company’s beta is 1.2, the required return on the market is 11.3%, and the risk-free rate is 5.5%. What is the company’s current stock price? a. $15.91 b. $18.50 c. $20.83 d. $22.35 49. Stocks X and Y sell at the same price. Stock X has a required return of 13% while Stock Y’s required return is 20%. Stock X’s dividend is expected to grow at a constant rate of 5% a year, while Stock Y’s dividend is expected to grow at a constant rate of 12%. If the market is in equilibrium so that expected returns equal required returns, which of the following statements is correct? a. Stock X has a higher dividend yield than Stock Y. b. Stock Y has a higher dividend yield than Stock X. c. Stock Y has a lower capital gains yield. d. One year from now, Stock X’s price is expected to be lower than Stock Y’s price.

50. A common share just paid a dividend of D0 = $1.95. The required rate of return is rs = 15%, and the constant growth rate is g = 6%. What is the current share price? a. $22.45 b. $22.70 c. $22.97 d. $23.26

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Chap 08_4ce 51. Which statement regarding market efficiency is true? a. The semistrong form of the EMH states that current market prices reflect all pertinent information. b. Weak-form market efficiency implies that recent trends in stock prices are of no use in predicting future stock prices. c. According to strong-form market efficiency, insiders would find it impossible to consistently earn abnormal returns in the stock market even if they have superior knowledge about the company. d. The efficient markets hypothesis (EMH) asserts that it is possible for an investor to “beat the market” and consistently earn a higher rate of return than is justified by the stock’s risk.

52. Which statement regarding preferred stock is true? a. Most preferred issues stipulate that the preferred shareholders cannot elect a minority of the directors if the preferred dividend is passed (omitted). b. Floating-rate preferred shares pay dividends based on the worst rate—for example, 10% of prime. c. From the viewpoint of the issuing corporation, preferred stock is less risky than bonds. However, from the viewpoint of the investor, preferred stock is riskier than bonds. d. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.

53. Which of the following best describes the formula for the total return on a stock? a. The total return on a share of stock is calculated by subtracting the dividend yield from the capital gains yield. b. The total return on a share of stock is calculated by adding the dividend yield and the capital gains yield. c. The total return on a share of stock is calculated by subtracting the dividend yield from the expected growth rate. d. The total return on a share of stock is calculated by dividing the expected growth rate by the capital gains yield.

54. Nikko Company’s last dividend was $1.60. The dividend growth rate is expected to be constant at 17% for 3 years, after which dividends are expected to grow at a rate of 8% forever. If Nikko’s required return (r s) is 13%, what is the company’s current share price? a. $42.91 b. $43.20 c. $43.52 d. $43.85 55. Goode Inc.’s stock has a required rate of return of 12.6%, and it sells for $29 per share. Goode’s dividend is expected to grow at a constant rate of 8% per year. What was Goode’s last dividend, D0? a. $0.86 b. $1.24 c. $1.55 d. $1.80

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Chap 08_4ce 56. Which of the following statements regarding semistrong-form and strong-form efficiency is correct? a. Insiders could make and have (illegally) made abnormal profits, suggesting that the strong-form EMH does not hold. b. Companies with high B/M ratios that have had higher returns than predicted by the CAPM mean markets are efficient in the semistrong form. c. Small companies with historical returns greater than predicted by the CAPM show that markets are efficient in the semistrong form. d. Most studies imply that markets are highly efficient in the semistrong form 57. You must estimate the intrinsic value of Tsetseko Technologies’ stock. Tsetseko’s end-of-year free cash flow (FCF) is expected to be $18.8 million, and it is expected to grow at a constant rate of 9% a year thereafter. The company’s WACC is 12%. Tsetseko has $133 million of long-term debt plus preferred stock, and there are 16 million common shares outstanding. What is Tsetseko’s estimated intrinsic value per common share? a. $30.85 b. $31.20 c. $31.65 d. $31.90 58. Most studies of stock market efficiency suggest that the stock market is highly efficient in the strong form.

Based on these findings, which of the following statements is correct? a. Managers who have inside information that is not available to the public cannot consistently earn abnormal returns, i.e., returns that are higher than those predicted by the SML. b. The stock price for a company has been decreasing for the past 3 months. Based on this information, it must be true that the stock price will also decrease during the current month. c. Information you read on a financial website such as Yahoo Finance today can be used to select stocks that will consistently beat the market. d. Information disclosed in companies’ most recent annual reports can be used to consistently beat the market.

59. Beranek Technologies was founded 10 years ago. It has been profitable for the past 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $0.60 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 9% thereafter. The forecast of the future dividend stream, along with the forecasted growth rates, is shown below. With a required return of 12%, what is the current intrinsic value?

Year Growth rate Dividend

0 NA $0

1 NA $0

2 NA $0

3 NA $0.60

4 60% $0.96

5 30% $1.25

6 9% $1.36

a. $26.50 b. $26.83 c. $27.12 d. $27.48 Copyright Cengage Learning. Powered by Cognero.

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Chap 08_4ce 60. You are considering buying a zero growth stock. If the firm pays a $15 annual dividend, and your required rate of return is 7.5%, what is the maximum price you would pay for this stock? a. $100 b. $150 c. $180 d. $200 61. If D0 = $3.28, g (which is constant) = 4%, and P0 = $43, what is the stock’s expected total return for the coming year? a. 11.60% b. 11.58% c. 11.93% d. 12.25% 62. If markets are in equilibrium, which of the following will occur? a. Each stock’s expected return should equal its realized return as seen by the marginal investor. b. All stocks should have the same realized return during the coming year. c. Each stock’s expected return should be greater than its required return as seen by the marginal investor. d. Each stock’s expected return should equal its required return as seen by the marginal investor.

63. What must occur for a stock to be in equilibrium, that is, for there to be no consistent pressure for its price to depart from its current level? a. The expected future returns must be equal to the required return. b. The past realized return must be equal to the expected return during the same period. c. The expected future returns must be greater than the most recent past realized return. d. The expected return must be equal to both the required future return and the past realized return.

64. S.P. Whitman Company’s last dividend was $1.30. The dividend growth rate is expected to be constant at 12% for 3 years, after which dividends are expected to grow at a rate of 8% forever. The current stock price is $18.

What is Whitman’s required return, rs? (Hint: Forecast the dividends for Years 1 to 4. Then you must find the discount rate that causes the PVs of the dividends at t = 1, t = 2, and t = 3 plus the price at t = 3, P3, to equal the actual known price. However, you must first estimate P3, and that requires an estimate of rs. You can make a guess as to rs, find P3 using it, then discount the dividends and the estimated P3 at that rate. If the sum does not equal the known price, then change the value used for rs, and continue until you get P0. This is a laborious, timeconsuming process with a calculator, but it’s easy with Excel.) a. 16.63% b. 16.95% c. 17.23% d. 17.50%

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Chap 08_4ce 65. Which of the following statements is correct? a. If a company has dual-class shares, Class A and Class B, the shares may pay different dividends and they have different voting rights. b. Market price incorporates all relevant available information about expected cash flows and risk, but intrinsic value is based on investors’ selection and interpretation of information. c. The preemptive right is a provision in the article of incorporation that gives common shareholders the right to sell (on a pro rata basis) issues of the firm’s common stock. d. The stock valuation model, P0 = D1/(rs – g), cannot be used for firms that have negative growth rates.

66. Which statement regarding the efficient markets hypothesis is true? a. If a market is strong-form efficient, this implies that current market prices reflect not only all publicly available information and all past information, but also all private information (insider information) as well. b. If a market is weak-form efficient, this implies that all pertinent information is rapidly incorporated into market prices. c. If your father earned a return lower than the overall stock market last year, this is evidence that the stock market is inefficient. d. If a market is weak-form efficient, this implies that analyzing its past price history will enable one to earn an above-normal rate of return on the stock in the future.

67. A share of common stock has just paid a dividend of $2.40. If the expected long-run growth rate for this stock is 6.2%, and if investors’ required rate of return is 11.9%, what is the stock price? a. $44.39 b. $44.72 c. $44.95 d. $45.31 68. A stock is expected to pay a year-end dividend of $3.00; that is, D1 = $3.00. The dividend is expected to decline at a rate of 4% a year forever (g = –4%). If the company’s expected and required rate of return is 16%, which of the following statements is correct? a. The company’s current stock price is $25. b. The company’s dividend yield 5 years from now is expected to be 12%. c. The company’s stock price next year is expected to be $14.40. d. The constant growth model cannot be used because the growth rate is negative.

69. Zumwalt Company is expected to pay a dividend of $2.68 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6% per year in the future. The company’s beta is 1.33, the market risk premium is 6.1%, and the risk-free rate is 5%. What is the company’s current stock price? a. $28.23 b. $30.85 c. $34.10 d. $37.68

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Chap 08_4ce 70. Which of the following statements is correct? a. If a stock’s beta decreased but its growth rate remained the same, then the new equilibrium price of the stock will be lower (assuming dividends continue to grow at the constant growth rate). b. Market efficiency says that the actual realized returns on all stocks will be equal to the required return. c. Weak-form efficiency suggests that tape watchers and chartists cannot earn profits by discovering patterns as to when stock prices rise or fall. d. An implication of the semistrong form of the efficient markets hypothesis is that even insiders would find it impossible to earn consistently abnormal returns in the stock market.

71. Sorenson Corp.’s expected year-end dividend is D1 = $1.90, its required return is rs = 13.5%, its dividend yield is 9%, and its growth rate is expected to be constant in the future. What is Sorenson’s expected stock price in 8 years; that is, what is P8? a. $21.36 b. $24.95 c. $28.50 d. $30.02 72. You are considering buying a zero growth stock. If the firm pays a $3.70 annual dividend, and your required rate of return is 16%, what is the maximum price you would pay for this stock? a. $22.31 b. $22.50 c. $23.13 d. $24.03 73. Carter’s preferred stock pays a dividend of $1.90 per quarter. If the price of the stock is $62, what is its nominal (not effective) annual rate of return? a. 11.75% b. 12.00% c. 12.26% d. 12.70% 74. Clinton’s preferred stock pays a dividend of $1.60 per quarter. If the price of the stock is $69, what is its effective annual (not nominal) rate of return? a. 9.15% b. 9.45% c. 9.60% d. 9.90%

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Chap 08_4ce 75. Which statement regarding preferred stocks is true? a. Similar to interest on debt, preferred dividends are deductible by the issuing corporation, so preferred stock has a lower cost of capital. b. By issuing preferred stock, the firm avoids the dilution of common equity that occurs when common stock is sold. c. Preferred dividends are rarely cumulative. d. Preferred stocks normally have voting rights.

76. What is the likely thinking of an investor who is of the opinion that a share’s expected return is lower than its required return? a. The investor thinks the share is experiencing negative growth. b. The investor thinks dividends are likely to be declared. c. The investor thinks the share should be purchased. d. The investor thinks the share should be sold.

77. Rentz RVs Inc. (RRV) is currently enjoying relatively high growth because of a surge in the demand for recreational vehicles. Management expects earnings and dividends to grow at a rate of 28% for the next 4 years, after which higher gas prices will probably reduce the growth rate in earnings and dividends to zero; that is, g = 0. The company’s last dividend, D0, was $1.50. RRV’s beta is 1.3, the market risk premium is 6%, and the riskfree rate is 4.5%. What is the current price of the common stock? a. $28.00 b. $28.35 c. $28.71 d. $29.00 78. Stock X is expected to pay a dividend of $4.80 at the end of the year—that is, D1 = $4.80—and that dividend is expected to grow at a constant rate of 8% a year. The stock currently trades at a price of $60 a share. Assume that the stock is in equilibrium; that is, the stock’s price equals its intrinsic value. Which of the following statements is correct? a. The stock’s required return is 16%. b. The stock’s expected dividend yield is greater than its growth rate. c. The stock’s expected dividend yield is 6%. d. The stock’s expected capital gains yield is 6%.

79. Pink Canada Inc. (PCI) pays an annual dividend of $3.40 per share. If PCI’s stock is currently trading at $59 per share, and PCI’s expected growth rate is 9.8%, what is PCI’s expected return? a. 15.03% b. 15.60% c. 15.80% d. 16.21%

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Chap 08_4ce 80. If D1 = $2.16, g (which is constant) = 5.8%, and P0 = $53, what is the stock’s expected dividend yield for the coming year? a. 3.76% b. 4.08% c. 4.41% d. 4.65% 81. Which statement regarding the efficient markets hypothesis is true? a. If the stock market is weak-form efficient, then one cannot outperform the market even if they have public information. b. Even though the efficient markets hypothesis (EMH) assumes that markets behave as if all investors were rational, under the EMH it is still possible to have some irrational investors in a rational market. c. If the stock market is strong-form efficient, then high beta stocks must have the same expected return as low beta stocks. d. If the stock market is semistrong-form efficient, then all stocks should have the same expected return.

82. If D1 = $1.69, g (which is constant) = 6.1%, and P0 = $49, what is the stock’s expected total return for the coming year? a. 9.33% b. 9.55% c. 9.80% d. 10.19% 83. Which statement regarding the efficient markets hypothesis is true? a. An implication of semistrong-form efficiency is that, whenever information is released to the public, stock prices will not respond if the information is different from what had been expected. b. An individual who has information about past stock prices would not be able to profit from this information if weak-form market efficiency exists. c. The EMH asserts that a stock’s market price is equal to the stock’s intrinsic value and new information would not change the stock’s intrinsic value. d. The EMH asserts that the market price will adjust to the new intrinsic value so slowly that there is time for an investor to receive the new information, evaluate the information, take a position in the stock before the market price changes, and then profit from the subsequent change in price.

84. If the stock market is semistrong-form efficient, which of the following statements is correct? a. Investors can consistently benefit from trading on information reported in The Wall Street Journal. b. In equilibrium, stocks and bonds should have the same required returns. c. Investors can outperform the market if they have access to information that has not yet been publicly revealed. d. All stocks should have the same required return.

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Chap 08_4ce 85. If two constant growth stocks have the same price and the same required rate of return, which of the following statements is correct? a. If one stock has a lower dividend yield, it will also have a higher dividend growth rate. b. If one stock has a lower dividend yield, it will also have a lower dividend growth rate. c. If one stock has a lower dividend growth rate, it will also have a lower dividend yield. d. The two stocks have the same dividend per share.

86. Isberg Company just paid a dividend of $1.10 per share, and that dividend is expected to grow at a constant rate of 7% per year in the future. The company’s beta is 1.6, the market risk premium is 6%, and the risk-free rate is 5%. What is the company’s current stock price? a. $15.20 b. $15.49 c. $15.75 d. $15.93 87. Which of the following statements is correct? a. It is appropriate to use the constant growth model to estimate stock value even if the dividend yield is never expected to become constant. b. If a stock has a required rate of return rs = 14% and if its dividend is expected to grow at a constant rate of 8%, this implies that the stock’s dividend yield is also 8%. c. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. d. The price of a stock is the present value of all expected future dividends, discounted at the required rate of return plus dividend growth rate.

88. Assuming that markets are semistrong-form efficient, which of the following statements is correct? a. All stocks should have the same realized return. b. An individual who has information about past stock prices should be able to profit from this information. c. Investors’ expected rate of return should be lower than the returns that are predicted by the SML. d. Investors should expect to earn returns commensurate with risk, namely the returns predicted by the SML, but they should not expect to do any better or worse other than by chance.

89. Canada Inc. pays an annual dividend of $4 per share. If your required rate of return on an equity investment is 14%, and Canada Inc.’s expected growth rate is 5%, what should Canada Inc.’s price be? a. $46.67 b. $47.10 c. $47.49 d. $47.80 90. Canada Inc. pays an annual dividend of $9.40 per share. If your required rate of return on an equity investment is 13.6%, and Canada Inc.’s expected growth rate is 5.2%, what should Canada Inc.’s price be? a. $116.15 b. $116.66 c. $117.30 d. $117.72 Copyright Cengage Learning. Powered by Cognero.

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Chap 08_4ce 91. A stock is expected to pay a dividend of $1.30 at the end of the year. The required rate of return is rs = 16.2%, and the expected constant growth rate is g = 9.1%. What is its current price? a. $18.31 b. $18.60 c. $18.82 d. $19.05 92. Which of the following statements is correct? a. The long-term reversals and momentum prove that the stock market is highly efficient in the weak form. b. Long-term reversals show that portfolios of stocks with poor past long-term performance (e.g., over the past 5 years) tend to do slightly better in the long-term future than the CAPM predicts, and vice versa. c. Momentum reveals that stocks with strong performance in the short-term past (e.g., over the past 6 to 9 months) tend to do slightly worse in the short-term future than the CAPM predicts, and likewise for weak performance. d. Strategies based on taking advantage of long-term reversals or short-term momentum can generate large excess returns, especially when transaction costs are considered.

93. Stocks A and B have the same price, but Stock A has the lower required rate of return. Which of the following statements is correct? a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s. b. Stock B must have a lower dividend yield than Stock A. c. Stock A must have a lower dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s.

94. Which of the following is the basis for stock values? a. expected dividends b. required rate of return c. expected sale price d. the firm’s liquidation value

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Chap 08_4ce Answer Key 1. True 2. False 3. False 4. True 5. True 6. False 7. True 8. False 9. True 10. False 11. True 12. False 13. True 14. d 15. a 16. d 17. b 18. c 19. c 20. a 21. c 22. c 23. d 24. d 25. b 26. a

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Chap 08_4ce 27. c 28. b 29. b 30. b 31. d 32. c 33. c 34. a 35. b 36. d 37. d 38. a 39. b 40. b 41. b 42. b 43. d 44. a 45. c 46. a 47. a 48. c 49. d 50. c 51. c 52. c 53. b 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 08_4ce 55. b 56. a 57. a 58. a 59. d 60. d 61. c 62. d 63. a 64. a 65. a 66. a 67. b 68. c 69. d 70. c 71. d 72. c 73. c 74. c 75. b 76. d 77. d 78. a 79. b 80. b 81. b 82. b Copyright Cengage Learning. Powered by Cognero.

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Chap 08_4ce 83. b 84. c 85. a 86. b 87. c 88. d 89. a 90. d 91. a 92. b 93. d 94. a

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Chap 09_4ce Indicate whether the statement is true or false.

1. Most mature companies regularly issue new public equity since the firm’s cost of external equity raised by issuing new stock is less than the required rate of return on the firm’s outstanding common stock. a. True b. False 2. When a firm raises new equity capital by retained earnings, the firm should earn on its reinvested earnings at least as much as its shareholders themselves could earn on alternative investments of equivalent risk due to the existence of opportunity cost. a. True b. False 3. The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than rd(1 – T). a. True b. False 4. 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 1 minus the percentage flotation cost required to sell the new stock (1 – F).” a. True b. False 5. The component costs of capital are always equal to embedded costs. a. True b. False 6. 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 b. False 7. Although a company is financed only through debt, it should use its WACC to evaluate this year’s projects. It is because all investors (new debtholders, old debtholders, and equity holders) have claims on all future cash flows. a. True b. False 8. The higher the firm’s tax rate, the higher its after-tax cost of debt and WACC will be, other things held constant. a. True b. False

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Chap 09_4ce 9. If a firm’s marginal tax rate is decreased, and other things held constant, this would lower the cost of debt used to calculate its WACC. a. True b. False 10. If a firm cannot earn on its reinvested earnings at least as much as its shareholders’ required rate of return, the firm should continue to reinvest the earnings in the hope of further growth. a. True b. False 11. The cost of new common equity or external equity is lower than the cost of equity raised internally by reinvesting earnings because of flotation costs involved in raising equity by reinvesting earnings. a. True b. False 12. It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. a. True b. False 13. Suppose the debt ratio (D/TA) is 20%, the current cost of debt is 7%, the current cost of equity is 15%, and the tax rate is 35%. An increase in the debt ratio to 70% would have to decrease the WACC. a. True b. False 14. If Firm X carries more risk than Firm Y, then X’s cost of debt can possibly be greater than Y’s cost of equity. a. True b. False 15. To estimate the required rate of return on common equity, the DCF method can be used for both constant growth stocks and nonconstant growth stocks. a. True b. False 16. In general, firms should use their WACC to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. When the firm plans to use only debt or only equity to fund a particular project, it should still use its WACC to evaluate that project. a. True b. False 17. In general, common stock flotation costs (as a percentage of capital raised) for IPOs in Canada increase as the amount of capital raised increases. a. True b. False

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Chap 09_4ce 18. When raising capital, companies prefer issuing preferred stock to issuing common stock since preferred stock has no flotation cost and preferred dividends are tax deductible. a. True b. False 19. 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.

Therefore, most firms can raise funds only through debt to achieve a minimum WACC. a. True b. False 20. Preferred dividends are not tax deductible. So, the company bears their full cost, and no tax adjustment is used when calculating the cost of preferred stock. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

21. Your employer pays a $1.20 dividend on its preferred shares. If the price of its preferred shares is $27 and flotation costs would be $0.60 per share, what is the required rate of return on the firm’s preferred shares? a. 4.08% b. 4.55% c. 5.00% d. 5.61% 22. Your employer pays a $2.60 dividend on its preferred shares. If the price of its preferred shares is $41 and flotation costs would be 2% per share, what is the required rate of return on the firm’s preferred shares? a. 5.08% b. 5.46% c. 6.05% d. 6.47% 23. Several years ago, Pettijohn Company sold a $1,000 par value, noncallable bond that now has 16 years to maturity and an 8% annual coupon that is paid semiannually. The bond currently sells for $931, and the company’s tax rate is 35%. What is the component cost of debt for use in the WACC calculation? a. 5.35% b. 5.73% c. 6.05% d. 6.49%

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Chap 09_4ce 24. Nelson Enterprises, an all-equity firm, has a beta of 2.5. Nelson’s chief financial officer is evaluating a project with an expected return of 27% before any risk adjustment. The risk-free rate is 6%, and the market risk premium is 8%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is correct? a. The accept/reject decision depends on the firm’s risk-adjustment policy. If Nelson’s policy is to increase the required return on a riskier-than-average project to 4% over rs, then it should reject the project. b. The project should definitely be rejected because its expected return (before risk adjustments) is less than its required return. c. 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. d. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

25. Safeco Company and Risco Inc. are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 12% and Risco a 14% WACC. Safeco is considering Project X, which has an IRR of 12.5% and is of the same risk as a typical Safeco project.

Risco is considering Project Y, which has an IRR of 13.5% and is of the same risk as a typical Risco project.

Now assume that the two companies merge and form a new company, Safeco/Risco 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. After the merger, Safeco/Risco would have a corporate WACC of 13%. Therefore, it should reject Project X but accept Project Y. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time. d. Safeco/Risco’s WACC, as a result of the merger, would be 12%.

26. Assume that you are on the financial staff of Michelson Inc., and you have collected the following data: – The yield on the company’s outstanding bonds is 9%, and its tax rate is 38%.

– The next expected dividend is $0.76 a share, and the dividend is expected to grow at a constant rate of 7% a year.

– The price of Michelson’s stock is $18.30 per share, and the flotation cost for selling new shares is F = 11%.

– The target capital structure is 48% debt and the balance is common equity.

What is Michelson’s WACC, assuming it must issue new stock to finance its capital budget? a. 9.05% b. 8.42% c. 8.75% d. 9.03%

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Chap 09_4ce 27. Which of the following statements is correct? a. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that little or no judgment is required. b. If the calculated beta overestimates the firm’s true investment risk, i.e., if the historical beta exceeds the forward-looking beta that investors think exists, then the CAPM method based on the historical beta will produce an estimate of rs and thus a WACC that is too low. c. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plusrisk-premium approach. d. Beta measures market risk, which is 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 shareholders are well diversified.

28. For a typical firm, which sequence is correct? All rates are after taxes, and assume the firm operates at its target capital structure. a. WACC > rd > re > rs b. rd < WACC < rs < re c. WACC < rs < re < rd d. rd < rs < re < WACC 29. A company’s perpetual preferred stock currently trades at $92.40 per share, and it pays a $9.30 annual dividend.

If the company were to sell a new preferred issue, it would incur a flotation cost of 6% of the issue price. What is the firm’s cost of preferred stock? a. 10.71% b. 10.25% c. 9.82% d. 9.50% 30. Which of the following statements is correct? a. 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. b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s shareholders could themselves earn a return on earnings by reinvesting the money in other investments if they were paid out rather than retained and reinvested. 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 will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 10 years. d. If a firm has enough retained 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.

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Chap 09_4ce 31. Scanlon Inc.’s CFO hired you as a consultant to help with the estimate of the cost of capital. You have been provided with the following data: rRF = 4.5%; RPM = 5.7%; and b = 0.8. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 8.11% b. 8.49% c. 8.82% d. 9.06% 32. Which of the following statements is correct? a. Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC. b. When calculating the cost of preferred stock companies don’t need to adjust for taxes, because dividends paid on preferred stock are not tax deductible by the paying corporation. c. When calculating the cost of debt a company doesn’t need to adjust for taxes, because interest payments are not deductible by the paying corporation. d. 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 retained earnings to take care of its equity financing and hence needs to issue new stock.

33. What are flotation costs? a. They are part of the capital cost calculations for all debt and equity components. b. They are not considered when estimating the cost of preferred stock. c. They are not considered for retained earnings. d. Most analysts ignore them when estimating the after-tax cost of long-term debt.

34. Alberta Bank’s long-term bonds are currently priced to offer a yield-to-maturity of 11.3%. If Alberta Bank’s marginal tax rate is 33%, what is the after-tax cost of debt on Alberta Bank’s bonds? a. 7.13% b. 7.57% c. 8.18% d. 8.69%

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Chap 09_4ce 35. Suppose a firm is a publicly owned corporation and is seeking to maximize shareholder wealth. Which of the following statements is correct? a. Project A has a standard deviation of expected returns of 30%, while Project B’s standard deviation is only 15%. 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. b. Projects with below-average risk typically have lower than average expected returns. Therefore, to maximize a firm’s shareholder wealth, its managers should choose high-beta projects over those with lower betas. c. 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. d. If a firm has a beta that is less than 1.0, say 0.7, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets.

36. Canada Corp.’s long-term bonds are currently priced to offer a yield-to-maturity of 6%. If Canada Corp.’s marginal tax rate is 17%, what is the after-tax cost of debt on Canada Corp.’s bonds? a. 4.98% b. 5.50% c. 5.88% d. 6.25% 37. Which of the following statements is correct? a. The cost of retained earnings is the rate of return shareholders require on a firm’s common stock. b. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount. c. We should use historical measures of the component costs from prior financings when estimating a company’s WACC for capital budgeting purposes. d. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.

38. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 16 years to maturity. This bond has an 11% annual coupon, paid semiannually, it sells at a price of $1,080, and it has a par value of $1,000. If Delano’s tax rate is 35%, what component cost of debt should be used in the WACC calculation? a. 6.49% b. 6.87% c. 7.16% d. 7.50%

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Chap 09_4ce 39. Mihov Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: (1) rd = yield on the firm’s bonds = 8%, and the risk premium over its own debt cost = 3.5%. (2) rRF = 6%, RPM = 7%, and b = 1.1. (3) D1 = $1.40; P0 = $36 and g = 7% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference? a. 2.81% b. 3.10% c. 3.50% d. 3.84% 40. When working with the CAPM, which factor can be determined with the most precision? a. the expected rate of return of the market, rM b. the beta coefficient of an average stock c. the most appropriate risk-free rate, rRF d. the beta coefficient, bi, of a very famous company’s stock 41. Which of the following statements is correct? a. 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. Empirical work suggests that the risk premium over a firm’s own bond yield has generally ranged from 5 to 10 percentage points, with recent values close to 5%. b. The WACC is calculated using a before-tax cost for debt equal to the interest rate that must be paid on new debt, along with the before-tax costs for common stock and for preferred stock if it is used. c. The WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure. d. A decrease in the risk-free rate is likely to increase the marginal costs of both debt and equity.

42. Durst Enterprises, which is debt-free and finances only with equity from retained earnings, is considering four large capital budgeting projects. Its CFO hired you to assist in deciding how many projects should be accepted.

You have the following information: – rRF = 5%; RPM = 6%; and b = 1.1.

– The company adds 4%, 2%, 0%, or –2% to the corporate WACC when it evaluates projects that differ in risk.

– Project A is in the –2% category, B is in the 0% group, C is in the +2% group, and D is in the +4% group.

– Each project has a cost of $30,000.

– The projects’ expected returns are as follows: A = 9.9%, B = 11.7%, C = 13.8%, and D = 15.9%. If these are the only projects under consideration, how large should Durst’s capital budget be? a. $30,000 b. $60,000 c. $90,000 d. $120,000

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Chap 09_4ce 43. You were hired as a consultant to Kroncke Company, whose target capital structure is 50% debt, 20% preferred, and 30% common equity. The after-tax cost of debt is 6.8%, the cost of preferred is 7.9%, and the cost of retained earnings is 14%. The firm will not be issuing any new stock. What is its WACC? a. 8.38% b. 8.62% c. 9.18% d. 9.75% The following data apply to problems 75–78 below.

You are employed by GCUT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some other information about GCUT follows below.

Assets Current assets Net plant, property, and equipment

$38,000,000 101,000,000

Total assets 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

$139,000,000

Total shareholders’ equity Total liabilities and shareholders’ equity

80,000,000 $139,000,000

$10,000,000 9,000,000 19,000,000 40,000,000 59,000,000 30,000,000 50,000,000

You check The Wall Street Journal and see that GCUT stock is currently selling for $8.20 per share and that GCUT bonds are selling for $910 per bond. The bonds have a $1,000 par value, an 8.5% annual coupon rate, semiannual payments, are not callable, and have a 22-year maturity. GCUT’s beta is 1.3, the yield on a 6-month Treasury bill is 3.9%, and the yield on a 20-year Treasury bond is 6%. The expected return on the stock market is 12.6%, but the market has had an average annual return of 15.1% during the past 5 years. GCUT is in the 40% tax bracket.

44. Using the CAPM approach, what is the best estimate of the cost of equity for GCUT? a. 13.00% b. 13.62% c. 14.06% d. 14.58%

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Chap 09_4ce 45. McCue Company has equal amounts of low-risk, average-risk, and high-risk projects. McCue estimates that its overall WACC is 13%. 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 high-risk projects and reject too many low-risk projects. b. The CFO’s recommendation will maximize the firm’s intrinsic value. c. The firm’s overall risk should decrease over time. d. The company’s overall WACC should decrease over time because its stock price should be increasing.

46. What will happen if a typical company uses the same cost of capital to evaluate all projects? a. The firm will likely become less risky over time, but its intrinsic value will remain unchanged. b. The firm will likely become less risky over time, and its intrinsic value will be minimized. c. The firm will likely become riskier over time, and its intrinsic value will be maximized. d. The firm will likely become riskier over time, and its intrinsic value will not be maximized.

47. Kovach Lumber Company hired you to help estimate its cost of capital. You were provided with the following data: D1 = $1.30; P0 = $28.90; g = 7% (constant); and F = 6%. What is the cost of equity raised by selling new common stock? a. 10.41% b. 10.80% c. 11.21% d. 11.79% 48. Which of the following best describes financial capital? a. “Capital” is sometimes defined as the funds supplied by customers. b. “Capital” is sometimes defined as the funds supplied by investors. c. “Capital” is sometimes defined as the funds supplied by arbitragers. d. “Capital” is sometimes defined as the funds supplied by regulators. c

.

d

.

49. Suppose a firm uses a single source of capital to fund a project. Which of the following statements is correct? a. This project should still be evaluated using the firm’s WACC. b. Only the cost of that source should be used to evaluate the project. c. The average historical cost of all previously raised capital should be used for evaluation. d. Book values of the funding source should be used in calculating WACC.

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Chap 09_4ce 50. Which of the following best defines the cost of debt component of the WACC? a. The cost of debt component of the WACC is equal to 1 plus the marginal tax rate divided by the average coupon rate on all outstanding debt. b. The cost of debt component of the WACC is equal to 1 plus the marginal tax rate multiplied by the average duration on the firm’s outstanding debt. c. The cost of debt component of the WACC is equal to 1 minus the marginal tax rate multiplied by the yieldto-maturity on the firm’s outstanding debt. d. The cost of debt component of the WACC is equal to 1 minus the marginal tax rate divided by the yield-tomaturity on all outstanding debt.

51. Which statement regarding cost of capital is true? a. Lower flotation costs tend to increase the cost of equity capital. b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. c. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. d. 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 should accept and to accept some risky projects that it should reject.

52. Bruner Breakfast Foods’ balance sheet shows a total of $30 million long-term debt with a coupon rate of 9%.

The yield to maturity on this debt is 11%, and the debt has a total current market value of $25 million. The balance sheet also shows that that the company has 10 million shares of stock, and the total of common equity (common stock plus retained earnings) is $40 million. The current stock price is $5 per share, and shareholders’ required rate of return, rs, is 13%. The company recently decided that its target capital structure should have 50% debt, with the balance being common equity. The tax rate is 35%. Calculate WACCs based on target, book, and market value capital structures, and then find the sum of these three WACCs. a. 30.04% b. 31.62% c. 31.95% d. 32.40% 53. Which of the following best describes the components of the weighted average cost of capital (WACC)? a. The component costs of capital are company-determined variables in the sense that they are based on investors’ historical required rates of return. c

.

b. The component costs of capital are company-determined variables in the sense that they are based on investors’ required returns. c. The component costs of capital are market-determined variables in the sense that they are based on investors’ historical required rates of return. d. The component costs of capital are market-determined variables in the sense that they are based on investors’ required returns.

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Chap 09_4ce 54. Canada Bank’s long-term bonds are currently priced to offer a yield-to-maturity of 10.6%. If Canada Bank’s marginal tax rate is 28%, what is the after-tax cost of debt on Canada Bank’s bonds? a. 6.42% b. 6.80% c. 7.13% d. 7.63% 55. Bing Inc. estimates that its average-risk projects have a WACC of 13%, its below-average-risk projects have a WACC of 11%, and its above-average-risk projects have a WACC of 15%. Which project (A, B, C, or D) should the company accept? a. Project A is of below-average risk and has a return of 10%. b. Project B is of above-average risk and has a return of 14%. c. Project C is of average risk and has a return of 13.5%. d. Project D is of above-average risk and has a return of 13.5%.

56. Which of the following statements is correct? a. A decrease in the flotation cost required to sell a new issue of stock will decrease the cost of retained earnings. b. 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 after-tax cost of debt. c. Since its shareholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. d. A decrease in a firm’s tax rate will decrease the component cost of debt, provided the YTM on the firm’s bonds is not affected.

57. Which of the following statements is correct? a. The WACC as used in capital budgeting is an estimate of a company’s before-tax and after-tax cost of capital. b. The percentage flotation costs associated with issuing new common equity are typically smaller than the flotation costs for new debt. c. There is an opportunity cost associated with using retained earnings, hence they are not “free.” d. The WACC as used in capital budgeting will 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.

58. Sara Sisters Inc. has always paid out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity.

Its target capital structure consists of common stock, preferred stock, and debt. Which circumstance would increase the WACC? a. decrease in expected inflation b. decrease in the flotation costs associated with issuing new common stock c. decrease in the company’s beta d. increase in the market risk premium

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Chap 09_4ce The following data apply to problems 75–78 below.

You are employed by GCUT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some other information about GCUT follows below.

Assets Current assets Net plant, property, and equipment

$38,000,000 101,000,000

Total assets Liabilities and equity Accounts payable Accruals

$139,000,000 $10,000,000 9,000,000

Current liabilities Long term debt (40,000 bonds, $1,000 par value) Total liabilities Common stock (10,000,000 shares) Retained earnings

19,000,000 40,000,000 59,000,000 30,000,000 50,000,000

Total shareholders’ equity

80,000,000

Total liabilities and shareholders’ equity

$139,000,000

You check The Wall Street Journal and see that GCUT stock is currently selling for $8.20 per share and that GCUT bonds are selling for $910 per bond. The bonds have a $1,000 par value, an 8.5% annual coupon rate, semiannual payments, are not callable, and have a 22-year maturity. GCUT’s beta is 1.3, the yield on a 6-month Treasury bill is 3.9%, and the yield on a 20-year Treasury bond is 6%. The expected return on the stock market is 12.6%, but the market has had an average annual return of 15.1% during the past 5 years. GCUT is in the 40% tax bracket.

59. What is the best estimate of the after-tax cost of debt for GCUT? a. 5.14% b. 5.69% c. 5.82% d. 6.13% 60. Which statement about WACC is true? a. An increase in a company’s target capital structure cannot affect its WACC. b. A decrease in the risk-free rate will normally increase the marginal costs of both debt and equity financing. c. Flotation costs associated with issuing new common stock normally reduce the WACC. d. If a company’s tax rate decreases, then, all else equal, its WACC will increase.

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Chap 09_4ce 61. Which of the following is not a capital component when calculating the WACC? a. long-term debt b. common stock c. accounts receivable d. preferred stock 62. Bankston Corporation forecasts that if all of its existing financial policies are adhered to, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which action would reduce its need to issue new common stock? a. increasing the percentage of debt in the target capital structure b. reducing the amount of accounts payable in order to reduce liabilities c. increasing monthly interest payments in order to reduce its store of capital d. increasing the payment of cash dividends for the upcoming year 63. Malitz Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information.

– Malitz’s noncallable bonds mature in 26 years, have a 9% annual coupon, a par value of $1,000, and a market price of $1,120.

– The company’s tax rate is 35%.

– The risk-free rate is 5%, the market risk premium is 6%, and the stock’s beta is 1.3.

– The target capital structure consists of 40% debt and the balance as common equity. Malitz uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? a. 9.73% b. 9.95% c. 10.32% d. 10.76% 64. P. Lange Ltd. hired your consulting firm to help the company estimate the cost of equity. The yield on Lange’s bonds is 8.36%, and your firm’s economists believe that the cost of equity can be estimated using a risk premium of 3.8% over a firm’s own cost of debt. What is an estimate of Lange’s cost of equity from retained earnings? a. 11.05% b. 11.48% c. 11.83% d. 12.16% 65. You have the following data: D1 = $0.90; P0 = $23.40; and g = 6% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 9.03% b. 9.42% c. 9.85% d. 10.16%

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Chap 09_4ce 66. Assume that Considine Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $1.10; P0 = $24.60; and g = 8% (constant). Based on the DCF approach, what is Considine’s cost of equity from retained earnings? a. 11.98% b. 12.40% c. 12.83% d. 12.28% 67. Among various sources of financing, which one will receive favourable tax treatments by issuers? a. preferred stock b. common shares c. retained earnings d. debentures 68. You were recently hired by Nast Media Inc. to estimate its cost of capital. You were provided with the following data: D1 = $3.00; P0 = $57.00; g = 7.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 12.60% b. 12.93% c. 13.04% d. 13.52%

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Chap 09_4ce The following data apply to problems 75–78 below.

You are employed by GCUT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some other information about GCUT follows below.

Assets Current assets Net plant, property, and equipment

$38,000,000 101,000,000

Total assets Liabilities and equity Accounts payable Accruals

$139,000,000 $10,000,000 9,000,000

Current liabilities Long term debt (40,000 bonds, $1,000 par value) Total liabilities Common stock (10,000,000 shares) Retained earnings

19,000,000 40,000,000 59,000,000 30,000,000 50,000,000

Total shareholders’ equity

80,000,000

Total liabilities and shareholders’ equity

$139,000,000

You check The Wall Street Journal and see that GCUT stock is currently selling for $8.20 per share and that GCUT bonds are selling for $910 per bond. The bonds have a $1,000 par value, an 8.5% annual coupon rate, semiannual payments, are not callable, and have a 22-year maturity. GCUT’s beta is 1.3, the yield on a 6-month Treasury bill is 3.9%, and the yield on a 20-year Treasury bond is 6%. The expected return on the stock market is 12.6%, but the market has had an average annual return of 15.1% during the past 5 years. GCUT is in the 40% tax bracket.

69. Which of the following is the best estimate for the weights to be used when calculating the WACC? a. wc = 65.10% wd = 34.90% b. wc = 68.20% wd = 31.80% c. wc = 69.26% wd = 30.74% d. wc = 73.40% wd = 26.60% 70. What is the best estimate of the WACC for GCUT? a. 11.85% b. 12.18% c. 12.50% d. 13.14%

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Chap 09_4ce 71. Which of the following statements is correct? a. 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 the project will be financed with equity. b. The before-tax cost of debt that should be used as the component cost when calculating the WACC is the average before-tax cost of all of the firm’s outstanding debt. c. The bond-yield-plus-risk-premium approach is the most complex and objective method for estimating a firm’s cost of equity capital, which is highly likely to produce a precise cost of equity. d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

72. Which of the following statements is correct? a. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital. b. The after-tax cost of equity is usually less than the after-tax cost of debt. c. Retained earnings that were generated in the past and are reflected on the firm’s balance sheet are generally available to finance the firm’s capital budget during the coming year. d. For a given firm, the after-tax cost of preferred stock is always cheaper than the after-tax cost of debt.

73. Which of the following best describes what the cost of capital should reflect? a. The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets. b. The cost of capital should reflect the average cost of the various sources of long-term bonds a firm uses to acquire fixed assets. c. The cost of capital should reflect the average cost of the various sources of short-term funds a firm uses to acquire current assets. d. The cost of capital should reflect the average cost of the various sources of long-term capital, as well as customers’ capital, the firm uses to acquire assets.

74. Which of the following statements is correct? a. All else being equal, a decrease in a company’s stock price will decrease its marginal cost of retained earnings, rs. b. If a company’s tax rate decreases but the YTM of its noncallable bonds remains the same, the after-tax cost of its debt will increase. c. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. d. All else being equal, a decrease in a company’s stock price will decrease its marginal cost of new common equity, re.

75. You have the following data: D1 = $1.50; P0 = $43.80; and g = 8% (constant). What is the cost of equity from retained earnings based on the DCF approach? a. 11.08% b. 11.42% c. 11.86% d. 12.06% Copyright Cengage Learning. Powered by Cognero.

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Chap 09_4ce 76. You have the following data: rRF = 5%; RPM = 6%; and b = 1.33. What is the cost of equity from retained earnings based on the CAPM approach? a. 12.40% b. 12.98% c. 13.25% d. 13.65% 77. Chambliss Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $1.20; P0 = $28.10; and g = 6% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 10.53% b. 10.96% c. 11.11% d. 11.50% 78. Hanihouse Company’s perpetual preferred stock sells for $108.20 per share, and it pays a $10.60 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5% of the price paid by investors. What is the company’s cost of preferred stock for use in calculating the WACC? a. 9.19% b. 9.65% c. 10.31% d. 10.64% 79. Grunewald Co.’s common stock currently sells for $70 per share, the company expects to earn $4 per share during the current year, its expected payout ratio is 50%, and its expected constant growth rate is 8%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? a. 0.25% b. 0.31% c. 0.38% d. 0.45% 80. Unless substantial amounts of capital are needed, if a firm obtains all of its common equity from retained earnings, what will happen to its marginal cost of capital curve? a. It will be upward sloping. b. It will be downward sloping. c. It will stay flat. d. It will be V-shaped.

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Chap 09_4ce 81. Schadler Systems is expected to pay a $3.80 dividend at year-end (D1 = $3.80), the dividend is expected to grow at a constant rate of 7% a year, and the common stock currently sells for $63.40 a share. The before-tax cost of debt is 8.1%, and the tax rate is 40%. The target capital structure consists of 30% debt and 70% common equity.

What is the company’s WACC if all equity is from retained earnings? a. 10.55% b. 10.92% c. 11.06% d. 11.42% 82. LePage Co. expects to earn $2.90 per share during the current year, its expected payout ratio is 60%, its expected constant dividend growth rate is 5%, and its common stock currently sells for $24 per share. New stock can be sold to the public at the current price, but a flotation cost of 6% would be incurred. What would be the cost of equity from new common stock? a. 11.81% b. 12.04% c. 12.35% d. 12.71% 83. Which of the following statements is correct? a. 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, then decision makers can have more confidence in the estimated cost of equity. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because the DCF model correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield and accurate estimates for its key inputs are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is always accurate, because its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures. d. 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 riskfree rate, and the market risk premium—can be estimated with no error.

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Chap 09_4ce 84. Cici Consolidated has two divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 9%, and stand-alone computer companies typically have a 15% WACC. He also believes that Cici’s restaurant and computer divisions have the same risk as their typical peers. Consequently, Cici estimates that its composite, or corporate, WACC is 12%. A consultant has suggested using a 9% hurdle rate for the restaurant division and a 15% hurdle rate for the computer division.

However, Cici’s CFO disagrees, and he has assigned a 12% WACC to all projects in both divisions. Which of the following statements is correct? a. While Cici’s decision not to use risk-adjusted WACCs will result in its accepting more projects in the computer division and fewer projects in its restaurant division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b. Cici’s decision not to adjust for risk means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This will lead to a reduction in the firm’s intrinsic value over time. c. Cici’s decision not to adjust for risk means, in effect, that it is favouring the restaurant division. Therefore, that division is likely to become a larger part of the consolidated company over time. d. Cici’s decision not to adjust for risk means that the company will accept too many projects in the restaurant business and too few projects in the computer business. This will lead to a reduction in its intrinsic value over time.

85. Which of the following statements is correct regarding preferred stock floatation costs and the cost of preferred share equity? a. The lower the flotation costs, the higher the required rate of return. b. The higher the flotation costs, the lower the required rate of return. c. The higher the flotation costs, the higher the required rate of return. d. There is no specific relationship between the flotation costs and required rate of return.

86. Which of the following best reflects the correct cost of debt used to calculate a firm’s WACC? a. 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. b. The before-tax cost of debt, which is higher than the after-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC. c. The after-tax cost of debt, which is lower than the before-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC. d. The after-tax cost of debt, which is higher than the before-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC. 87. Suppose a company’s target capital structure calls for 50% debt and 50% common equity. Which of the following statements is correct? a. The cost of equity is always less than the cost of debt. b. The WACC is calculated on an after-tax basis. c. The WACC exceeds the cost of equity. d. The cost of retained earnings typically exceeds the cost of new common stock.

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Chap 09_4ce 88. ABC Canada pays a $3.30 dividend on its preferred shares. If the price of its preferred shares is $51 and flotation costs would be 6% per share, what is the required rate of return on ABC’s preferred shares? a. 5.13% b. 5.78% c. 6.20% d. 6.88% 89. Jackson Inc. uses only equity capital, and it has two equally sized divisions. Division A’s cost of capital is 12%, Division B’s cost is 18%, and the composite WACC is 15%. All of Division A’s projects have the same risk, as do all of Division B’s projects. However, the projects in Division A have less risk than those in Division B. Which of the following projects should Jackson accept? a. Division B project with a 15% return b. Division B project with a 16% return c. Division A project with a 10% return d. Division A project with a 13% return 90. You were hired as a consultant to Quigley Company, whose target capital structure is 30% debt, 25% preferred, and 45% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7%, the cost of retained earnings is 12.8%, and the tax rate is 35%. The firm will not be issuing any new stock. What is Quigley’s WACC? a. 8.29% b. 8.62% c. 8.97% d. 9.49%

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Chap 09_4ce Answer Key 1. False 2. True 3. True 4. False 5. False 6. False 7. True 8. False 9. False 10. False 11. False 12. False 13. False 14. True 15. True 16. True 17. False 18. False 19. False 20. True 21. b 22. d 23. b 24. a 25. c 26. c

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Chap 09_4ce 27. d 28. b 29. a 30. b 31. d 32. b 33. d 34. b 35. a 36. a 37. a 38. a 39. a 40. b 41. c 42. d 43. c 44. d 45. a 46. d 47. d 48. b 49. a 50. c 51. d 52. b 53. d 54. d Copyright Cengage Learning. Powered by Cognero.

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Chap 09_4ce 55. c 56. b 57. c 58. d 59. b 60. d 61. c 62. a 63. a 64. d 65. c 66. c 67. d 68. a 69. c 70. a 71. d 72. a 73. a 74. b 75. b 76. b 77. a 78. c 79. b 80. c 81. a 82. d Copyright Cengage Learning. Powered by Cognero.

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Chap 09_4ce 83. a 84. b 85. c 86. c 87. b 88. d 89. d 90. c

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Chap 10_4ce Indicate whether the statement is true or false.

1. 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 less 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 2. Theoretically speaking, hard capital rationing exists. a. True b. False 3. The IRR of normal Project Y is smaller than the IRR of normal Project X, and both IRRs are greater than zero.

Also, the NPV of Y is smaller than the NPV of X 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 4. 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 a different decision on which project to undertake. a. True b. False 5. Basic capital budgeting procedures are used when making merger decisions for the purchase of a whole firm (or division). a. True b. False 6. A better solution to control estimation bias is to implement a post-audit program and to link the accuracy of forecasts to the compensation of the managers who initiated the projects. a. True b. False 7. When considering two mutually exclusive projects, the firm should always select that project whose IRR 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 8. In theory, any capital budgeting investment rule should depend not only on forecasted cash flows and the opportunity cost of capital, but also on managers’ tastes, the choice of accounting method, or the profitability of other independent projects. a. True b. False

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Chap 10_4ce 9. A decision to undertake significant downsizing to control fixed costs is usually made by the firm’s board of directors. a. True b. False 10. If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm should select X rather than Y if the cost of capital is less than the crossover rate. a. True b. False 11. In Canada, the discounted cash flow (DCF) criterion (that is, NPV or IRR) was not used significantly prior to 1970. By 1995, however, the majority of firms had adopted DCF methods. a. True b. False 12. An increase in the firm’s discount rate (r, or WACC) will decrease projects’ NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on the project’s IRR; therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False 13. The phenomenon called “multiple internal rates of return” arises when a project has normal cash flows (that is, the cash flows have only one sign change). a. True b. False 14. Since payback is easy to calculate and provides information on project liquidity, it is still used by companies as the single most important method. a. True b. False 15. 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 before or at the end of the project’s life. a. True b. False 16. Selecting the project that has the highest equivalent annual annuity seems to be the rule for comparing projects with different lives. This rule should apply only to independent projects. a. True b. False 17. A firm sometimes can undertake an investment if accepting the project would lead to an increase in the firm’s cost of capital. a. True b. False

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Chap 10_4ce 18. Normal Projects Q and R have the same NPV when the discount rate is zero. However, Project Q’s cash flows come in faster than those of R. Therefore, we know that at any discount rate greater than zero, R will have a lower NPV than Q. a. True b. False 19. The MIRR method assumes that cash flows are reinvested at the cost of capital (or some other explicit rate) rather than at the IRR, but it doesn’t eliminate the multiple IRR problem. a. True b. False 20. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist and we don’t know which IRR is better. a. True b. False 21. Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the MIRR method chooses the other, should generally be resolved in favour of the project with the higher NPV. a. True b. False 22. The IRR method’s assumption that cash inflows are reinvested at the cost of capital is more reasonable than the NPV’s assumption that cash flows are reinvested at the IRR. This is an important reason that the IRR method is generally preferred over the NPV method. a. True b. False 23. The first and most difficult step in project analysis is calculating the evaluation measures, such as net present value (NPV), internal rate of return (IRR), and profitability index (PI). a. True b. False 24. The NPV and IRR methods, when used to evaluate independent and equally risky projects, will always lead to the same accept/reject decisions: If NPV says accept, IRR also says accept. a. True b. False

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Chap 10_4ce Indicate the answer choice that best completes the statement or answers the question.

25. Projects S and L both have an initial cost of $20,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $30,000, while L’s total undiscounted flows are $40,000. At a WACC of 11%, the two projects have identical NPVs. Which project’s NPV is less sensitive to changes in the WACC? a. Project S b. Project L c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.

26. Which statement about multiple IRRs is true? a. For a project to have more than one IRR, both IRRs must be less than the WACC. b. If two projects are mutually exclusive, then they are very likely to have multiple IRRs. c. 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. d. Multiple IRRs can occur only if the signs of the cash flows change more than once.

27. Edmondson Electric Systems is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows:

11.00% 0 –$1,000

1 $600

2 $600

3 $600

a. $440.43 b. $466.23 c. $470.38 d. $478.80 28. Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 17% and Project B’s IRR is 22%. The company’s WACC is 14%, and at that rate Project A has the higher NPV. Which of the following statements is correct? a. The crossover rate for the two projects must be greater than 14%. b. Assuming the timing pattern of the two projects’ cash flows is the same, Project A probably has a lower cost (and larger scale). c. Assuming the two projects have the same scale, Project A probably has a faster payback than Project B. d. Since A has the lower IRR, then it must also have the lower NPV if the crossover rate is less than the WACC of 14%.

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Chap 10_4ce 29. Which of the following is correct regarding a change in a project’s cost of capital and its IRR? a. Other things held constant, an increase in the cost of capital will result in no change in a project’s IRR. b. Other things held constant, a decrease in the cost of capital will result in a decrease in a project’s IRR. c. Other things held constant, an increase in the cost of capital will result in an increase in a project’s IRR. d. Other things held constant, a decrease in the cost of capital will result in an increase in a project’s IRR. 30. Projects A and B both have positive NPVs. If A and B are mutually exclusive, other things held constant, which project will management reject? a. Management will reject the project with the lower NPV. b. Management will reject the project with the higher NPV. c. Management will reject neither A nor B since they both have positive NPVs. d. When projects are mutually exclusive, the NPV rule is ignored and both projects are rejected.

31. Choi Computer Systems is considering a project that has the following cash flow data. What is the project’s IRR? Year: Cash flows:

0 –$1,000

1 $460

2 $480

3 $500

a. 19.89% b. 20.38% c. 21.15% d. 22.65% 32. Which of the following is true regarding the payback method? a. One advantage of the payback method for evaluating potential investments is that it provides some information about a project’s liquidity and its wealth maximization. b. One advantage of the payback method for evaluating potential investments is that it provides some information about how much wealth a project adds. c. One advantage of the payback method for evaluating potential investments is that it provides some information about a project’s risk and cash flow during the whole investment period. d. One advantage of the payback method for evaluating potential investments is that it provides some information about a project’s liquidity and risk.

33. A project has a series of non-normal cash flows that result in a terminal value (TV) of $2,070 in 5 years. If the project’s initial costs are $1,100 and the firm’s WACC is 10%, what is your recommendation to management regarding this project (accept/reject)? a. accept as the MIRR is 11.12% b. accept as the MIRR is 13.48% c. accept as the terminal value is greater than the present value of the costs d. reject as the MIRR is greater than zero

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Chap 10_4ce 34. Scanlon Inc. 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 IRR, how much value will be foregone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV. WACC: CFS CFL

11% 0 –$2,,380 –$4,540

1 $900 $1,600

2 $910 $1,618

3 $920 $1,636

4 $930 $1,654

a. $44.59 b. $45.72 c. $46.42 d. $47.67 35. Rappaport Enterprises is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $298.29 b. $302.77 c. $314.50 d. $328.84

11% 0 –$1,000

1 $410

2 $420

3 $430

4 $440

36. Humboldt Inc. is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $507.94 b. $510.09 c. $516.31

10% 0 –$1,000

1 $400

2 $400

3 $400

4 $400

5 $400

d. $520.61 37. Which of the following statements is correct? a. 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 less of its cash flows coming in the later years. b. 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. c. The NPV and IRR methods both assume cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the IRR. d. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. Copyright Cengage Learning. Powered by Cognero.

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Chap 10_4ce 38. A project has the following cash flows: CF 0 –$12,000 CF 1 $2,600 CF 2 $4,900 CF 3 $9,000 CF 4 $8,800 Assuming a required rate of return of 7%, what is this project’s PI? a. 1.01 b. 1.50 c. 1.73 d. 1.96 39. Project X’s IRR is 22% and Project Y’s IRR is 18%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 13%, Project Y has a higher NPV than X. Given this information, which of the following statements is correct? a. The crossover rate between the two projects must be less than 13%. b. If the WACC is 11%, Project Y will have the lower NPV. c. The crossover rate between the two projects must be greater than 13%. d. If the WACC is 20%, Project X will have the lower NPV. 40. 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 increase—what will happen to projects S and L? a. Other things held constant, this change will cause L to become preferred to S. b. Other things held constant, this change will cause S to become preferred to L. c. Other things held constant, this change will cause L and S to have the same NPV. d. Other things held constant, this change will cause L and S to have the same MIRR. 41. Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 10%, while Project B’s IRR is 16%. When the WACC is 7%, the projects have the same NPV. Given this information, which of the following statements is correct? a. If the WACC is 14%, Project A’s NPV will be lower than Project B’s. b. If the WACC is 8%, Project A’s NPV will be higher than Project B’s. c. If the WACC is 6%, Project B’s NPV will be higher than Project A’s. d. If the WACC is 9%, Project B’s NPV will be lower than Project A’s.

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Chap 10_4ce 42. Rentz Recreation Inc. is considering a project that has the following cash flow data. What is the project’s IRR? Year: Cash flows: a. 17.50% b. 18.44%

0 –$690

1 $280

2 $260

3 $240

4 $220

c. 19.60% d. 20.39% 43. A firm 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 favours the NPV method, and you were hired to advise the firm on the best procedure. If the CEO’s preferred criterion is used, how much value will the firm lose as a result of this decision?

WACC: CFS CFL

12% 0 –$1,055 –$2,450

1 $395 $860

2 $400 $869

3 $405 $878

4 $410 $887

a. $32.51 b. $33.88 c. $34.46 d. $35.79 44. Last month, Smith Systems Inc. decided to accept the project whose cash flows are shown below. However, before actually starting the project, the Bank of Canada took actions that lowered interest rates and therefore Smith’s WACC. By how much did the change in the WACC affect the project’s forecasted NPV? Assume that the Bank of Canada’s action does not affect the cash flows.

New WACC: 9% Old WACC: 12% Year: 0 1 2 Cash flows: –$1,200 $600 $600

3 $600

a. $72.18 b. $75.19 c. $77.68 d. $79.69

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Chap 10_4ce 45. With respect to the required level of capital budget analysis, would likely require the least level of investigation while would likely require the greatest level of analysis.

1. contraction decisions 2. merger decisions 3. replacement needs to continue profitable operations 4. expansion into existing products or markets a. 4,1 b. 3,1 c. 3,2 d. 4,2 46. Project Delta has the following cash flows: CF 0 –$1,200,000 CF 1 $400,000 CF 2 $600,000 CF 3 $300,000 CF 4 $70,000

Calculate the project’s IRR given a required rate of return of 23%. a. IRR = 6.83% b. IRR = 7.24% c. IRR = 8.56% d. IRR = 11.50% 47. As of 2011, which method of capital budgeting was preferred in Canada? a. payback period b. IRR c. MIRR d. NPV 48. Which of the following statements is correct? a. The NPV is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The IRR and payback methods are generally regarded by academics as being the best two methods for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The MIRR is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

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Chap 10_4ce 49. Which statement about a project’s MIRR 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 regular IRR is always greater than its MIRR. b. A project’s regular IRR is always less than its MIRR. c. To find a project’s MIRR, we can compound cash inflows at the WACC 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, 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.

50. Barry Company is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $303.81 b. $312.01 c. $320.21 d. $330.03

11% 0 –$1,300

1 $450

2 $445

3 $440

4 $435

5 $430

51. Which of the following statements is correct? a. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. d. The MIRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

52. Wells Inc. is considering a project that has the following cash flow data. What is the project’s payback?

Year: Cash flows: a. 2.00 years b. 2.16 years c. 2.50 years d. 2.73 years

0 –$1,000

1 $600

2 $400

3 $400

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Chap 10_4ce 53. McCall Manufacturing has a WACC of 13%. The firm is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 18%, while Project B has an IRR of 24%. Which of the following statements is correct? a. Each project must have a negative NPV. b. Since the projects are mutually exclusive, the firm should always select Project B. c. If the crossover rate is 10%, Project B will have the lower NPV. d. If the crossover rate is 10%, Project A will have a lower NPV than Project B. 54. Steve Hawke is a football star who has been offered contracts by two different teams. The payments (in millions of dollars) under the two contracts are shown below:

Year 0 1 2 3 4

Team A Cash Payment $9.0 5.0 5.0 5.0 5.0

Team B Cash Payment $3.0 5.0 5.0 10.0 9.0

Steve plans to accept the contract that provides him with the highest NPV. At what discount rate would he be indifferent between the two contracts? a. 9.66% b. 10.65% c. 11.35% d. 12.55% 55. Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 13%, whereas Project D has a higher NPV if the WACC exceeds 13%. Which of the following statements is correct? a. Project D has a lower IRR. b. Project D is probably larger in scale than Project C. c. Project C has a lower IRR. d. Project C probably has a faster payback.

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Chap 10_4ce 56. Adler Enterprises is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $182.37 b. $195.72

11% 0 –$1,000

1 $480

2 $490

3 $500

c. $199.50 d. $204.82 57. Tucker Corp. is considering a project that has the following cash flow data. What is the project’s IRR? Year: Cash flows: a. 24.70% b. 25.65% c. 26.08% d. 27.36%

0 –$1,000

1 $510

2 $510

3 $510

58. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project can be accepted unless its IRR exceeds the project’s riskadjusted WACC. 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 WACC 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—that is, the analysis and recommendation that’s 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 its MIRR is less than the WACC, and that indicates the firm’s value will decline if it is accepted. b. You should recommend that the project be accepted, because although one IRR is less than the WACC, the other IRR is greater than the WACC and its NPV is positive. c. You should recommend that the project be rejected, because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted. d. 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 WACC. You should explain this to the president and tell him that the firm’s value will increase if the project is accepted.

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Chap 10_4ce 59. Which statement about a project’s IRR 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 WACC, then under all reasonable conditions the project’s NPV must be zero. b. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s IRR must be negative. c. If a project’s IRR is equal to its WACC, then under all reasonable conditions the project’s NPV must be negative. d. When evaluating mutually exclusive projects, those projects with relatively short lives will tend to have relatively low NPVs when the cost of capital is relatively low.

60. A project has a series of non-normal cash flows that result in a terminal value (TV) of $220,000 in 6 years. If the project’s initial costs are $41,000 and the firm’s WACC is 20%, what is your recommendation to management regarding this project (accept/reject)? a. accept as the MIRR is 30.50% b. reject as the MIRR is greater than zero c. accept as the MIRR is 32.31% d. accept as the terminal value is greater than the present value of the costs 61. Yonan Inc. 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 foregone. 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.

WACC: CFS CFL

9% 0 –$1,200 –$2,400

1 $600 $900

2 $900 $800

3 $0 $400

4 $0 $1,000

a. $18.36 b. $10.42 c. $13.79 d. $15.16 62. You are considering two mutually exclusive and equally risky projects. Both have IRRs that exceed the WACC that is used to evaluate them. 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 two projects’ NPV profiles do not cross in the upper right quadrant, then there will be a sharp conflict as to which one should be selected. b. For a conflict to exist between NPV and IRR, one project must have a decreasing stream of cash flows over time while the other has an increasing stream. If both sets of cash flows are increasing or decreasing, there must be no conflicts, even if one project is smaller than the other. c. For a conflict to exist between NPV and IRR, the initial investment cost of one project must be less than the cost of the other. d. 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. One project will rank higher by both criteria.

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Chap 10_4ce 63. ZumBahlen Inc. is considering the following mutually exclusive projects:

Year 0 1 2 3 4

Project A Cash Flow –$6,000 300 900 3,300 5,400

Project B Cash Flow –$6,000 3,100 3,200 1,000 500

At what cost of capital will the NPV of the two projects be the same? (That is, what is the “crossover” rate?) a. 15.85% b. 16.24% c. 16.71% d. 17.30% 64. Which statement about the NPV is true? a. The NPV method was once the favourite of academics and business executives, but today most authorities regard the discounted payback method as being the best indicator of a project’s profitability. b. 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. c. A project’s NPV depends on the total net amount of cash flows the project produces, but because the cash flows are discounted at the IRR, it does not matter if the cash flows occur early or late in the project’s life. d. 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.

65. Hindelang Ltd. is considering a project that has the following cash flow and WACC data. What is the project’s MIRR? Note that a project’s projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year: Cash flows: a. 18.69% b. 19.01% c. 19.41% d. 19.95%

10% 0 –$1,000

1 $400

2 $420

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3 $440

4 $460

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Chap 10_4ce 66. Projects S and L both have normal cash flows, and the projects have the same risk; hence, both are evaluated with the same WACC, 11%. However, S has a higher IRR than L. Which of the following statements is correct? a. Project L must have a lower NPV than Project S. b. If Projects S and L have the same NPV at the current WACC, 11%, then Project S, the one with the higher IRR, would have a lower NPV if the WACC used to evaluate the projects declined. c. If the WACC increases, then each project’s IRR will decrease. d. If Project S has a positive NPV, then Project L must also have a positive NPV. 67. Which statement regarding normal cash flows is correct? a. If a project has normal cash flows, then its IRR must be negative. b. The definition of “normal” cash flows is that the cash flow stream has one negative cash flow followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life. c. If a project has normal cash flows then it can have only one real IRR, whereas a project with non-normal cash flows might have more than one real IRR. d. If a project has normal cash flows, then it will have exactly three real IRRs. 68. 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 a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive. b. If Project A has a lower IRR than Project B, then Project A must also have a lower NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at the risk-free rate. d. If Project A has a lower IRR than Project B, then Project A must have the higher NPV. 69. Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B. System A requires an up-front cost of $120,000, after which it generates positive after-tax cash flows of $80,000 at the end of each of the next 2 years. System B also requires an up-front cost of $120,000, after which it generates positive after-tax cash flows of $58,000 at the end of each of the next 3 years. The company’s cost of capital is 12%. Based on the equivalent annual annuity, which system will be chosen? a. A for $8,038.03 b. B for $8,038.03 c. A for $8,996.18 d. B for $8,996.18

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Chap 10_4ce 70. Pinkerton Truck Rental is considering two mutually exclusive engine development projects. The RPX design has an expected life of 4 years and projected cash inflows are $4.8 million at the end of each of the first 2 years and $2.4 million in each of the next 2 years. The RPB design is more flexible and has an 8-year life. The projected end-of-year flows from the RPB design are $3.2 million in each of the first 2 years and $2.8 million in each of the next 6 years. Both projects require an initial investment of $6.9 million, and Pinkerton’s cost of capital is 13%. What is the NPV (on an 8-year extended basis) of the project with the most value to the company? a. $6.844 million b. $7.204 million c. $7.985 million d. $8.311 million 71. Which of the following is the best description of the IRR? a. The IRR is the discount rate that results in the present value of the cash outflows (or costs) being less than the present value of the cash inflows. b. The IRR is the discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. c. The IRR is the discount rate that results in the present value of the cash inflows being greater than the present value of the firm’s net income. d. The IRR is the discount rate that equates the present value of the cash inflows with the net present value of the firm’s net income.

72. A project has the following cash flows: CF 0 –$1,300 CF 1 $600 CF 2 $500 CF 3 $500 CF 4 $200 Assuming a required rate of return of 11%, what is this project’s PI? a. 1.11 b. 1.28 c. 1.40 d. 1.63

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Chap 10_4ce 73. Flint Fruits is considering two equally risky, mutually exclusive projects, Projects A and B, that have the following cash flows: Year Project A Project B 0 –$130,000 –$130,000 1 52,000 40,000 2 40,000 25,000 3 80,000 93,000 4 50,000 71,000 At what WACC would the two projects have the same NPV? a. 10.06% b. 10.73% c. 11.21% d. 11.82% 74. Which of the following is correct regarding profitability indices (PI)? a. The higher the PI, the lower the ranking. b. The lower the PI, the higher the ranking. c. A project with a PI above 1.0 should be accepted. d. A project with a PI above 0 should be accepted.

75. Levin Company is considering a project that has the following cash flow data. What is the project’s IRR? Year: Cash flows: a. 15.94% b. 17.71% c. 18.68% d. 19.14%

0 –$1,000

1 $380

2 $380

3 $380

4 $380

76. The Bank of Canada recently shifted its monetary policy, causing Lasik Vision’s WACC to change. Lasik had recently analyzed the project whose cash flows are shown below. However, the CFO wants to reconsider this and all other proposed projects in view of the Bank of Canada’s action. How much did the changed WACC cause the forecasted NPV to change? Assume that the Bank of Canada’s action does not affect the cash flows.

New Year: Cash flows:

WACC: 0 –$1,200

8% 1 $600

Old WACC: 11% 2 3 $620 $640

a. $72.03 b. $75.66 c. $79.57 d. $83.45 Copyright Cengage Learning. Powered by Cognero.

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Chap 10_4ce 77. Bey Bikes is considering a project that has the following cash flow and WACC data. What is the project’s discounted payback?

WACC: Year: Cash flows: a. 2.85 years b. 3.02 years

10% 0 –$1,400

1 $625

2 $585

3 $545

4 $505

c. 3.43 years d. 3.76 years 78. A project has a series of non-normal cash flows that result in a terminal value (TV) of $4,610 in 6 years. If the project’s initial costs are $2,000 and the firm’s WACC is 10%, what is your recommendation regarding this project to management (accept/reject)? a. accept as the MIRR is 16.57% b. reject as the MIRR is greater than zero c. accept as the terminal value is greater than the present value of the costs d. accept as the MIRR is 14.93% 79. Van Auken Inc. is considering a project that has the following cash flows: Year 0 1 2 3 4

Cash Flow –$1,000 $500 $200 $400 $400

The company’s WACC is 10%. What are the project’s payback, IRR, and NPV? a. payback = 2.25, IRR = 18.91%, NPV = $169 b. payback = 2.25, IRR = 19.50%, NPV = $183 c. payback = 2.75, IRR = 18.91%, NPV = $169 d. payback = 2.75, IRR = 19.50%, NPV = $183 80. The regular payback method has a number of disadvantages. Which of these items is a disadvantage of this method? a. It accounts for the time value of money. b. It ignores cash flows beyond the payback period. c. It cannot be used as an indicator of a project’s risk. d. It does not provide any indication regarding a project’s liquidity.

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Chap 10_4ce 81. Garvin Enterprises is considering a project that has the following cash flow and WACC data. What is the project’s discounted payback?

WACC: Year: Cash flows: a. 2.01 years

10.00% 0 –$1,300

1 $600

2 $600

3 $600

b. 2.14 years c. 2.38 years d. 2.57 years 82. Rivoli Roofing is considering mutually exclusive Projects A and B, which have the following cash flows:

Year 0 1 2 3 4 5

Project A Cash Flow –$300 30 50 50 60 90

Project B Cash Flow –$420 110 80 100 60 60

At what cost of capital would the two projects have the same NPV? a. 6.60% b. 7.30% c. 8.61% d. 9.54% 83. Pappas Products 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 foregone? Note that under some conditions the choice will have no effect on the value gained or lost.

WACC: CFS CFL

10% 0 –$1,130 –$2,780

1 $570 $680

2 $620 $755

3 $120 $830

4 $120 $1,430

a. $0.00 b. $1.14 c. $1.30 d. $1.62

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Chap 10_4ce 84. Projects A and B are equally risky, mutually exclusive, and have normal cash flows. Project A has an IRR of 14%, while Project B’s IRR is 18%. The two projects have the same NPV when the WACC is 9%. Which of the following statements is correct? a. If the WACC is 13%, both projects will have negative NPVs b. If the WACC is 7%, Project A will have the higher NPV. c. If the WACC is 15%, Project B will have the lower NPV. d. If the WACC is 17%, both projects will have negative NPVs. 85. Which of the following statements is correct? a. For independent projects, 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 a given project. b. The percentage difference between the IRR and the MIRR is equal to the project’s WACC. c. If a firm uses the regular payback method with a required payback of 5 years, then it will accept fewer projects than if it used as its cutoff criterion the discounted payback of 5 years. d. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favour the MIRR over the regular IRR. 86. Nast Inc. 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 not cause any value to be lost.

WACC: CFS CFL

8% 0 –$1,200 –$2,400

1 $405 $775

2 $405 $775

3 $405 $775

4 $405 $775

a. $20.71 b. $22.46 c. $25.49 d. $28.90 87. A company is choosing between two projects. The larger project has an initial cost of $120,000, annual cash flows of $50,000 for 10 years, and an IRR of 15.68%. The smaller project has an initial cost of $60,000, annual cash flows of $25,000 for 10 years, and an IRR of 16.92%. 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 cannot cross, and the smaller project’s NPV will be higher at all positive values of WACC. b. 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 WACC. c. 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 larger project will look better if the WACC is greater than the crossover rate. d. 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 smaller project will have the lower NPV if the WACC is less than the crossover rate.

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Chap 10_4ce 88. Anderson Associates is considering two mutually exclusive projects that have the following cash flows:

Year 0 1 2 3 4

Project A Cash Flow –$12,000 2,000 3,000 7,000 9,000

Project B Cash Flow –$9,000 8,000 1,000 2,000 3,000

At what cost of capital do the two projects have the same NPV? (That is, what is the crossover rate?) a. 15.07% b. 15.86% c. 16.03% d. 16.95% 89. Which statement regarding the IRR method is correct? a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life. b. One defect of the IRR method is that it does not take account of the time value of money. c. One defect of the IRR method is that it assumes that the cash flows to be received from a project can only be reinvested at the IRR itself. d. One defect of the IRR method is that it does not take account of the reinvestment of capital.

90. Which of the following statements is correct? a. 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. b. One advantage of the NPV over the MIRR method is that NPV discounts cash flows at the WACC whereas the MIRR is based on undiscounted cash flows. c. One advantage of the NPV over the MIRR method is that NPV discounts cash flows at the WACC whereas MIRR discounts cash flows at the MIRR. d. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more likely to be appropriate.

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Chap 10_4ce 91. Thompson Stores is considering a project that has the following cash flow data. What is the project’s IRR? Year: 0 1 2 3 4 5 Cash –$1,000 $310 $305 $300 $295 $280 flows:

a. 14.16% b. 15.23% c. 16.78% d. 17.16% 92. A project has the following cash flows: CF 0 –$15,000 CF 1 $4,500 CF 2 $6,800 CF 3 $6,000 CF 4 $4,800 Assuming a required rate of return of 16%, what is this project’s PI? a. 0.85 b. 1.03 c. 1.20 d. 1.33 93. Which statement about a project’s MIRR 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 greater than its regular IRR. b. A project’s MIRR is always less than its regular IRR. c. If a project’s IRR is less than its WACC, then the MIRR will be less than the IRR. d. If a project’s IRR is less than its WACC, then the MIRR will be greater than the IRR. 94. A project has a series of non-normal cash flows that result in a terminal value (TV) of $76,000 in 11 years. If the project’s initial costs are $24,700 and the firm’s WACC is 10%, what is your recommendation regarding this project to management (accept/reject)? a. accept as the MIRR is 10.76% b. reject as the MIRR is greater than zero c. accept as the terminal value is greater than the present value of the costs d. accept as the MIRR is 15.39%

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Chap 10_4ce 95. Mills Corp. is considering two mutually exclusive machines. Machine A requires an up-front expenditure at t = 0 of $510,000, has an expected life of 2 years, and will generate positive after-tax cash flows of $390,000 per year (all cash flows are realized at the end of the year) for 2 years. At the end of 2 years the machine will have zero salvage value, but every 2 years the company can purchase a replacement machine with the same cost and identical cash inflows.

Alternatively, it can choose Machine B, which requires an expenditure of $1.2 million at t = 0, has an expected life of 4 years, and will generate positive after-tax cash flows of $430,000 per year (all cash flows are realized at year-end). At the end of 4 years, Machine B will have an after-tax salvage value of $100,000.

The cost of capital is 11%. What is the NPV (on an extended 4-year life) of the better machine? a. $197,438 b. $199,925 c. $283,552 d. $286,026 96. Sorenson Stores is considering a project that has the following cash flows: Year Cash Flow 0 CF0 = ?

1 $3,000 2 4,000 3 2,000 4 3,500 The project has a payback of 2.8 years, and the firm’s cost of capital is 13%. What is the project’s NPV? a. $720.17 b. $765.91 c. $849.80 d. $891.32 97. 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 WACC used to calculate the NPV, the higher the calculated NPV will be. b. If a project’s NPV is greater than zero, then its IRR must be less than the WACC. 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 high WACCs.

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Chap 10_4ce 98. Moerdyk & 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 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 one with the higher IRR will also have the higher NPV. WACC: CFS CFL

13% 0 –$1,065 –$1,065

1 $660 $110

2 $460 $310

3 $260 $510

4 $60 $710

a. –$35.04 b. –$32.28 c. $0.00 d. $25.70 99. Which of the following is correct regarding a project’s NPV? a. If a project’s NPV exceeds its MIRR, then the project should be accepted. b. If a project’s NPV is less than its MIRR, then the project should be accepted. c. If a project’s NPV is positive, then the project should be accepted. d. If a project’s NPV is negative, then the project should be accepted.

100. Babcock Inc. is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $31.43 b. $37.49

11% 0 –$950

1 $600

2 $400

3 $200

c. $40.52 d. $43.54 101. Which statement about an NPV profile graph is true? a. An NPV profile graph shows how a project’s IRR varies as the cost of capital changes. b. 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. c. We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV. d. The NPV profile graph for a normal project will generally have a negative (downward) slope as the life of the project increases.

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Chap 10_4ce 102. Sadik Company 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 IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will not cause any value to be lost.

WACC: CFS CFL a. $4.29 b. $5.38 c. $6.10 d. $7.09

7% 0 –$1,230 –$1,230

1 $795 $420

2 $770 $420

3

4

$420

$420

103. Project Delta has the following cash flows: CF 0 –$11,000 CF 1 $0 CF 2 $700 CF 3 $1,000 CF 4 $4,000 CF 5 $7,000 If this project has a required rate of return of 16%, will management accept or reject the project? a. Management would reject the project since there are no positive cash flows in year 1. b. Management would reject the project because the project has an NPV of –$4,297. c. Management would reject the project because the project has an NPV of –$4,598. d. Management would accept the project because the project has an NPV of $4,297.

104. Edelman Electric Systems is considering a project that has the following cash flow and WACC data. What is the project’s MIRR? Note that a project’s projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year: Cash flows: a. 16.58% b. 17.64% c. 18.29% d. 19.14%

10% 0 –$900

1 $450

2 $450

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3 $450

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Chap 10_4ce 105. 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 payback criterion for evaluating projects is that this method does not properly account for the time value of money. b. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion. c. If a project’s payback is positive, then the project should be rejected because it must have a zero NPV. d. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 5 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.

106. Assume a project has normal cash flows. All else being equal, which of the following statements is correct? a. The project’s IRR decreases as the WACC increases. b. The project’s MIRR is unaffected by changes in the WACC. c. The project’s NPV decreases as the WACC increases. d. The project’s regular payback decreases as the WACC increases.

107. A project has a series of non-normal cash flows that result in a terminal value (TV) of $41,000 in 13 years. If the project’s initial costs are $9,200 and the firm’s WACC is 10%, what is your recommendation regarding this project to management (accept/reject)? a. accept as the terminal value is greater than the present value of the costs b. reject as the MIRR is greater than zero c. accept as the MIRR is 12.18% d. accept as the MIRR is 12.60% 108. In general, where there is a conflict between two mutually exclusive projects, the NPV of a project and its internal rate of return, in terms of making a go/no go decision, the conflict is resolved by which of the following rules? a. Where the NPV method chooses one project but the IRR method chooses the other, the conflict should generally be resolved in favour of the project with the higher MIRR. b. Where the NPV method chooses one project but the IRR method chooses the other, the conflict should generally be resolved in favour of the project with the higher IRR. c. Where the NPV method chooses one project but the IRR method chooses the other, the conflict should generally be resolved in favour of the project with the higher NPV. d. Where the NPV method chooses one project but the IRR method chooses the other, the conflict should generally be resolved in favour of the project with the shorter payback period.

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Chap 10_4ce 109. 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:

Which of the following statements is correct? a. More of Project A’s cash flows occur in the earlier years. b. More of Project B’s cash flows occur in the earlier years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The crossover rate, i.e., the rate at which Project A and B have the same NPV, is greater than Project A’s IRR, but less than Project B’s IRR. 110. Which statement regarding normal cash flows is correct? a. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.” b. The normal cash flows must begin with negative cash flows, switch to positive cash flows, and then remain positive. c. The “multiple IRR problem” can arise if a project’s cash flows are normal. d. Projects with normal cash flows can have only one real IRR.

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Chap 10_4ce 111. Project Delta has the following cash flows: CF 0 –$1,100,000 CF 1 $200,000 CF 2 $600,000 CF 3 $600,000 CF 4 $50,000 If this project has a required rate of return of 21%, will management accept or reject the project? a. Management would reject the project because the project has a NPV of $234,398. b. Management would reject the project because the project has a NPV of –$293,206. c. Management would reject the project because the project has a NPV of $293,206. d. Management would reject the project because the project has a NPV of –$649,550.

112. Energy Project Beta has the following cash flows: CF 0 –$4,500 CF 1 $0 CF 2 $0 CF 3 $1,200 CF 4 $3,400 CF 5 $7,500 If this project has a required rate of return of 11%, will management accept or reject the project? a. Management would reject the project because there are no positive cash flows in years 1 and 2. b. Management would accept the project because the project has an NPV of $5,000. c. Management would accept the project because the project has an NPV of $4,147. d. Management would accept the project because the project has an NPV of $3,068.

113. Mountain Fresh Water Company is considering two mutually exclusive machines. Machine A has an up-front cost of $130,000 (CF0 = –130,000), and it produces positive after-tax cash inflows of $50,000 a year at the end of each of the next 6 years. Machine B has an up-front cost of $70,000(CF0 = –70,000), and it produces aftertax cash inflows of $40,000 a year at the end of the next 3 years. The company’s cost of capital is 11%. Based on the equivalent annual annuity, which machine will be chosen? a. A for $11,355.09 b. A for $19,271.05 c. B for $11,355.09 d. B for $19,271.05

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Chap 10_4ce 114. Which of the following statements is correct? a. When evaluating independent projects, the NPV and MIRR methods often yield conflicting results regarding a project’s acceptability. b. The discounted payback method eliminates all of the problems associated with the payback method. c. 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. d. To find the MIRR, we discount the PV of costs at the IRR. 115. Which of the following is true regarding projects with non-normal cash flows? a. A project has non-normal cash flows when all of the cash flows have negative signs after the initial positive cash flow. b. A project has non-normal cash flows when all of the cash flows have negative signs. c. A project has non-normal cash flows when the signs of the cash flows change two or more times. d. A project has non-normal cash flows when all of the cash flows have positive signs after year 3.

116. 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 WACC used to calculate it, the higher the calculated NPV will be. b. The NPV of a relatively high-risk project should be found using a relatively low WACC. c. 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 WACC. d. If a project’s NPV is less than zero, then its WACC must be greater than the IRR. 117. Which of the following statements is correct? a. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on what is generally a more reasonable assumption about the reinvestment rate than the regular IRR. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. The MIRR method assumes that cash flows are reinvested at the crossover rate. d. The lower the WACC, the longer the discounted payback period.

118. Johnson Enterprises is considering a project that has the following cash flow and WACC data. What is the project’s NPV? WACC: Year: Cash flows: a. $193.78

11% 0 –$1,000

1 $390

2 $390

3 $390

4 $390

b. $197.98 c. $201.45 d. $209.95

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Chap 10_4ce 119. A small manufacturer is considering two alternative machines. Machine A costs $1.4 million, has an expected life of 5 years, and generates after-tax cash flows of $450,000 per year. At the end of 5 years, the salvage value of the machine is zero, but the company will be able to purchase another Machine A at a cost of $1.3 million. The second Machine A will generate after-tax cash flows of $475,000 a year for another 5 years, at which time its salvage value will again be zero. Alternatively, the company can buy Machine B at a cost of $1.9 million today. Machine B will produce after-tax cash flows of $500,000 a year for 10 years, after which it will have an after-tax salvage value of $100,000. Assume that the cost of capital is 13%. Based on the equivalent annual annuity, if the company chooses the machine that adds the most value to the firm, by how much will the company’s value increase per year? a. $79,757.41 b. $155,278.80 c. $383,946.95 d. $842,580.57 120. 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 WACC to find the terminal value (TV), then compounding this TV to find the IRR. b. 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. c. If a project’s IRR is greater than the WACC, then its NPV is always negative. d. To find a project’s IRR, we must find a discount rate that causes the PV of the inflows to equal 0.

121. Stewart Associates is considering a project that has the following cash flow data. What is the project’s payback?

Year: Cash flows: a. 2.54 years b. 3.16 years c. 3.89 years d. 4.21 years

0 –$1,300

1 $400

2 $410

3 $420

4 $430

5 $440

122. Which statement regarding payback is true? a. The regular payback method recognizes all cash flows over a project’s life. b. Although the payback methods have serious faults as ranking criteria, they do provide information on liquidity and risk because it gives managers an idea of how long it will take to recover the funds invested in a project. c. The regular payback method doesn’t recognize cash flows beyond the payback year, but the discounted payback method solves this problem. d. The discounted payback method recognizes cash flows after the payback year, and it also adjusts these cash flows to account for the time value of money.

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Chap 10_4ce 123. Which of the following statements is correct? a. If the NPV is negative, the IRR cannot be positive. b. If Project A’s IRR is smaller than Project B’s, then A must have the lower NPV. c. If a project with normal cash flows has an IRR greater than the WACC, the project must have a positive NPV. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. 124. Which of the following statements is a major disadvantage of the payback method? a. The payback criterion is useless as a risk indicator. b. The payback method ignores the cash flows beyond the payback period. c. The payback method doesn’t directly account for the time value of money. d. Answers b and c are correct.

125. Aubey Inc. is considering two projects that have the following cash flows:

Year 0 1 2 3 4 5

Project 1 Cash Flow –$2,300 600 800 1,100 1,200 1,400

Project 2 Cash Flow –$2,100 1,300 1,200 900 700 600

At what cost of capital would the two projects have the same NPV? a. 2.73% b. 3.85% c. 4.51% d. 5.50% 126. Which of the following statements regarding IRR is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The IRR must exceed the cost of capital in order for the firm to accept the investment. b. The IRR changes when the cost of capital changes. c. The IRR is totally different from the yield to maturity on a bond. d. To find a project’s IRR, we must solve for the discount rate that causes the PV of the outflows to equal the FV of the project’s inflows.

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Chap 10_4ce 127. A project has a series of non-normal cash flows that result in a terminal value (TV) of $180,800 in 8 years. If the project’s initial costs are $60,000 and the firm’s WACC is 10%, what is your recommendation regarding this project to management (accept/reject)? a. accept as the MIRR is 14.78% b. reject as the MIRR is greater than zero c. accept as the terminal value is greater than the present value of the costs d. accept as the MIRR is 17.00%

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Chap 10_4ce Answer Key 1. True 2. False 3. False 4. False 5. True 6. True 7. False 8. False 9. True 10. False 11. True 12. False 13. False 14. False 15. True 16. False 17. True 18. True 19. False 20. False 21. True 22. False 23. False 24. True 25. a 26. d

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Chap 10_4ce 27. b 28. a 29. a 30. a 31. b 32. d 33. b 34. b 35. c 36. c 37. a 38. c 39. c 40. b 41. a 42. a 43. b 44. c 45. c 46. a 47. d 48. a 49. c 50. d 51. c 52. a 53. d 54. d Copyright Cengage Learning. Powered by Cognero.

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Chap 10_4ce 55. c 56. b 57. a 58. d 59. a 60. c 61. a 62. d 63. c 64. b 65. a 66. b 67. c 68. a 69. c 70. b 71. b 72. a 73. d 74. c 75. d 76. d 77. a 78. d 79. c 80. b 81. d 82. b Copyright Cengage Learning. Powered by Cognero.

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Chap 10_4ce 83. a 84. b 85. d 86. c 87. d 88. a 89. c 90. d 91. b 92. b 93. d 94. a 95. d 96. a 97. d 98. c 99. c 100. a 101. b 102. d 103. b 104. c 105. a 106. c 107. c 108. c 109. b 110. d Copyright Cengage Learning. Powered by Cognero.

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Chap 10_4ce 111. c 112. d 113. b 114. c 115. c 116. d 117. a 118. d 119. b 120. b 121. b 122. b 123. c 124. d 125. c 126. a 127. a

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Chap 11_4ce Indicate whether the statement is true or false.

1. Estimating project cash flows is generally very important but also the most difficult step in the capital budgeting process. However, methodology, such as the use of NPV versus IRR, is more important than estimating projects’ cash flows. a. True b. False 2. The primary advantage of declining balance depreciation over straight-line depreciation is that, while the total amount of depreciation (and thus tax savings) is unchanged, charges are taken later. This means that the firm gets the benefits of the tax savings later, which decreases their present value. a. True b. False 3. The change in net operating working capital associated with new projects is always negative, because new projects mean that less working capital will be required. This situation is true for both expansion and replacement projects. a. True b. False 4. The present value of the CCA tax shield requires three calculations: (1) calculating the total present value of the tax shield assuming the asset is held in perpetuity, (2) accounting for the half-year rule, and (3) calculating the present value of the tax shield you give up when you sell the asset. a. True b. False 5. When determining the present value of the tax shield for assets being replaced rather than bought new, the calculation must reflect the cash flow differentials between the new and old projects, and these differentials are the incremental cash flows that we must analyze. a. True b. False 6. Changes in net operating working capital need not be considered in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. a. True b. False 7. Suppose Thinker Publishing Company is considering bringing out a new finance text whose projected sales include sales that will be taken away from another of Thinker’s books. The lost sales on the existing book are a sunk cost and as such should not be considered in the analysis of the new book. a. True b. False 8. Within the same asset class in the same year, when the proceeds from the sale of assets exceed the cost of the purchases, the net acquisition is positive. The half-year rule will not apply. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 11_4ce 9. Sometimes, analysts think that an externality is present in a project, but they recognize that the particular externality cannot be quantified with any precision—estimates of its effect would really just be guesses.

However, if the externality is potentially important, the externality should not be ignored, otherwise a large error might be made. a. True b. False 10. In reality, with capital budgeting analysis we should discount cash flows based on the exact moment when they occur. So, we should estimate daily cash flows, not annual cash flows, and analyze them. a. True b. False 11. Sensitivity analysis measures the stand-alone risk of a project by showing how much the project’s NPV is affected by a small change in one of the input variables, such as the WACC. Other things held constant, with the independent variable graphed on the horizontal axis, the flatter the graph of the relationship line, the less risky the project. a. True b. False 12. Using the same discount rate to evaluate projects with differing degrees of risk would, over time, cause the firm to accept too many low-risk projects and to reject too many high-risk proposals. a. True b. False 13. Opportunity costs include those cash inflows that could be generated from assets the firm already owns, if those assets were not used for the project being evaluated. a. True b. False 14. 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 15. When the cash flows for a project are estimated, interest payments should not be included in projected cash flows, otherwise it will result in double-counting interest costs. a. True b. False 16. The undepreciated capital cost (UCC) is defined as the total cost of all assets in a class plus the accumulated CCA for that class. a. True b. False

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Chap 11_4ce 17. 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 together with a discounted cash flow analysis. a. True b. False 18. Because of the improvements in forecasting techniques, estimating the cash flows associated with a project has become the simplest and most inconsequential step in the capital budgeting process. a. True b. False 19. The focus of capital budgeting is on cash flows rather than on net income, but changes in noncash balance sheet accounts such as inventory are also relevant in a capital budgeting analysis. a. True b. False 20. In cash flow estimation, the existence of externalities must be taken into account if those externalities have any effects on the firm’s cash flows. a. True b. False 21. Inflation (or deflation) occurs in Canada and other countries, so it should be considered in a capital budgeting analysis. Forgetting to include inflation in a capital budgeting analysis normally causes the estimated NPV to be higher than the true NPV; this could cause a company to accept a project it should have rejected. a. True b. False 22. If an investment project would make use of land that the firm currently owns, the project should be charged with zero cost for the land because it will not need to buy the required land. a. True b. False 23. 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 24. The two cardinal rules that financial analysts follow to avoid capital budgeting errors are (1) capital budgeting decisions must be based on accounting net income, and (2) all incremental cash flows should be considered when making accept/reject decisions. a. True b. False

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Chap 11_4ce Indicate the answer choice that best completes the statement or answers the question.

25. Which of the following does NOT have incremental cash flow effects and thus should NOT be considered in capital budgeting decisions? 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 of costs for shipping and installing the new machinery will be required. c. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products. d. A firm has spent $3 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered if the new project is rejected.

26. What is the best approach to take into account the relative risk of a proposed project? a. picking a risk factor equal to the average discount rate b. reducing the NPV by 20% for risky projects c. adjusting the discount rate downward if the project is judged to have below-average risk d. ignoring risk because project risk cannot be measured accurately 27. Which of the following statements is correct? a. If a project can create employment in a slump area, the firm should include such an externality in the NPV calculations. b. If cannibalization exists, then the lost cash flows associated with the project must be charged to the new project. Otherwise, the calculated NPV will be biased upward. c. If cannibalization is determined to exist, then this means that the calculated NPV without considering cannibalization will be lower than the NPV that recognizes these effects. d. Cannibalization is a type of externality that is not against the law, but any harm it causes is done to other firms.

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Chap 11_4ce 28. Majestic Theatres is considering investing in some new projection equipment whose data are shown below. The required equipment has a 7-year project life falling into a CCA class of 30%, but it would have a positive pre-tax salvage value at the end of Year 7. Also, some new working capital would be required, but it would be recovered at the end of the project’s life. Revenues and cash operating costs are expected to be constant over the project’s 7-year life. What is the project’s NPV? WACC Net capital investment in fixed assets Required new working capital Sales revenues, each year Cash operating costs, each year Expected pre-tax salvage value Tax rate

13% $980,000 $40,000 $690,000 $370,000 $60,000 33%

a. $177,492 b. $178,517 c. $179,160 d. $180,702 29. Young Corp.’s management has determined that two independent projects have the following NPVs: Project A NPV $6,100 Project B NPV $(5,300) Which best describes the correct managerial decision given the information above? a. Accept A and decline B since A has a positive NPV and B has a negative NPV. b. Accept both projects since the NPV of A will offset any losses resulting from B. c. Reject both projects since both projects must be NPV positive if they are independent. d. In order to decide between these independent projects, we need the MIRR of each project.

30. As a member of Midwest Corporation’s financial staff, you must estimate the Year 1 operating cash flow for a proposed project with the following data. What is the Year 1 net operating cash flow?

Sales revenues $38,000 – Cash operating costs 19,000 – CCA 12,000 Operating income (EBIT) $7,000 – Taxes Rate = 37% 2,590 After-tax EBIT $4,410 + CCA 12,000 Net operating cash flow $16,410 a. $16,050 b. $16,410 c. $17,250 d. $17,600 Copyright Cengage Learning. Powered by Cognero.

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Chap 11_4ce 31. Fool Proof Software is considering a new project whose data are shown below. The equipment has an economic life of 3 years, and is in CCA class 10 (30%). Revenues and cash operating costs are expected to be constant over the project’s 3-year life. What is the net operating cash flow for Year 1?

Equipment cost Annual sales revenues Annual cash operating costs Tax rate

$68,000 $70,000 $31,000 40%

a. $27,162.50 b. $27,480.00 c. $28,359.25 d. $28,715.50 32. When evaluating a new project, which of the following should firms NOT include in the projected cash flows? a. changes in net working capital attributable to the project b. the value of a building owned by the firm that will be used for this project c. previous expenditures associated with a market test to determine the feasibility of the project provided those costs have been expensed for tax purposes d. the salvage value of assets used for the project at the end of the project’s life 33. You work for Athens Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow?

Sales revenues Capital cost allowance Cash operating costs Tax rate

$18,000 $5,000 $7,000 40.0%

a. $7,550 b. $7,831 c. $8,317 d. $8,600

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Chap 11_4ce 34. Zeta Software is considering a new project whose data are shown below. The required equipment has a 3-year project life, after which it will be worthless, and it has a constant deduction rate over 3 years. Revenues and cash operating costs are expected to be constant over the project’s 3-year life. What is the project’s operating cash flow for Year 1?

Sales revenues Capital cost allowance Cash operating costs Tax rate

$70,000 $27,000 $30,000 36%

a. $34,196 b. $34,945 c. $35,320 d. $35,800 35. Which of the following statements best describes externalities? a. An externality is a situation where a project would have an adverse effect on some other part of the firm or on the environment. If the project would have a favourable effect on other operations, then this is not an externality. 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 favour the NPV. c. 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. d. Identifying an externality can never lead to an increase in the calculated NPV. 36. Merritt Company is considering a new project that has a cost of $1,200,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. Merritt 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, Merritt would have to make a payment to those parties. How much is the option to abandon worth (in thousands) to Merritt?

WACC = 12% Prob = Prob = Prob =

30% 50% 20%

Dollars in Thousands t=0 t=1 t=2 $900 $900 –$1,200 $610 $610 –$280 –$280

t=3 $900 $610 –$280

NPV this Prob × State NPV $961.7 $288.5 $265.1 $132.6 –$1,872.5 –$374.5 Exp. NPV =$46.6

a. $71.2 b. $76.5 c. $80.3 d. $84.5

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Chap 11_4ce 37. Which of the following statements is correct? a. Only incremental cash flows are relevant in project analysis, and the proper incremental cash flows are the reported accounting profits, which form the best basis for investor and managerial decisions. b. If a terminal loss or CCA recapture could occur at the conclusion of the business, no subsequent cash flows would be received. c. It is unrealistic to believe that increases in net operating 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. d. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they are not considered in a capital budgeting analysis.

38. Bing Services is now in the final year of a project. The equipment originally cost $30,000. The existing UCC is $6,000. Bing can sell the used equipment today for $7,500, and its tax rate is 40%. What is the equipment’s net after-tax salvage value for use in a capital budgeting analysis? Note that the recapture is fully taxable. a. $5,320 b. $5,800 c. $6,640 d. $6,900 39. Which of the following statements regarding CCA is true? a. Companies calculate CCA not on individual assets, but rather by asset class. b. When corporations use CCA, the shareholder report financially looks better. c. Since CCA is a cash expense, the slower an asset is depreciated, the higher the projected NPV from investing in the asset. d. Using CCA declining balance depreciation rather than straight line normally has the effect of slowing down cash flows and thus increasing a project’s forecasted NPV. 40. Currently, Clemson Products has a beta of 1.2, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the company’s average projects. 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 market risk. b. The proposed new project would increase the firm’s corporate risk. c. The proposed new project would have more stand-alone risk than the firm’s typical project. d. The proposed new project would have less stand-alone risk than the firm’s typical project.

41. Which factor should be included in the cash flows used to estimate a project’s NPV? a. the end-of-project recovery of any working capital required to operate the project b. interest on funds borrowed to help finance the project c. expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes d. cannibalization effects, but only if those effects increase the project’s projected cash flows

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Chap 11_4ce 42. Your company, Q4 Inc., is considering a new project whose data are shown below. The required equipment has an economic year of 5 years, and has a CCA rate of 30% in class 10. Revenues and cash operating costs are expected to be constant over the project’s 5-year operating life. What is the project’s net operating cash flow for Year 2?

Equipment cost Sales revenues (each year) Cash operating costs (each year) Tax rate

$80,000 $70,000 $35,000 38%

a. $28,213.00 b. $28,667.50 c. $29,097.50 d. $29,452.00 43. Which of the following statements regarding real options is correct? a. Real options involve both “real” and “financial” assets. b. An investment timing option is the ability to abandon a project if the cash flows turn out to be lower than expected. It reduces the risk of a project and increases its value. c. The abandonment option involves the possibility of delaying major expenditures until more information on likely outcomes is known. d. A flexibility option is the option to modify operations depending on how conditions develop during a project’s life, especially the type of output produced or the inputs used.

44. Manitoba Hideaways is considering a new project whose data are shown below. The equipment has a 4-year project life. This equipment falls into class 43 with a CCA rate of 30% and would have zero salvage value. No new working capital would be required. Revenues and cash operating costs are expected to be constant over the project’s 4-year life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1 to 4.)

WACC Net investment cost Sales revenues, each year Cash operating costs Tax rate a. $33,594 b. $34,402 c. $35,417 d. $36,284

9% $70,000 $68,000 $27,000 36%

45. Which of the following is NOT a cash flow and thus should NOT be reflected in the analysis of a capital budgeting project? a. increases in net operating working capital b. sunk costs that have been expensed for tax purposes c. cannibalization effects d. opportunity costs Copyright Cengage Learning. Powered by Cognero.

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Chap 11_4ce 46. Which of the following statements best describes CCA? a. Under CCA rules, lower CCA deductions occur in the later years, and this reduces the early cash flows and thus lowers a project’s projected NPV. b. Corporations must use the same depreciation method (e.g., straight-line or CCA) for shareholder reporting and tax purposes. c. Since CCA is not a cash expense, it has no effect on operating cash flows and thus no effect on capital budgeting decisions. d. Using CCA rather than straight-line depreciation 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. 47. Which of the following statements regarding CCA is true? a. Although CCA is a cash expense, it plays no role in capital budgeting. b. The CCA deduction is equal to the year-end UCC for the pool to the power of the mandated CCA rate. c. CCA uses a specific mandated CCA rate for each asset class. d. CCA allows that the net capital cost of an asset is added to the pool in the year after the asset is put in use.

48. Moore & Moore (MM) is considering the purchase of a new machine for $60,000, installed. MM will use the CCA method to depreciate the machine. This machine is included in CCA class 8 (20%). MM expects to sell the machine at the end of its 4-year operating life for $11,000. If MM’s marginal tax rate is 38%, what will be the present value of the CCA tax shield when it disposes of the machine at the end of Year 4? Assume that the relevant discount rate is 9%. a. $12,105 b. $12,859 c. $13,033 d. $13,930 49. Which of the following statements is correct? a. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas Monte Carlo simulation cannot account for probabilities. c. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. d. Scenario analysis allows us to assign probabilities to the base (or most likely) case and the worst case; then we can find the range of the project’s NPV to get a better idea of the project’s risk.

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Chap 11_4ce 50. You work for Alberta Corp. and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow?

Sales revenues Capital cost allowance Cash operating costs Tax rate a. $95,320 b. $96,860

$170,000 $29,000 $54,000 22.0%

c. $97,617 d. $98,500 51. Which of the following statements best describes a sunk cost? a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. b. 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. c. A sunk cost is a cash outlay not directly related to the project and can be recovered if the firm decides to go forward with the project. d. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered in the future regardless of whether or not the project is accepted.

52. Easy Payment Loan Company is thinking of opening a new office, and the key data are shown below. Easy Payment owns the building, free and clear, and it would sell it for $120,000 after taxes if the company decides not to open the new office. The equipment that would be used would be depreciated by the straight-line method over the project’s 3-year life, and would have a zero salvage value. An extra $6,000 of new working capital would be required to get this project running. Revenues and cash operating costs would be constant over the project’s 3year life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1–3 and the increased working capital will be recovered when this project ends. A simplified CCA is for mathematical convenience.)

WACC 9% Net equipment capital cost $85,650 Annual CCA deduction for equipment $28,550 Sales revenues, each year $210,000 Cash operating costs, each year $30,000 Tax rate 36% a. $116,940 b. $110,604 c. $118,672 d. $119,915

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Chap 11_4ce 53. Temple Inc., a household products firm, is considering production of a new detergent. In evaluating whether to go ahead with the project, which item should NOT be explicitly considered when cash flows are estimated? a. The company will produce the detergent 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 other Temple products. b. The company has spent and expensed for tax purposes $4 million on research related to the new detergent. These funds cannot be recovered, but the research is expected to benefit other projects that might be proposed in the future. c. The project will utilize some equipment the company currently owns but is not now using. A usedequipment dealer has offered to buy the equipment. d. The new detergent will cut into sales of the firm’s other detergents.

54. Which factor is NOT relevant when determining incremental cash flows for a new product? a. the cost of a marketing study that was completed last year related to the new product—this research led to the tentative decision to go ahead with the new product, and the cost of the research was expensed for tax purposes last year b. revenues from an existing product that would be lost as a result of customers switching to the new product c. 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 d. the land the company owns and would use for the new project, if it is accepted, that could be sold to another firm 55. Rocky Top Car Wash 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 the project’s 3-year life, and would have 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. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. If the number of cars washed declined by 50% from the expected level, by how much would the project’s NPV change? (Hint: Cash flows are constant in Years 1 to 3.)

WACC Net capital investment cost Number of cars washed Average price per car Fixed cash operating cost Variable op. cost/unit (i.e., per car washed) Annual capital cost allowance Tax rate

10% $75,000 3,400 $30 $11,000 $5.294 $25,000 35%

a. $65,423 b. $66,119 c. $67,891 d. $68,453

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Chap 11_4ce 56. What is the correct rule for capital budgeting analysis? a. The interest paid on funds borrowed to finance a project must be included in the project’s estimated cash flows. b. Only incremental cash flows are relevant when making accept/reject decisions. c. 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. 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 will have no effect on the cash flows used in the analysis.

57. A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s WACC. Which factor should the CFO include in the cash flows when estimating the relevant cash flows? a. all interest expenses on debt used to help finance the project b. all sunk costs that have been incurred relating to the project c. sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year d. 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 58. You work for Canada Corp. Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow?

Sales revenues Capital cost allowance Cash operating costs Tax rate a. $11,800 b. $12,110

$34,000 $8,000 $18,000 38.0%

c. $12,960 d. $13,450 59. Which item 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 time last year evaluating the new project, a portion of their salary for that year should be charged to the project’s initial cost. b. The new project is expected to reduce sales of one of the company’s existing products by 10%. c. The company has spent and expensed $2 million on R&D associated with the new project. d. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $2.3 million per year.

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Chap 11_4ce 60. Langston Labs has an overall (composite) WACC of 11%, which reflects the cost of capital for its average asset.

Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 9%, average projects at 11%, and high-risk projects at 13%. The company is considering the following projects: Project A B C D E

Risk High Average High Low Low

Expected Return 16% 13 14 10 8

Which set of projects would maximize shareholder wealth? a. A, B, and C b. A, B, and D c. A, B, C, and D d. A, B, C, D, and E 61. A firm is considering a new project whose risk is smaller than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, what would it be reasonable for management to do? a. decrease the estimated IRR of the project to reflect its smaller risk b. decrease the cost of capital used to evaluate the project to reflect the project’s lower-than-average risk c. ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets d. decrease the estimated NPV of the project to reflect its smaller risk 62. A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is correct? a. When estimating the project’s operating cash flows, it is important to include any sunk costs, but the firm should ignore opportunity costs and cash flow effects of externalities since they are accounted for in the discounting process. b. Since depreciation is a noncash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. c. 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 WACC. If interest were deducted when identifying relevant cash flows, it would in effect be “double-counted.” d. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a beforetax basis.

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Chap 11_4ce 63. Boulder Company spent $5 million 2 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. Boulder owns the building free and clear—there is no mortgage on it. Which of the following statements is correct? a. 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. b. If there is a mortgage loan on this building, then the interest on that loan would have to be charged to any new project that used the building. c. This is an example of a negative externality, because the very existence of the building affects the cash flows for any new project that Boulder might consider. d. 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.

64. Which of the following statements is correct? a. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the new project were not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration. b. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality. c. In a capital budgeting analysis where part of the funds used to finance the project are 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. 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 cost associated with that asset is a sunk cost and should be ignored.

65. Which statement best describes sensitivity analysis? a. Sensitivity analysis is a method for evaluating a project that uses a number of possible values for a given variable, such as cash inflows, to assess its impact on the firm’s return in simulation analysis. b. Sensitivity analysis is a statistically based behavioural approach to project analysis that applies predetermined probability distributions in the scenario approach. c. Straightforward sensitivity analysis, as it is generally employed, is incomplete in that it fails to consider the range of likely values for the key input variables and the probabilities of different input values. d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.

66. Which of the following statements best describes a situation involving sunk costs? a. A good example of a sunk cost is money that an investment corporation spent last year to investigate the site for a new office, then expensed those funds for tax purposes, and now is deciding whether to go forward with the project. b. A good example of a sunk cost is a situation where a company opens a new shopping centre, and that new shopping centre leads to a decline in sales of the company’s other shopping centres. c. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. d. If sunk costs are ignored and not reflected in a project’s cash flows, then the project’s calculated NPV will be lower than it otherwise would be.

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Chap 11_4ce 67. What will result from a decrease in the risk-adjusted discount rate for a less risky project? a. an increase in the NPV b. an increase in the IRR c. no change in the NPV d. a decrease in the NPV 68. Canada Corp.’s management has determined that two mutually exclusive projects have the following NPVs: Project A NPV $7,000 Project B NPV $8,000 Which best describes the correct managerial decision given the information above? a. Reject both projects since both projects must have an NPV greater than $15,000. b. Accept both projects since the NPV of A and B can maximize the firm’s value. c. Accept B and reject A since B has a higher NPV than A. d. Accept A and decline B since A has greater growth potential.

69. Taussig 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 numbers: Project X $460,000 $130,000 1.5

Expected NPV Standard deviation ( NPV) Project beta (versus market) Correlation of the project cash flows with cash flows from currently existing projects.

Project Y $460,000 $170,000 0.9 Cash flows Cash flows are not correlated are highlycorrelated with the cash flows from existing with the cash flows from projects. existing projects.

Which of the following statements is correct? a. Project Y has less stand-alone risk than Project X. b. Project Y has less corporate (or within-firm) risk than Project X. c. Project Y has the same level of corporate risk as Project X. d. Project Y has less market risk than Project X.

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Chap 11_4ce 70. Your company, Omega Corporation, is considering a new project that you must analyze. Based on the following data, what is the project’s Year 1 operating cash flow?

Sales revenues Capital cost allowance Cash operating costs Tax rate a. $12,720 b. $12,913

$29,000 $9,000 $14,000 38%

c. $13,250 d. $13,581 71. Ontario Corp.’s management has determined that two independent projects have the following NPVs: Project A NPV $8,000 Project B NPV $16,000 Which best describes the correct managerial decision given the information above (assume Ontario Corp can fund both projects if required)? a. Accept both projects since they are independent and have positive NPVs. b. Reject both projects since they are independent and have positive NPVs. c. Accept B and decline A since A has a lower positive NPV compared to B. d. In order to decide between these independent projects, we need the MIRR of each project.

72. Party Place is considering a new investment whose data are shown below. Assume the equipment that would be used would have a constant annual capital cost allowance over the project’s 3-year life and a zero salvage value.

This project would require some additional working capital that would be recovered at the end of the project’s life. Revenues and cash operating costs are expected to be constant over the project’s 3-year life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1 to 3. CCA is modified to smooth out the calculations.)

WACC Net investment in fixed assets (basis) Required new working capital Annual capital cost allowance Sales revenues, each year Cash operating costs, each year Tax rate

11% $85,920 $20,000 $28,640 $82,000 $30,000 37%

a. $10,112 b. $15,286 c. $12,584 d. $13,913

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Chap 11_4ce 73. TexMex Products is considering a new salsa whose data are shown below. The equipment has a constant capital cost allowance over its 3-year life with a zero salvage value. No new working capital would be required.

Revenues and cash operating costs are expected to be constant over the project’s 3-year life. However, this project would compete with other TexMex products and would reduce the company’s pre-tax annual cash flows.

What is the project’s NPV? (Hint: Cash flows are constant in Years 1 to 3. Actual CCA varies. The proposed CCA is for computational convenience.)

WACC Pre-tax cash flow reduction in other products (cannibalization) Investment cost Annual capital cost of allowance Annual sales revenues Annual cash operating costs Tax rate a. $26,666 b. $34,599 c. $35,125 d. $35,740

11% $6,000 $77,340 $25,780 $89,000 $31,000 36%

74. You work for Sing Oil Company, which is considering a new project whose data are shown below. What is the project’s net operating cash flow for Year 1?

Sales revenues, each year Capital cost allowance Cash operating costs Interest expense Tax rate a. $24,260 b. $24,700 c. $25,386 d. $25,815

$62,000 $10,000 $29,000 $9,500 38%

75. Which of the following is correct regarding real options? a. Real options give owners the obligation, but not the right, to exercise these opportunities at a later date. b. Real options are also called strategic options because they are often associated with routine maintenance projects rather than large, strategic projects. c. Real options should be exercised when they decrease the NPV of a project. d. Opportunities to respond to changing circumstances are called managerial options because they give managers the option to influence the outcome of a project.

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Chap 11_4ce 76. Suppose Tapley Corporation uses a WACC of 9% for below-average-risk projects, 11% for average- risk projects, and 14% for above-average-risk projects. Which independent project should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR of 12% b. Project B, which has below-average risk and an IRR of 8% c. Project C, which has above-average risk and an IRR of 13% d. Without information about the projects’ NPVs, we cannot determine which one(s) should be accepted

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Chap 11_4ce Answer Key 1. False 2. False 3. False 4. False 5. True 6. False 7. False 8. False 9. True 10. False 11. True 12. False 13. True 14. True 15. True 16. False 17. True 18. False 19. True 20. True 21. False 22. False 23. False 24. False 25. d 26. c

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Chap 11_4ce 27. b 28. a 29. a 30. b 31. b 32. c 33. d 34. c 35. c 36. d 37. b 38. d 39. a 40. c 41. a 42. d 43. d 44. a 45. b 46. d 47. c 48. c 49. a 50. b 51. d 52. b 53. b 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 11_4ce 55. c 56. b 57. d 58. c 59. b 60. c 61. b 62. c 63. d 64. a 65. c 66. a 67. a 68. c 69. d 70. a 71. a 72. b 73. a 74. a 75. d 76. a

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Chap 12_4ce Indicate whether the statement is true or false.

1. Although they operate in different industries, two firms 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 2. 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 3. In a world with no taxes, MM showed that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM showed a positive relationship between debt and value; that is, its value rises as its debt is increased. a. True b. False 4. The MM model employs the concept of arbitrage to develop its theory. a. True b. False 5. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes. a. True b. False 6. MM showed that in a world without taxes, a firm’s value is affected by its capital structure. a. True b. False 7. According to MM, in a world with taxes, a firm’s value is maximized at almost 100% debt financing since the gain from leverage increases as debt increases. a. True b. False 8. The Miller model begins with the MM model with corporate taxes and then adds personal taxes. a. True b. False 9. The trade-off theory states that the capital structure decision involves a trade-off between the costs and benefits of debt financing. a. True b. False

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Chap 12_4ce 10. The Miller model begins with the MM model without corporate taxes and then adds personal taxes. a. True b. False 11. 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 12. The MM model is the same as the Miller model, but with zero corporate taxes. a. True b. False 13. If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is very likely that they would have concluded that 100% debt financing is optimal. a. True b. False 14. Financial distress, agency costs, and direct and indirect bankruptcy costs have no effect on a firm’s target capital structure. a. True b. False 15. A firm’s financial policy has no effect on its equity beta. a. True b. False 16. During a recession, companies with a significant portion of their capital structure in the form of debt (i.e., high leverage) often experience financial distress (or even worse) as they struggle to meet their legally binding interest obligations. a. True b. False 17. Firms having positive prospects try to avoid using debt and, rather, to raise any required new capital by other means, including selling stock. a. True b. False 18. During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders. a. True b. False

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Chap 12_4ce 19. Other things held constant, an increase in financial leverage will decrease a firm’s market (or systematic) risk as measured by its beta coefficient. a. True b. False 20. The presence of personal taxes reduces but does not completely eliminate the benefits of debt financing. a. True b. False 21. 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 22. Business risk is the risk a firm’s debtholders would face if the firm had no equity. a. True b. False 23. 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 24. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage affects only EBIT. a. True b. False 25. A firm’s financial risk refers to the extra risk shareholders bear as a result of using debt as compared with the risk they would bear if no debt were used. a. True b. False 26. Bankruptcy risk produces an ambiguous effect on agency costs, since debt can reduce one aspect of agency costs (wasteful spending) but may increase another (underinvestment). a. True b. False

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Chap 12_4ce Indicate the answer choice that best completes the statement or answers the question.

27. Assuming the following variables, what is the value of the firm according to MM with corporate taxes?

EBIT: $340,000 rd: 13% Tc: 35% Debt: $600,000 rsU: 18% a. $1,275,875 b. $1,337,500 c. $1,437,778 d. $1,546,250 28. Which of the following statements best describes WACC? a. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC. b. 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. c. 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. d. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC. 29. Senbet Ventures is considering starting a new company to produce stereos. The sales price would be set at 1.9 times the variable cost per unit; the VC/unit is estimated to be $3.10; and fixed costs are estimated at $170,000.

What sales volume would be required in order to break even; that is, to have an EBIT of zero for the stereo business? a. 66,640 b. 51,200 c. 56,314 d. 60,932 30. Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 8% 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 basic earning power, which is currently 18%. The CFO believes that this recapitalization would reduce the WACC and increase the stock price. What would also be likely to occur if the company goes ahead with the recapitalization plan? a. The company’s cost of equity would increase. b. The company’s earnings per share would decline. c. The company’s net income would increase. d. The company’s ROE would decline.

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Chap 12_4ce 31. Which of the following is a correct statement regarding expected rates of return and bankruptcy? a. Bankruptcy is costly to lenders. Therefore, lenders charge lower rates to borrowers judged to be more at risk of going bankrupt. b. Bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt. c. Bankruptcy is costly to lenders. Therefore, lenders charge similar rates to borrowers judged to be more at risk of going bankrupt, compared to solvent borrowers. d. Bankruptcy is not costly to lenders. Therefore, lenders charge lower interest rates to borrowers judged to be more at risk of going bankrupt, compared to solvent borrowers.

32. Victor Publishing is considering a proposed increase in its debt ratio, which would also increase the company’s interest expense. The plan would involve issuing new bonds and using 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. Since the proposed plan increases Victor’s business risk, the company’s share price is also likely to decline. b. Since the proposed plan increases Victor’s financial risk, the company’s share price still might fall even if EPS increases. c. Since the plan is expected to increase EPS, this implies that EBIT is also expected to increase. d. If the plan does increase the EPS, the share price will automatically increase at the same rate.

33. Vu Enterprises expects to have the following data during the coming year. What is Vu’s expected ROE? Assets D/A EBIT a. 10.51% b. 11.14% c. 12.28% d. 13.49%

$300,000 70% $38,000

Interest rate Tax rate

10% 35%

34. Suppose that the personal tax rate on income from bonds is 37%, and the personal tax rate on income from stocks is 25%. What is the critical corporate tax rate below which leverage will add no value to the unlevered firm per dollar of debt? a. 13.0% b. 14.8% c. 15.5% d. 16.0%

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Chap 12_4ce 35. Suppose a levered firm has a debt-to-equity ratio (D/S) of 0.6 and a cost of debt of 14%. The cost of equity to an otherwise identical but unlevered firm is 21%. What will be the levered firm’s cost of equity? a. 25.20% b. 25.67% c. 26.30% d. 27.17% 36. What should the firm’s target capital structure be set to do? a. minimize the cost of preferred stock b. minimize the weighted average cost of capital (WACC) c. minimize the cost of equity (rs) d. minimize the cost of debt (rd) 37. Which statement best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s EBIT. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt.

38. A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $300, the sales price would be set at twice the VC/unit, fixed costs are estimated at $950,000, and the investors will put up the funds if the project is likely to have an operating income of $850,000 or more. What sales volume would be required in order to meet this profit goal? a. 6,000 b. 6,750 c. 7,000 d. 7,250 39. Which of the following correctly defines a firm’s operating break-even? a. EBIT is equal to total sales less total variable and fixed costs. b. EBIT is equal to EBDITA less total fixed costs. c. EBIT is less than total sales less total variable costs. d. EBIT is equal to total dividends.

40. Which of the following statements is correct regarding interest tax shields? a. The benefits of interest tax shields are captured only by debtholders. b. The benefits of interest tax shields are captured by both debt and equity investors. c. The benefits of interest tax shields are captured only by management. d. The benefits of interest tax shields are captured only by equity investors.

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Chap 12_4ce 41. Which of the following would decrease the likelihood that a company would increase its debt ratio, other things held constant? a. a decrease in costs incurred when filing for bankruptcy b. a decrease in the personal tax rate c. a decrease in the corporate tax rate d. the company’s stock price hitting a new high 42. Canada Manu Corp. (CMC) reports total fixed costs of $20,000. If its average price per unit is $20 and its variable costs per unit are $8, what is CMC’s break-even unit production? a. 1,300 b. 1,667 c. 2,000 d. 2,815 43. ABC Co. has an asset beta of 1.13 and a debt beta of 0.9. Target debt-to-equity (D/E) ratio is 0.7. With no taxes, what is the equity beta? a. 1.15 b. 1.19 c. 1.23 d. 1.29 44. Lauterbach Corporation uses no debt, has a beta of 1.2, and its tax rate is 35%. However, the CFO is considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 6% and the market risk premium is 7%. By how much would the firm’s cost of equity change as a result of altering its capital structure? a. 2.63% b. 3.80% c. 3.64% d. 3.15% 45. What is the amount of annual interest tax shield for a firm with $4 million in debt that pays 13% interest if the corporate tax rate is 38%? a. $173,500 b. $184,000 c. $197,600 d. $205,000

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Chap 12_4ce 46. Which of the following statements is correct? a. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry. b. 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. c. When current market rates are sufficiently high relative to rates on a firm’s outstanding debt, managers should consider a refunding operation, in which a company issues new debt immediately. 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.

47. Which statement regarding debt is correct, other things held constant? a. If changes in the bankruptcy code make bankruptcy more costly to corporations, then this would likely lead to higher debt ratios for corporations. b. A decrease in the corporate tax rate is likely to encourage a company to use less debt in its capital structure. c. A decrease in the company’s degree of operating leverage is likely to encourage a company to use less debt in its capital structure. d. A decrease in the personal tax rate is likely to decrease the debt ratio of the average corporation.

48. Which of the following statements is correct? a. 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. b. If a firm finds that the cost of debt is less than the cost of equity, decreasing its debt ratio must increase its WACC. c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its EBIT. d. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.

49. DeLong Inc. has fixed operating costs of $510,000, variable costs of $3.20 per unit produced, and its products sell for $5 per unit. What is the company’s break-even point; that is, at what unit sales volume would income equal costs? a. 283,333 b. 296,667 c. 310,813 d. 345,403

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Chap 12_4ce 50. What is the value of the firm according to MM with corporate taxes if the following is true?

EBIT: $200,000 rd: 14% Tc: 35% Debt: $600,000 rsU: 17% a. $965,875 b. $974,706 c. $987,500 d. $996,250 51. In a perfect world of no taxes, what happens if the weighted average cost of capital (WACC) is unaffected by the capital structure? a. SML is upward sloping. b. MM Proposition II holds. c. MM Proposition I holds. d. SML is downward sloping.

52. Which of the following statements is correct regarding financial risk? a. Financial risk refers to the extra risk shareholders bear as a result of using preferred shares as compared with the risk they would bear if no debt were used. b. Financial risk refers to the reduced risk shareholders bear as a result of using debt as compared with the risk they would bear if no debt were used. c. Financial risk refers to the extra risk shareholders bear as a result of using debt as compared with the risk they would bear if no debt were used. d. Financial risk refers to the extra risk shareholders bear as a result of using bank loans as compared with the risk they would bear if new short-term debt were issued.

53. Which statement concerning capital structure theory is correct? a. According to signalling theory, a stock issue sets off a positive signal, while using debt is a negative signal. b. Signalling theory suggests that a firm should try to use more debt in “normal” times than the MM trade-off theory would suggest. c. Signalling theory suggests firms should in normal times maintain reserve borrowing capacity that can be used if an especially good investment opportunity comes along. d. Many of the corporate takeovers and leveraged buyouts in recent years were designed to improve efficiency by increasing the cash flow available to managers.

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Chap 12_4ce 54. Which statement concerning capital structure theory is correct? a. According to the trade-off theory, an increase in the costs of bankruptcy would lead firms to reduce the amount of debt in their capital structures. b. According to the trade-off theory, the optimal capital structure strikes a balance between the tax benefits of debt and the firm’s WACC. c. The pecking order hypothesis asserts that the presence of flotation costs or asymmetric information may cause a firm to raise different types of capital in a sequence that maximizes these costs. d. The market timing theory suggests that managers issue equity when they believe that stock market prices are abnormally low and issue debt when they believe that interest rates are abnormally high.

55. What is the major contribution of the Miller model? a. It demonstrates that debt costs increase with financial leverage. b. It demonstrates that financial distress and agency costs reduce the value of using corporate debt. c. It demonstrates that personal taxes can eliminate the benefits of debt financing. d. It demonstrates that personal taxes decrease the value of using corporate debt.

56. Which of the following statements regarding risk, or the avoidance of risk, is correct? a. A firm’s business risk can be eliminated by the good control of management. b. A firm’s financial risk can be minimized by diversification. c. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. d. Risk due to industry characteristics is beyond the control of the firm’s management.

57. Given that its debt is $600,000, its leverage value is $679,800, a tax rate of 33%, a cost of debt (unleveraged) of 17%, and a cost of debt of 13%, what is this firm’s cost of equity? a. 35.33% b. 36.49% c. 37.15% d. 38.20% 58. In a perfect world of no taxes, which statement regarding MM propositions is true? a. According to Proposition I, a firm is able to find its optimal capital structure. b. Proposition I states that the total firm value critically depends on capital structure. c. According to Proposition II, changes in the capital mix of a firm will not affect the debt and equity values of the firm. d. Proposition II implies that an increase in leverage raises the risk of equity and thereby the required return on equity.

59. Suppose the corporate tax rate is 37%, personal tax rate on interest income is 12%, and personal tax rate on equity income is 45%. How much value will leverage add to the unlevered firm per dollar of debt? a. $0.502 b. $0.540 c. $0.606 d. $0.693 Copyright Cengage Learning. Powered by Cognero.

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Chap 12_4ce 60. Other things held constant, which event is most likely to encourage a firm to decrease the amount of debt in its capital structure? a. Its sales become more stable over time. b. The costs that would be incurred in the event of bankruptcy increase. c. Management believes that the firm’s stock has become undervalued. d. The corporate tax rate increases.

61. Ang Enterprises has a levered beta of 1.2, its capital structure consists of 45% debt and 55% equity, and its tax rate is 35%. What would Ang’s beta be if it used no debt; that is, what is its unlevered beta? a. 0.69 b. 0.78 c. 0.83 d. 0.90 62. If the value of a levered firm is $7 million, what is the value of the same firm with all-equity financing? a. $7 million b. $6 million c. $8 million d. $10 million 63. Which of the following is correct regarding the relationship between a firm’s capital structure and its free cash flows (FCF)? a. A firm’s capital structure affects its calculated free cash flows, because FCF reflects only interest payments. b. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only free cash flow to equity. c. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows. d. None of the above is correct.

64. Assume that the firm’s gain from leverage according to the Miller model is $175,880. If the effective personal tax rate on stock income is Ts = 22%, what is the implied personal tax rate on debt income if the following is true?

EBIT = $200,000, rd = 13%, Tc = 33%, Debt = $600,000, rsU = 17%. a. 25.52% b. 26.07% c. 26.85% d. 27.30%

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Chap 12_4ce 65. Which of the following statements is a reasonable criticism of the MM and Miller models? a. Both MM and Miller assume that personal and corporate leverage are perfect substitutes. However, an individual investing in a levered firm has less loss exposure as a result of corporate limited liability than if “homemade” leverage had been used. b. Brokerage costs were assumed away by MM and Miller, making the switch from L to U costless. Even though brokerage and other transaction costs do exist, they would not impede the arbitrage process. c. MM initially assumed that corporations and investors can borrow at the risk-free rate, because most individual investors must borrow at the same rates as those paid by large corporations. d. MM and Miller assume that there are no costs associated with financial distress, and they also consider agency costs.

66. 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 Assets $300 EBIT $80 Tax rate 40%

Firm HD’s Data Debt ratio 60% Interest rate 15%

Firm LD’s Data Debt ratio 20% Interest rate 11%

a. 8.15% b. 8.69% c. 9.21% d. 9.54% 67. Which event is likely to encourage a company to decrease its target debt ratio, other things held constant? a. a decrease in the personal tax rate b. a decrease in the corporate tax rate c. a decrease in the company’s operating leverage d. the company’s stock price hitting a new low 68. Based on the information below, what is Ezzel Enterprises’ optimal capital structure? a. Debt = 30%; Equity = 70%; EPS = $3.02; Common share price = $28.50 b. Debt = 50%; Equity = 50%; EPS = $3.24; Common share price = $30.90 c. Debt = 85%; Equity = 15%; EPS = $3.76; Common share price = $33.60 d. Debt = 65%; Equity = 35%; EPS = $3.51; Common share price = $35.90 69. Which of the following statements best describes capital structure? a. The capital structure that minimizes the interest rate on debt also maximizes the bond price. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the WACC also maximizes the price per share of common shares. d. The capital structure that minimizes the required return on equity also maximizes the share price.

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Chap 12_4ce 70. With corporate taxes but no personal taxes, and without financial distress, what happens? a. The optimal amount of leverage for a firm is 100% debt. b. Equity costs increase with less debt financing. c. An unlevered firm cannot benefit from increased leverage. d. Debt costs increase with financial leverage.

71. Vafeas Inc.’s capital structure consists of 75% debt and 25% common equity, it has a beta of 1.5, and its tax rate is 40%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 45% debt and 55% equity. The risk-free rate is 6% and the market risk premium is 7%. By how much would the firm’s cost of equity change as a result of altering its capital structure? a. –3.20% b. –3.78% c. –4.36% d. 4.91% 72. On which of the following items will a decrease in the debt ratio generally have no effect? a. the firm’s beta b. total risk c. financial risk d. business risk 73. Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $13,000 and variable costs of $1.20 per deck of cards. The other method would use a less expensive machine (fixed cost = $7,000), but with greater variable costs ($1.80 per deck of cards). If the selling price per deck of cards is the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)? a. 10,000 decks b. 15,000 decks c. 20,000 decks d. 25,000 decks 74. Which of the following statements is correct? a. The optimal capital structure is the one that simultaneously (1) minimizes its WACC and (2) maximizes its EPS. b. A change in the personal tax rate should not affect firms’ capital structure decisions. c. “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 factors such as sales variability, cost variability, and operating leverage. d. If corporate tax rates were decreased while other things were held constant, and if the Modigliani–Miller tax-adjusted trade-off theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

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Chap 12_4ce 75. Which of the following statements is correct? a. A firm with low business risk is less likely to increase its use of financial leverage than a firm with high business risk, assuming all else is equal. b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions. c. In general, a firm with high operating leverage also has a large proportion of its total costs in the form of fixed costs. 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.

76. The CFO of a large Canadian public company believes that the company’s greatest strategic goal should be to maintain flexibility. To achieve this goal, which of the following financial structures is most likely in place at the company? a. The company holds large amounts of cash and short-term investments in spite of the opportunity loss resulting from low investment earnings. b. The company has issued significantly more equity (common shares) to avoid the restrictions that debt would impose through restrictive covenants. c. The company has issued significantly more long-term debt than equity (common shares) because debt has a significantly lower after-tax cost. d. The company maintains a higher dividend payout ratio than other firms in the industry to ensure that its common shares are attractive to investors.

77. Business risk is affected by a firm’s operations. Which of the following is NOT associated with (or does not contribute to) business risk? a. the extent to which interest rates on the firm’s long-term debt fluctuate b. sales price variability c. exchange rate fluctuations d. ability to develop new products in a timely and cost-effective manner 78. Suppose a levered firm has a debt-to-equity ratio (D/S) of 0.6 and a cost of debt of 16%. The cost of equity to an otherwise identical but unlevered firm is 24%. What will be the levered firm’s cost of equity? a. 27.10% b. 27.60% c. 28.00% d. 28.80% 79. Which statement best describes optimal capital structure? a. The optimal capital structure simultaneously maximizes EBIT and minimizes the WACC. b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. c. The optimal capital structure simultaneously maximizes common share price and minimizes the WACC. d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.

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Chap 12_4ce 80. Which of the following is correct regarding the indirect costs of bankruptcy (e.g., financial distress) as a firm approaches bankruptcy? a. they will tend to increase b. they will tend to decrease c. they will tend to remain constant d. they will tend to decrease in proportion to the sales of the firm, less the allowance for doubtful accounts 81. According to MM, which of the following is correct? a. MM shows that in a world without taxes, a firm’s optimal capital structure would be almost 100% debt. b. MM shows that in a world with taxes, a firm’s maximum capital structure would be almost 60% debt. c. MM shows that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt. d. MM shows that in a world without taxes, a firm’s suboptimal capital structure would be almost 99% debt.

82. If debt financing is used, which of the following is correct? a. 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. b. The percentage change in net operating income will be greater than a given percentage change in net income. c. The percentage change in net operating income will be less than the percentage change in net income. d. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.

83. Which statement concerning capital structure theory is NOT true? a. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt. b. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing. c. 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. d. Under MM with zero taxes, financial leverage has no effect on a firm’s value.

84. Suppose a firm decreases the operating leverage used to produce a given quantity of output. What will this normally lead to? a. an increase in its fixed assets turnover ratio b. an increase in its business risk c. an increase in the variability of its expected EPS d. an increase in the standard deviation of its expected EBIT

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Chap 12_4ce 85. Which of the following statements is correct? a. The capital structure that maximizes the common share price is also the capital structure that maximizes earnings per share. b. The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC. c. Decreasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing; however, this still may decrease the company’s WACC. d. Decreasing the personal tax rate but increasing the corporate tax rate would encourage companies to decrease their debt ratios.

86. Elephant Books sells paperback books for $8 each. The variable cost per book is $6. At current annual sales of 300,000 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 $1.50. 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. $200,000 b. $310,000 c. $450,000 d. $550,000

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Chap 12_4ce Answer Key 1. False 2. True 3. True 4. True 5. True 6. False 7. True 8. True 9. True 10. False 11. True 12. False 13. False 14. False 15. False 16. True 17. False 18. False 19. False 20. True 21. False 22. False 23. False 24. False 25. True 26. True

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Chap 12_4ce 27. c 28. b 29. d 30. a 31. b 32. b 33. c 34. d 35. a 36. b 37. a 38. a 39. a 40. d 41. c 42. b 43. d 44. c 45. c 46. b 47. b 48. d 49. a 50. b 51. c 52. c 53. c 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 12_4ce 55. d 56. d 57. c 58. d 59. c 60. b 61. b 62. b 63. c 64. b 65. a 66. a 67. b 68. d 69. c 70. a 71. d 72. d 73. a 74. d 75. c 76. a 77. a 78. d 79. c 80. a 81. c 82. c Copyright Cengage Learning. Powered by Cognero.

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Chap 12_4ce 83. b 84. a 85. b 86. c

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Chap 13_4ce Indicate whether the statement is true or false.

1. The MM dividend irrelevance theory necessarily negates the information content/signalling hypothesis on stock price changes from dividend announcements. a. True b. False 2. The clientele effect and information content in dividend announcements imply the desirability for stable dividends. a. True b. False 3. If the holder-of-record date for a dividend payment is Friday, March 27 and the ex-dividend date is Wednesday, March 25, an investor who wishes to receive the dividend must buy the stock on or before March 25. a. True b. False 4. 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 5. 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 6. If the information content, or signalling, 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 7. Companies that have no cash on hand will necessarily pay no dividends. a. True b. False 8. Given perfect capital mobility and a global economy, dividend yields in different stock markets are similar throughout the world. a. True b. False 9. 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

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Chap 13_4ce 10. 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 11. From a company’s perspective, varying repurchases is better than varying dividends, as the former will not send adverse signals to the market. a. True b. False 12. Share repurchases result in a decrease in a firm’s stock price. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

13. A company planning to pay a cash dividend in excess of the regular dividend does not want investors to believe that such an extra dividend will be repeated. What will the firm likely call this extra dividend? a. a stock dividend b. a cash-liquidating dividend c. a special dividend d. a residual dividend 14. Which statement regarding dividends is true? a. They are usually more stable than earnings. b. They fluctuate more widely than earnings. c. They tend to be a lower percentage of earnings for mature firms. d. They are usually changed every year to reflect earnings changes, and these changes are randomly higher or lower, depending on whether earnings increased or decreased.

15. Which of the following best describes a firm’s optimal distribution policy? a. The optimal distribution policy strikes a balance between cash dividends and capital gains that minimizes the firm’s stock price risk. b. The optimal distribution policy strikes a balance between cash dividends and stock dividends that maximizes the firm’s stock price. c. The optimal distribution policy strikes a balance between cash dividends and issuance of new debt that maximizes the firm’s stock price. d. The optimal distribution policy strikes a balance between cash dividends and capital gains that maximizes the firm’s stock price.

16. Which circumstance would be most likely to lead to a decrease in a firm’s dividend payout ratio? a. Its earnings become more stable. b. Its access to the capital markets increases. c. Its R&D efforts pay off, and it now has more high-return investment opportunities. d. Its accounts receivable decrease due to a change in its credit policy.

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Chap 13_4ce 17. Which statement about dividend policies is correct? a. Stock splits, stock dividends, and reverse splits are all designed to make the firm’s shares more appealing to the average investor. b. Dividend reinvestment plans are designed to aid in the distribution of stock dividends. c. The key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. d. The main goal of the share repurchases is solely to avoid taxes for investors.

18. Which of the following characteristics will likely be exhibited by companies that rigidly follow a residual dividend policy compared to companies that follow a stable dividend policy? a. higher required returns on equity b. higher stock prices c. fewer investment opportunities d. lower debt ratings 19. Which of the following statements best describes stock splits? a. 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. 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 2for-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 per share. 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.

20. Which of the following variables will be the same regardless of whether a company distributes its excess cash flows with dividends or repurchases? a. total return b. number of shares outstanding c. taxes payable by shareholders d. market value of assets 21. Which of the following statements is correct? a. One disadvantage of dividend reinvestment plans is that they increase transaction costs for investors who want to increase their ownership in the company. b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. c. Stock repurchases can be used by a firm that wants to increase its debt ratio. d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

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Chap 13_4ce 22. Which statement about dividend policies is correct? a. 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. 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. The 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.

23. Toombs Media Corp. recently completed a 3-for-1 stock split. 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 b. $52.50 c. $55.13 d. $57.88 24. Which action 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.

25. CAD Co. is considering a 5-for-2 stock split. The current stock price is $57 per share, and the firm believes that its total market value would increase by 3% 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. $22.18 b. $23.48 c. $35.44 d. $37.21 26. Which of the following statements is correct? a. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive. b. If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep shareholders happy, it should not follow the strict residual dividend policy. c. 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. 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.

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Chap 13_4ce 27. Brooks Corp.’s 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 will it pay out? a. $228,000 b. $216,600 c. $205,770 d. $0 28. The following data apply to Grullon-Ikenberry Inc.: Net income (NI) expected for the coming year Currently outstanding shares Current stock price

$625,000 100,000 $40

The company is in a mature industry. Therefore, it plans to distribute all of its income at year-end, and its earnings are not expected to grow. The CFO is now deciding whether to distribute income to shareholders as dividends or to use the funds to repurchase common shares. She believes the P/E ratio will not be affected by a repurchase. Moreover, she believes that the shares can be repurchased at the end of the year at the then-current price, which is expected to be the now-current price plus the dividend that would otherwise be paid at year-end.

Disregarding any possible tax effects, how much would a shareholder who owns 100 shares gain if the firm used its net income to repurchase shares rather than pay dividends? a. $564.06 b. $593.75 c. $625.00 d. $656.25 29. What are automatic dividend reinvestment plans designed to do? a. aid shareholders in creating their preferred dividend policy b. raise new equity capital for the firm through market repurchases c. eliminate excess illiquid shares from the open market d. help investors avoid paying taxes on dividends 30. Which of the following describes MM’s argument regarding a company’s stock price increase after an increase in dividends? a. it necessarily indicates that investors prefer dividends to retained earnings b. it indicates that equity is a preferred means of financing relative to debt c. it does not necessarily indicate that investors prefer dividends to capital gains d. it does not necessarily indicate that investors prefer cash dividends to stock dividends

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Chap 13_4ce 31. Empirical research showed financial companies tend to maintain low levels of retained earnings and technology companies tend to maintain high levels of retained earnings. According to the clientele effect, how will investors behave given this evidence? a. Investors in their peak earning years should buy shares of financial companies. b. Pension funds should buy shares of technology companies. c. Investors seeking high capital yields should buy shares of technology companies. d. Investors who have bought financial shares would always be invested in these shares.

32. All other things equal, a stock split will have which of the following effects on shareholders’ wealth? a. Shareholders’ wealth should be reduced. b. Shareholders’ wealth should remain constant. c. Shareholders’ wealth should be increased. d. Stock splits and shareholders’ wealth are not related.

33. Which of the following statements is correct? a. If a company has a 2-for-1 stock split, its stock price should roughly double. b. Capital gains earned in a share repurchase are taxed less favourably than dividends; this explains why companies typically pay dividends and avoid share repurchases. c. Very often, a company’s stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen. d. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.

34. Which of the following is clearly suggested by current empirical evidence on dividend announcements? a. When a company announces a dividend cut, its stock price tends to fall. b. When a company announces a dividend increase, its stock price tends to rise. c. When a company announces a dividend cut, its stock price tends to rise. d. When a company announces a dividend increase, its stock price tends to fall.

35. Which of the following is an argument against frequent switching between companies’ shares suggested by the clientele effect? a. Investors will avoid capital gains taxes by buying and selling shares frequently. b. Investors will likely incur high brokerage costs. c. Debt covenants may prevent companies from paying dividends. d. There are regulatory roadblocks to companies issuing more shares.

36. Which of the following statements is correct? a. If a firm repurchases some of its shares in the open market, then shareholders who sell their shares for more than they paid for them will be subject to capital gains taxes. b. An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional common shares through investment bankers. c. Stock repurchases tend to reduce financial leverage. d. If a company declares a 2-for-1 stock split, its stock price should roughly double.

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Chap 13_4ce 37. Given that investors do not like fluctuating dividends, what are the implications for firms with stable dividend policy and expected growth in sales and earnings? a. Dividends should remain the same year over year. b. Payout ratios should remain the same year over year. c. Regular cash dividends should grow at a steady rate. d. Stable cash dividends should be supplemented with share repurchases.

38. D&P Co. has a capital budget of $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. $200,000 b. $300,000 c. $400,000 d. $500,000 39. Golden Inc. has just announced a share repurchase with its excess cash on hand of $1,000,000. The company’s capital structure is 100% equity, with 500,000 shares outstanding before the repurchase. The company’s current share price is $20. How many shares will remain outstanding after the repurchase, assuming that its share price remains unchanged? a. 400,000 b. 425,000 c. 450,000 d. 466,667 40. A reverse stock split has which of following effects on the number of shares outstanding? a. increases the number of shares outstanding b. decreases the number of shares outstanding c. has no effect on the number of shares outstanding d. reduces the number of shares outstanding in proportion to the debt outstanding 41. 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 lower debt ratio than Firm N. b. Firm M probably has a higher dividend payout ratio than Firm N. c. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. d. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income.

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Chap 13_4ce 42. Ross Financial has suffered losses in recent years, 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. 24.50 b. 25.00 c. 50.00 d. 52.50 43. Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75 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 44. Aside from signalling and investor preferences, which of the following factors could influence a firm’s decision to retain more earnings? a. low flotation costs for new equity b. high shareholder propensity for proxy fights c. few legal restrictions on liquidating dividends d. restrictive bond indentures on liquidity ratios 45. DeAngelo Corp.’s projected net income is $150 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors has decreed that it cannot issue any new shares in the foreseeable future.

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 Debt to 75% W. $120.0 X. $126.4 Y. $133.0 Z. $140.0 a. Choice W b. Choice X c. Choice Y d. Choice Z

Lower Payout to 20% $77.2 $81.2 $85.5 $90.0

Do Both $351.5 $370.0 $389.5 $410.0

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Chap 13_4ce 46. Which of the following statements is correct? a. One 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 for this 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 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.

47. Sheehan Corp. is forecasting an EPS of $3 for the coming year on its 500,000 outstanding common shares. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2 dividend per share. It finances with debt and common equity, but it wants to avoid issuing any new common shares during the coming year.

Given these constraints, what percentage of the capital budget must be financed with debt? a. 32.15% b. 33.84% c. 35.63% d. 37.50% 48. Graham Inc.’s cash flows and profits have been quite volatile over the past 5 years. The company’s management believes in both the clientele effect and the signalling hypothesis. Which distribution policy is most suitable for Graham Inc.? a. residual dividend b. regular dividend plus extras c. stable dividend d. stock repurchases only 49. Fauver Worldwide forecasts a capital budget of $650,000, and it wants to maintain a target capital structure of 40% debt and 60% equity. It also wants to pay a dividend of $225,000. If the company follows a 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. $711,939

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Chap 13_4ce 50. Brammer Corp.’s projected capital budget 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. $128,606 b. $135,375 c. $142,500 d. $150,000 51. A reverse stock split reduces the number of shares outstanding, and thus has which of the following effects on the share price? a. reduces the number of shares outstanding, and thus reduces the share price b. reduces the number of shares outstanding, and thus increases the share price c. has no effect on the number of shares outstanding and thus no effect on the share price d. reduces the number of shares outstanding in proportion to the debt outstanding and thus increases the share price 52. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. On which assumption is their argument based? a. that investors require that the dividend yield and capital gains yield equal a constant b. that capital gains are taxed at a higher rate than dividends c. that investors view dividends as being less risky than potential future capital gains d. that investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains 53. Which of the following statements is NOT true? a. Stock repurchases can be used by a firm as part of a plan to change its capital structure. b. After a 3-for-1 stock split, a company’s price per share should fall, but the number of shares outstanding will rise. c. Investors can interpret a stock repurchase program as a signal that the firm’s managers believe the stock is undervalued. d. Shareholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan.

54. Ontario Co. is considering an 8-for-3 stock split. The current share price is $100 per share, and the firm believes that its total market value would increase by 6% 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. $39.75 b. $33.75 c. $37.50 d. $37.21

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Chap 13_4ce 55. Which of the following is NOT an advantage of stock repurchases? a. Shareholders can decide between current and future cash inflows. b. Distributions of excess cash flow using repurchases do not send adverse signals on a company’s future performance. c. A company can increase its stock price by repurchasing its shares at a premium. d. Companies can easily use repurchases to change their capital structures.

56. Which of the following statements is correct? a. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above-average payout ratios. b. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. c. An increase in the stock price when a company decreases its dividend is consistent with signalling theory as postulated by MM. d. Stock repurchases make the most sense at times when a company believes its stock is undervalued.

57. Dentaltech Inc. projects the following data for the coming year. If the firm follows a residual dividend policy and also maintains its target capital structure, what will be its payout ratio?

EBIT Interest rate Debt outstanding Common shares a. 37.2% b. 39.1% c. 41.2% d. 43.3%

$2,000,000 10% $5,000,000 $7,500,000

Capital budget % Debt % Equity Tax rate

$850,000 40% 60% 40%

58. Suppose a firm adheres strictly to the residual dividend policy and 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). What should the firm pay? a. no dividends except out of past retained earnings b. no dividends to common stockholders c. dividends only out of funds raised by the sale of new common shares d. dividends only out of funds raised by selling off fixed assets 59. You own 100 shares of Troll Brothers stock, which currently sells for $120 a share. The company is contemplating a 2-for-1 stock split. What will your position be after such a split takes place? a. You will have 200 shares of stock, and the stock will trade at or near $120 a share. b. You will have 200 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.

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Chap 13_4ce 60. All other things equal, what should stock dividends and stock splits do? a. have, at least conceptually, the same effect on shareholders’ wealth b. not have, at least conceptually, the same effect on shareholders’ wealth c. have no relationship to shareholders’ wealth d. have the same effect on debtholders as they do on equity holders 61. P&D Co. has a capital budget of $1,000,000. The company wants to maintain a target capital structure of 30% debt and 70% equity. The company forecasts that its net income this year will be $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 62. Trenton Publishing follows a strict residual dividend policy. All else being equal, which circumstance would be most likely to lead to an increase in the firm’s dividend per share? a. The firm’s net income increases. b. The company increases the percentage of equity in its target capital structure. c. The number of profitable potential projects increases. d. Earnings are unchanged, but the firm issues new common shares.

63. Big Corp. Canada has done extremely well in recent years, and its shares now sell for $140 per share.

Management wants to lower the price to a more typical level, which it thinks is $15 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. 2.40 b. 6.50 c. 10.70 d. 9.33 64. If a firm adheres strictly to the residual dividend policy, what would the issuance of new common shares suggest? a. The dividend payout ratio has remained constant. b. The dividend payout ratio is increasing. c. No dividends were paid during the year. d. The dividend payout ratio is decreasing.

65. What is the chronology of a dividend payment? a. declaration date, holder-of-record date, ex-dividend date, payment date b. declaration date, ex-dividend date, holder-of-record date, payment date c. declaration date, holder-of-record date, payment date, ex-dividend date d. holder-of-record date, declaration date, ex-dividend date, payment date

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Chap 13_4ce 66. Whited Products 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. $24.00 b. $30.00 c. $31.50 d. $33.50 67. Becker Financial recently completed a 7-for-2 stock split. Prior to the split, its stock sold for $90 per share. If the total market value was unchanged by the split, what was the price of the stock following the split? a. $23.21 b. $24.43 c. $25.71 d. $27.00 68. Blease Inc. 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 a residual dividend policy, what is its forecasted dividend payout ratio? a. 40.61% b. 42.75% c. 45.00% d. 47.37% 69. Pavlin Corp.’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 will it pay in dividends or, alternatively, how much new stock must it issue?

W. X. Y. Z. a. Choice W b. Choice X

Dividends $514,425 $541,500 $570,000 $0

Stock Issued $162,901 $171,475 $180,500 $200,000

c. Choice Y d. Choice Z

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Chap 13_4ce 70. Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is $550,000, and its board of directors has decreed that no new shares may be issued during the coming year. If the firm follows a 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 71. Which of the following statements is correct? a. 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. b. The clientele effect can explain why so many firms change their dividend policies so often. c. 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. d. 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.

72. Saskatchewan Corp. is considering a 5-for-1 stock split. The current stock price is $86 per share, and the firm believes that its total market value would increase by 2% 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. $17.20 b. $89.00 c. $35.44 d. $17.54 73. Which circumstance should NOT influence a firm’s dividend policy decision? a. the firm’s ability to accelerate or delay investment projects b. a strong preference by most shareholders for current cash income versus capital gains c. constraints imposed by the firm’s bond indenture d. the fact that much of the firm’s equipment has been leased, rather than bought and owned 74. Golden Inc. has just announced a share repurchase with its excess cash on hand of $1,000,000. The company’s capital structure is 100% equity, with 500,000 shares outstanding before the repurchase. The company’s current share price is $20. What is the market value of Golden’s equity after the repurchase, assuming that its share price remains unchanged? a. $5,000,000 b. $6,666,667 c. $8,000,000 d. $9,000,000

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Chap 13_4ce 75. Big Bank Canada has done extremely well in recent years, and its stock now sells for $100 per share.

Management wants to lower the price to a more typical level, which it thinks is $50 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. 2 b. 6 c. 7 d. 8 76. In real life, what is the main reason that would induce financial managers to make capital budgeting and capital structure decisions jointly? a. maximization of shareholder wealth b. the presence of asymmetric information c. restrictions in debt covenants d. competition in equity markets 77. D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and the company wants to pay dividends of $500,000. If the company follows a residual dividend policy, how much income must it earn, and what will be its dividend payout ratio?

Net Income W. $898,750 X. $943,688 Y. $990,872 Z. $1,040,415 a. Choice W b. Choice X c. Choice Y d. Choice Z

Payout 55.63% 58.41% 61.34% 64.40%

78. Keys Financial has done extremely well in recent years, and its stock now sells for $175 per share. Management 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. 5 b. 6 c. 7 d. 8

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Chap 13_4ce 79. Pate & Co. 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 80. Which of the following statements is correct? a. Current Canadian tax law encourages companies to pay dividends rather than retain earnings. b. If a company uses the residual dividend model to determine its dividend payments, dividend payouts will tend to increase whenever the company’s profitable investment opportunities increase. c. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model. d. Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm’s financial risk.

81. Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the company follows a residual dividend policy, how much in dividends will it pay? a. $42,869 b. $45,125 c. $47,500 d. $50,000 82. All other things equal, a stock dividend will have which of the following effects on shareholders’ wealth? a. Shareholders’ wealth should remain constant. b. Shareholders’ wealth should be reduced. c. Shareholders’ wealth should be increased. d. Stock dividends and shareholders’ wealth are not related.

83. Ting Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and 65% equity, and it also 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

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Chap 13_4ce 84. Which of the following theories is supported by the argument that shareholders can transform a company dividend policy into a different policy by means of investors buying and selling on their own account? a. “bird-in-the-hand” theory b. dividend irrelevance theory c. residual distribution model d. tax preference theory

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Chap 13_4ce Answer Key 1. False 2. True 3. False 4. False 5. True 6. True 7. False 8. False 9. True 10. False 11. True 12. False 13. c 14. a 15. d 16. c 17. a 18. a 19. d 20. a 21. c 22. d 23. a 24. d 25. b 26. b

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Chap 13_4ce 27. d 28. c 29. a 30. c 31. c 32. b 33. c 34. a 35. b 36. a 37. c 38. d 39. c 40. b 41. b 42. c 43. b 44. d 45. d 46. c 47. d 48. b 49. b 50. d 51. b 52. c 53. d 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 13_4ce 55. c 56. d 57. d 58. b 59. b 60. a 61. a 62. a 63. d 64. c 65. b 66. c 67. c 68. d 69. d 70. d 71. a 72. d 73. d 74. d 75. a 76. b 77. a 78. c 79. c 80. d 81. d 82. a Copyright Cengage Learning. Powered by Cognero.

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Chap 13_4ce 83. b 84. b

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Chap 14_4ce Indicate whether the statement is true or false.

1. Going private involves a simple rearrangement of the left side of a company’s balance sheet. a. True b. False 2. For providing funds to start-up firms, venture capital investors would like to be equity holders getting shares rather than just being lenders. a. True b. False 3. The first round of financing for most start-up companies is through angel investors. a. True b. False 4. One big advantage of going private through a leveraged buyout is the tax shields from the borrowing. a. True b. False 5. Government of Canada bonds are traded electronically or by telephone. a. True b. False 6. In a dealer market, all bid quotes are matched with ask quotes by a computer system. a. True b. False 7. When a firm refunds a debt issue, the firm’s shareholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a noncallable bond will typically command a higher price than an otherwise similar callable bond. a. True b. False 8. The only role of an investment bank is to help the issuer determine the preliminary offering share price and the number of shares to be sold. a. True b. False 9. Special purpose acquisition companies are set up to collect funds from investors to acquire publicly traded companies and then take them private. a. True b. False

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Chap 14_4ce 10. If its managers make a tender offer buying up all shares not held by the management team, this is called a private placement. a. True b. False 11. In order to secure investor interest, underwriters like to provide more information during the roadshow presentations than what has been given in the prospectus. a. True b. False 12. ICE Futures Canada, originated from the Winnipeg Stock Exchange, is Canada’s leading exchange trading derivative products. a. True b. False 13. If a 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 b. False 14. Angel investors usually inject cash into a start-up company without being concerned with its strategic or operational direction. a. True b. False 15. The big payoff for the entrepreneur and venture capitalist is when the firm is closely held by its founders. a. True b. False 16. The cost of filing reports with various regulatory bodies, 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 17. Alpha and Pure Trading System are the two electronic communications networks used by dealers in the trading floor of the TSX exchange. a. True b. False 18. 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 shareholders, it “carves out” some of their value. a. True b. False

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Chap 14_4ce 19. The phrase “leaving money on the table” refers to the situation where an investment bank 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 their firm would normally earn on the job. a. True b. False 20. Going public establishes a market value for the firm’s shares, 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 21. IPOs with underwriting syndicates gain publicity because institutional investors are involved with marketing functions. a. True b. False 22. Best efforts deals are commonly used by well-known, established issuers. a. True b. False 23. The Investment Industry Regulatory Organization of Canada, combining the Investment Dealers Association and Market Regulation Services Inc., is a federal government supervisory agency for the securities industry. a. True b. False 24. Once approved with a shelf prospectus, firms have the right to sell new shares any time up to a 25-month period by providing investors with a prospectus supplement. a. True b. False 25. Investment banks sometimes act as an agent for the issuer on a best efforts basis, whereby they are paid with a fixed commission. a. True b. False 26. With no recourse, firms prefer to use project financing for risky but small capital investments. a. True b. False 27. Since providing updated information about company activities and status is costly, it has absolutely no advantage for firms. a. True b. False

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Chap 14_4ce 28. Going public means a company is required to disclose information to the public for investigation. a. True b. False 29. 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 Indicate the answer choice that best completes the statement or answers the question.

30. With an underwritten stock issue, an investment bank agrees to sell 1 million shares to the public at $25 per share with a spread of $3. How much does the issuing company receive if only 900,000 shares are sold? Assume no other costs of issuing shares. a. $22.0 million b. $20.0 million c. $19.8 million d. $18.0 million 31. Which statement about leveraged buyouts is true? a. LBOs will not benefit public shareholders. b. Incumbent management may be penalized by LBOs. c. LBOs do not affect the asset values of the company. d. LBOs affect the option trading in related subsidiaries.

32. ABC Waste (ABCW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. 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 8.4% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. ABCW’s marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will be the net increase in the annual flotation cost tax savings if refunding takes place? a. $6,480 b. $7,200 c. $8,000 d. $8,800

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Chap 14_4ce 33. Which statement regarding debt refunding is true? a. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt. b. The key benefits associated with refunding debt are the reduction in the firm’s debt ratio and the creation of more reserve borrowing capacity. c. 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. d. 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.

34. Bonhomme Corporation is considering refunding a $60,000,000, annual payment, 15% coupon, 25-year bond issue that was issued 5 years ago. It has been amortizing $5 million of flotation costs on these bonds over their 25-year life. The company could sell a new issue of 20-year bonds at an annual interest rate of 12.5% in today’s market.

A call premium of 7.5% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Bonhomme’s marginal tax rate is 35%. The new bonds would be issued when the old bonds are called. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will be the net increase or decrease in the annual flotation cost tax savings if refunding takes place? a. $8,000 b. $8,750 c. $17,500 d. $35,000 35. An investment bank recently sold 2 million shares during the IPO for Text Prediction Ltd. Each share was offered at $60, with a spread of $5 per share. Text Prediction received net proceeds of $137.5 million from this stock issue. How many shares were issued in this IPO, given that it was an underwritten issue? Assume no other costs of issuing shares. a. 3,500,000 b. 3,000,000 c. 2,500,000 d. 2,000,000 36. Which term refers to the money offered to fund a start-up company? a. private placement b. bought deal c. project financing d. venture capital fund 37. What is the average spread of new security issues in Canada? a. 5.0% b. 5.5% c. 6.0% d. 7.0%

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Chap 14_4ce 38. ABC Waste (ABCW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. 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 8.4% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. ABCW’s marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. What will be the after-tax annual interest savings for ABCW if the refunding takes place? a. $664,050 b. $699,000 c. $768,900 d. $845,790 39. Rainier Bros. has 12% semiannual, $1,000 face value coupon bonds outstanding that mature in 10 years. 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. Ignoring taxes, 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? (Hint: What is the nominal annual “break-even rate”?) a. 9.29% b. 9.78% c. 10.29% d. 10.81% 40. An entrepreneur first started a business with $100,000. Later, a venture capitalist (VC) agrees to invest $300,000 to sustain the growth. In return, this VC will take up a 50% equity position in the firm. How much is this business worth now? a. $400,000 b. $600,000 c. $700,000 d. $800,000 41. Which of the following is included in the direct costs of an IPO? a. senior managers’ time spent working on the IPO b. underwriter’s spread c. undersubscription option d. overpricing 42. Bestie Inc. is planning to issue 1 million new shares. It has an agreement with ABC Investment Bank to sell the shares at $25 per share on a best efforts basis with a spread of $3. How much will Bestie receive if only 900,000 shares are sold? Assume no other costs of issuing shares. a. $22.0 million b. $20.0 million c. $19.8 million d. $18.0 million

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Chap 14_4ce 43. What is one of the advantages of going private? a. reduced managerial flexibility b. lower shareholder participation c. higher cost in security registration d. increased managerial efficiency 44. In a Canadian IPO issue, the issuing company has incurred $2 million for the flotation costs and legal fees. The issue involves 7.5 million shares. As an underwritten issue, the investment bank agrees to buy the shares at $2.50 each and resells to the public at $4.50 per share. What will be the direct costs as a percentage of total costs in this deal? a. 11.50% b. 10.01% c. 11.76% d. 13.33% 45. Who is responsible for distributing the shares in a large IPO? a. the lead underwriter b. the syndicate c. the stock exchange on which the company is listed d. the selling group 46. Which statement regarding the Canadian securities industry is true? a. The industry is very concentrated. b. The industry is unregulated. c. The industry is not governed nationally. d. The industry is supervised by the Canadian Security Association.

47. What is a general disadvantage of going public? a. It facilitates shareholder diversification. b. It increases the liquidity of the firm’s shares. c. It establishes a market value for the firm. d. It makes it easier for owner-managers to engage in profitable self-dealings.

48. Which of the following stock indexes measures Canadian stock market performance? a. Dow Jones Industrial Average (DJIA) b. S&P 500 Index c. S&P/TSX 60 Index d. NYSE Composite Index

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Chap 14_4ce 49. Which of the following best describes what occurs in the secondary market for stocks? a. securities are sold after they have been issued b. securities are sold only by the first buyers c. options on stocks are bought and sold by IPO investors d. options on stocks are bought and sold by secondary investors 50. What is likely to happen when a shelf prospectus system is adopted for corporations issuing securities? a. The time for raising capital will increase. b. The issuer’s financial flexibility will increase. c. The profit of the issuers will decrease. d. The underwriting expenses will increase.

51. Which of the following statements best describes private placements? a. In a private placement, securities are sold to private (individual) investors rather than to institutions. b. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement. c. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs. d. Private placements can generally bring in funds faster than is the case with public offerings.

52. Tuttle Buildings Inc. has decided to go public by selling $5,000,000 of new common shares. The firm’s investment bankers (underwriters) agreed to take a smaller fee now (6% of gross proceeds, versus their normal 10%) in exchange for a 1-year option to purchase an additional 200,000 shares at $5 per share. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly 1 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 1 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. $1,300,973 b. $1,369,446 c. $1,441,522 d. $1,517,391 53. Access Inc. is holding an initial public offering for its common shares to finance a $200 million project. Each share will be offered at $75. The company has reached a best efforts agreement with ABC Investment Bank, with a spread of 5.5%. ABC estimates that the IPO will be 90% subscribed (i.e., 90% of the issued shares will be sold). What is the minimum number of shares that must be issued in this IPO in order for Access to finance the project? Assume no other costs of issuing shares. a. 3,293,582 b. 3,135,411 c. 2,523,372 d. 2,434,529

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Chap 14_4ce 54. ABC Waste (ABCW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. 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 8.4% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. ABCW’s marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding? a. $5,315,725 b. $5,595,500 c. $5,890,000 d. $6,200,000 55. What type of transaction is involved when a company sells new shares to a consortium of private investors? a. private equity carve-out b. private investment in public equity c. private merger d. private project financing 56. Which factor would increase the likelihood that a company would call its outstanding bonds at a point in time? a. The yield to maturity on the company’s outstanding bonds increases due to a weakening of the firm’s financial situation. b. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates. c. The flotation costs associated with issuing new bonds rise. d. The firm’s CFO believes that interest rates are likely to decline in the future.

57. An equity carve-out can be described as not only a spin-out but also a special type of which of the following? a. stock traded in the secondary market b. IPO that trades in the secondary market c. bond traded in the secondary market d. IPO 58. What can underwriters likely do for new IPO issues with uncertain market demand from investors? a. undertake the issue on a best efforts basis b. reduce the spread c. cut short the roadshows d. apply a shelf prospectus for the issue

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Chap 14_4ce 59. In a Canadian IPO issue, the issuing company has incurred $8 million for the flotation costs and legal fees. The issue involves 45 million shares. As an underwritten issue, the investment bank agrees to buy the shares at $19 each and resells to the public at $20.50 per share. What will be the direct costs as a percentage of total costs in this deal? a. 11.50% b. 10.60% c. 9.10% d. 8.40% 60. Which type of firm is qualified to issue new stock under the short-form prospectus distribution? a. well-established large corporations b. new start-up small companies c. government subsidiaries d. Canadian-controlled private companies 61. An underwriter follows a best efforts basis to sell 2 million shares at $10 each. Such a public offering price has included a $1 spread. How much will the issuer receive if only 1.5 million shares are sold in this issue? Assume no other costs in this share issue. a. $20.0 million b. $18.0 million c. $15.0 million d. $13.5 million 62. Why does underpricing always occur for an IPO? a. to guarantee sales by underwriters b. to discourage oversubscription from investors c. to reward customers by issuers d. to protect investors from deceptive firms 63. Canadian Corporation incurred $4 million for the flotation costs and legal fees of its IPO. The issue involved 17 million shares. As an underwritten issue, the investment bank agreed to buy the shares at $50 each and resell them to the public at $54 per share. What will be the direct costs as a percentage of total costs in this deal? a. 5.60% b. 15.01% c. 21.76% d. 13.33% 64. A bought deal occurs when which of the following takes place? a. an underwriter sells an issue to a firm and buys the securities from investors b. an underwriter buys an issue from a firm and sells the securities to investors c. an issuer sells an issue to investors that do not have a prospectus d. an underwriter executes a best-efforts deal

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Chap 14_4ce 65. How will “going public” benefit a company? a. There is no possibility for management to indulge in perquisites in a publicly traded company. b. “Going public” establishes a firm’s true intrinsic value and increases market visibility for the firm. c. When a company’s stock is publicly traded, the company’s prospectus is guaranteed by the stock exchange on which its stock is listed. d. A firm whose stocks are publicly traded can raise additional new capital without submitting a prospectus.

66. Which statement concerning common stock and the investment banking process is true? a. The preemptive right gives each bondholder the right to convert their bonds into shares. b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs on the Toronto Stock Exchange. c. Listing a small firm’s stock is often considered to be beneficial to shareholders because the resulting increases in liquidity and reputation probably outweigh the additional costs to the firm. d. If shareholders are dissatisfied with management’s performance, an outside group may ask the shareholders to vote for it in an effort to take control of the business. This action is called a tender offer.

67. In an IPO issue, the issuing company has incurred $15 million for the flotation costs and legal fees. The issue involves 50 million shares. As an underwritten issue, the investment bank agrees to buy the shares at $20 each and resells to the public at $23 per share. What will be the total costs (direct and indirect costs) in this deal? a. $16.5 million b. $100 million c. $150 million d. $165 million 68. Which of the following is a major stock exchange in Canada? a. Toronto Stock Exchange b. Winnipeg Stock Exchange c. Vancouver Stock Exchange d. Halifax Stock Exchange 69. Which statement concerning bought deals is true? a. They reduce risk to underwriters. b. They are also known as follow-on offerings. c. They involve increased risk to the underwriter. d. They are issued to new shareholders using treasury stock.

70. Which of the following projects is more likely to be funded with project financing by investors? a. smaller-scale but complex projects b. large-scale and complex projects c. smaller-scale and independent projects d. large-scale and routine projects

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Chap 14_4ce 71. Bonhomme Corporation is considering refunding a $60,000,000, annual payment, 15% coupon, 25-year bond issue that was issued 5 years ago. It has been amortizing $5 million of flotation costs on these bonds over their 25-year life. The company could sell a new issue of 20-year bonds at an annual interest rate of 12.5% in today’s market.

A call premium of 7.5% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Bonhomme’s marginal tax rate is 35%. The new bonds would be issued when the old bonds are called. What will be the after-tax annual interest savings for the company if the refunding takes place? a. $699,000 b. $753,000 c. $836,000 d. $975,000 72. ABC Waste (ABCW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. 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 8.4% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. ABCW’s marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. What is the NPV if ABCW refunds its bonds today? a. $1,746,987 b. $1,838,933 c. $1,935,719 d. $2,037,599 73. Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12%, and 15 years left to maturity. 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 and 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 break-even 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% 74. Immense Popularity Corp. recently completed an IPO that raised $1 billion. The company has no operating business and the money raised was placed in a trust for the purchase of Gigantic Inc. in 6 months’ time. What kind of investment vehicle is Immense Popularity Corp.? a. reverse takeover b. private placement c. special purpose acquisition company d. equity carve-out

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Chap 14_4ce 75. Which statement about equity carve-outs is true? a. They are overpriced issues. b. They are sold by private placements. c. No prospectus is required. d. They are a special type of IPO. 76. Which of the following is an example of a seasoned equity offering? a. Shares are sold by founding members from their holdings in the primary market. b. Unsubscribed new shares from the previous IPO are sold in the secondary market. c. New shares are sold to the general public by companies in the primary market. d. Used shares are sold to existing shareholders in the secondary market.

77. ABC Inc. has no significant operating assets but is listed on the Toronto Venture Exchange. XYZ Corporation is a privately held technology company with operating assets of $2 billion. To take advantage of a “hot market” in technology stocks, XYZ recently merged with ABC, and after the merger, XYZ shareholders gained control of most of the shares in ABC. What kind of financial transaction did XYZ engage in? a. reverse takeover b. private placement c. special purpose acquisition company d. equity carve-out d

.

78. Bonhomme Corporation is considering refunding a $60,000,000, annual payment, 15% coupon, 25-year bond issue that was issued 5 years ago. It has been amortizing $5 million of flotation costs on these bonds over their 25-year life. The company could sell a new issue of 20-year bonds at an annual interest rate of 12.5% in today’s market.

A call premium of 7.5% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Bonhomme’s marginal tax rate is 35%. The new bonds would be issued when the old bonds are called. What is the NPV if Bonhomme refunds its bonds today? a. –$1,038,192 b. $1,554,531 c. $1,935,719 d. $2,037,599 79. Consider the following information about an IPO underwriting transaction. The net proceeds to the issuing firm are $141.75 million. The public offering price is $50 per share. The spread is $2.75 per share. Two million shares are sold. How many shares are issued in this IPO? Assume no other costs in this IPO. a. 3,500,000 b. 3,000,000 c. 2,500,000 d. 2,000,000

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Chap 14_4ce 80. Bonhomme Corporation is considering refunding a $60,000,000, annual payment, 15% coupon, 25-year bond issue that was issued 5 years ago. It has been amortizing $5 million of flotation costs on these bonds over their 25-year life. The company could sell a new issue of 20-year bonds at an annual interest rate of 12.5% in today’s market.

A call premium of 7.5% would be required to retire the old bonds, and flotation costs on the new issue would amount to $5 million. Bonhomme’s marginal tax rate is 35%. The new bonds would be issued when the old bonds are called. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding? a. $5,000,000 b. $6,200,000 c. $8,100,000 d. $8,900,000 81. Which of the following statements best describes listing on a stock exchange? a. Listing is a decision of more significance to a firm than going public. 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 securities commission. d. The OTC is the second largest market for listed stock, and it is exceeded only by the TSX. 82. Which of the following are major sources of equity capital for start-up companies? a. personal assets b. “love money” c. government loans d. both a and b 83. Which of the following entities belongs to the TMX Group? a. New York Stock Exchange b. ICE Futures Canada c. Dow Jones Exchange d. TSX Venture Exchange 84. With an underwritten stock issue, an investment bank agrees to sell 2 million shares to the public at $10 per share with a spread of $1. How much does the issuing company receive if only 1.5 million shares are sold? Assume no other costs in this share issue. a. $20.0 million b. $18.0 million c. $15.0 million d. $13.5 million

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Chap 14_4ce 85. In a Canadian IPO issue, the issuing company has incurred $12 million for the flotation costs and legal fees. The issue involves 75 million shares. As an underwritten issue, the investment bank agrees to buy the shares at $25 each and resells to the public at $27.50 per share. What will be the direct costs as a percentage of total costs in this deal? a. 11.50% b. 10.01% c. 6.02% d. 13.33% 86. In an IPO issue, the issuing company has incurred $10 million for the flotation costs and legal fees. The issue involves 50 million shares. As an underwritten issue, the investment bank agrees to buy the shares at $18 each and resells to the public at $20 per share. What will be the direct costs as a percentage of total costs in this deal? a. 11.50% b. 10.00% c. 9.09% d. 8.40%

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Chap 14_4ce Answer Key 1. False 2. True 3. True 4. True 5. True 6. False 7. True 8. False 9. False 10. False 11. False 12. False 13. False 14. False 15. False 16. True 17. False 18. False 19. False 20. False 21. False 22. False 23. False 24. True 25. True 26. False

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Chap 14_4ce 27. False 28. False 29. False 30. a 31. c 32. c 33. c 34. c 35. c 36. d 37. b 38. b 39. c 40. b 41. b 42. c 43. d 44. c 45. d 46. c 47. d 48. c 49. a 50. b 51. d 52. d 53. b 54. d Copyright Cengage Learning. Powered by Cognero.

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Chap 14_4ce 55. b 56. b 57. d 58. a 59. b 60. a 61. d 62. a 63. a 64. b 65. b 66. c 67. d 68. a 69. c 70. b 71. d 72. d 73. d 74. c 75. d 76. c 77. a 78. b 79. b 80. c 81. b 82. d Copyright Cengage Learning. Powered by Cognero.

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Chap 14_4ce 83. d 84. b 85. c 86. c

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Chap 15_4ce Indicate whether the statement is true or false.

1. Off–balance sheet financing with leases resulted in overreporting of financial leverage and underreporting of firm risk. a. True b. False 2. Under International Financial Reporting Standards IFRS 16, all leases must be capitalized (i.e., reported as liabilities on the balance sheet) without exception. a. True b. False 3. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget. a. True b. False 4. Prior to the IASB rule change in 2019, leasing was often referred to as off–balance sheet financing because lease payments were shown as operating expenses on a firm’s income statement and, under certain conditions, leased assets and associated liabilities did not appear on the firm’s balance sheet. a. True b. False 5. “Per-procedure leases” are used in U.S. hospitals to convert the fixed cost of medical equipment purchase to a variable cost of lease cost charged each time the equipment is used. This type of lease reduces operating leverage for the hospital. a. True b. False 6. A fully taxable recapture exists if the lease provides the lessee with an option to purchase the asset at a bargain price. a. True b. False 7. 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 8. By entering into a lease, the lessee incurs an opportunity cost equal to the forgone CCA tax shield provided by the CCA of the asset. a. True b. False

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Chap 15_4ce 9. Most airlines prefer to borrow and buy their aircraft to reduce their operating risk. a. True b. False 10. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under CRA guidelines. a. True b. False 11. The after-tax cost of debt is used as the discount rate for leasing analysis, and to be consistent with the capital budgeting purposes. a. True b. False 12. Because of down payments, it is cheaper for lessees to lease an asset than to borrow money and purchase the asset. a. True b. False 13. 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 14. In Canada, if a lessee has the option to purchase the asset and if the asset can be sold for a price greater than the purchase option, then the CCA recapture will be taxable. a. True b. False 15. 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 16. A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease. a. True b. False 17. 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

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Chap 15_4ce Indicate the answer choice that best completes the statement or answers the question.

18. ABC Leasing has an after-tax cost of borrowing of 10%. The company is in the 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable. What is the required annual lease payment that the lessor must charge? a. $17,391 b. $21,915 c. $26,535 d. $29,318 19. Ms. Daisy is deciding between buying a car or leasing it. The capitalized cost of the car is $30,000. The car dealer is offering lease terms of 36 months with a quoted APR of 3.5%. The estimated residual value of the car in 36 months is $10,000. What is the monthly finance payment on this car lease? a. $58 b. $60 c. $63 d. $68 20. Consider the following information: original investment = $5,000, PV of CCA tax shield = $3,500, PV of after-tax lease payments = $1,900. What is the NAL? a. $550 b. $650 c. –$400 d. $350 21. ABC Inc. is a technology company operating in a business environment wherein consumer requirements change approximately every 12 months. Which of the following would constitute the main reason for ABC to lease its manufacturing equipment? a. financing flexibility b. tax savings on CCA tax shields c. lower maintenance costs d. option to abandon 22. Which of the following statements correctly describes the value of the lease liability for lessees after each lease payment is made? a. previous lease liability value – lease payment b. previous lease liability value + imputed interest cost on lease – lease payment c. right-of-use asset value – depreciation – lease payment d. previous lease liability value + depreciation – lease payment

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Chap 15_4ce 23. Consider the following information: original investment = $2,500, PV of CCA tax shield = $850, PV of after-tax lease payments = $1,700. What is the NAL? a. $2,550 b. $1,650 c. –$800 d. –$50 24. Which of the following best describes a cancellation clause in a lease? a. The lessee can cancel the lease and return the asset before the lease contract expires. b. The lessor can cancel the lease and repossess the asset before the lease contract expires. c. The lessee can cancel the lease and buy the asset before the lease contract expires. d. The lessee can cancel the lease and buy the asset after the lease contract expires.

25. Buster’s Beverages is negotiating a lease on a new piece of equipment that would cost $100,000 if purchased.

The equipment belongs to the asset class with a CCA rate of 30%, 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. The firm is in the 20% tax bracket, and it could obtain a 3-year loan 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? (Hint: Use the PV(CCATS) formula and the shortcut method of calculating NAL.) a. $5,736 b. $6,023 c. $6,324 d. $6,849 26. Ms. Daisy is deciding between buying a car or leasing it. The capitalized cost of the car is $30,000. The car dealer is offering lease terms of 36 months with a quoted APR of 3.5%. The estimated residual value of the car in 36 months is $10,000. What is the monthly lease payment on this car lease? a. $556 b. $614 c. $727 d. $849 27. Which type of organization are Xerox and IBM good examples of? a. firms specializing in lease financing b. firms using only leases for asset financing c. manufacturers of items that are financed exclusively by firms specializing in lease financing d. manufacturers providing lease financing as part of their regular sales effort

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Chap 15_4ce 28. In theory, we may regard the lease alternative as a commitment to finance the asset with what level of debt? a. 0% b. 25% c. 50% d. 100% 29. In the lease-versus-buy decision, why is leasing often preferable? a. because it has no effect on the firm’s ability to borrow to make other investments b. because, generally, no down payment is required, and there are no indirect interest costs c. because lease obligations do not affect the firm’s risk as seen by investors 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 30. Under which circumstances should an asset be leased? a. when the NPV is positive and the NAL is also positive b. when the NPV is positive but the NAL is negative c. when the NPV is negative and the NAL is also negative d. when the NPV is negative and the NAL is positive, but smaller than the NPV 31. Under which circumstances will a lessor likely charge higher lease rates? a. if the lessor’s tax rate increases b. if the cost of borrowing increases c. if the residual value of the asset increases d. if the purchase price of the asset decreases 32. Which of the following is an effect of off–balance sheet financing? a. overreported financial leverage b. underreported expenses c. underreported business and financial risk d. unreported CCA recapture 33. Under which of the following conditions can a lessee not report the asset on its balance sheet and still be in compliance with IFRS 16? a. The lease term is under 18 months. b. The lease is on commercial vehicles. c. The lessee has a purchase option on the asset at the end of the lease contract. d. The lease term is under 12 months.

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Chap 15_4ce 34. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. 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 three 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 40%. 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? (Hint: Delete three zeros from dollars and work in thousands.) a. $96 b. $106 c. $112 d. $117 35. What will heavy use of off–balance sheet lease financing tend to do? a. make a company appear more risky than it actually is because its stated debt ratio will be increased b. make a company appear less risky than it actually is because its stated debt ratio will appear lower c. affect a company’s cash flows but not its degree of risk d. affect the lessee’s cash flows but only due to tax effects 36. Consider the following information: original investment = $3,500, PV of CCA tax shield = $1,850, PV of after-tax lease payments = $2,000. What is the NAL? a. $2,550 b. $1,650 c. –$800 d. –$350 37. Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and belongs to the asset class with a CCA rate of 30%. If the firm borrows money to buy the truck, the beforetax loan rate would be 10%. 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 call for a $10,000 lease payment (4 payments total) at the beginning of each year. The lessor will be responsible for maintenance. DTC’s tax rate is 40%.

Should the firm lease or buy? (Hint: Use the PV(CCATS) formula and the shortcut method of calculating NAL.) a. $997 b. $1,094 c. $1,568 d. $1,804

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Chap 15_4ce 38. How is a capitalized lease reported on the financial statements under International Financial Reporting Standards IFRS 16? a. It shows up as a liability on the lessor’s financial statements. b. It is a debt on the right-hand side of the lessee’s balance sheet, and an asset on the left. c. The lease’s present value shows as a liability on the lessee’s balance sheet, but not as an asset. d. The lease becomes a capital asset for the lessor, allowing the firm to capitalize on its value to borrow more.

39. Consider the following information: original investment = $1,900, PV of CCA tax shield = $1,000, PV of after-tax lease payments = $900. What is the NAL? a. $2,550 b. $1,650 c. $0.00 d. –$350 40. Consider the following information: original investment = $20,000, PV of CCA tax shield = $10,000, PV of aftertax lease payments = $15,900. What is the NAL? a. $2,550 b. $1,650 c. $0.00 d. –$5,900 41. Sutton Corporation, which has a zero tax rate due to tax loss carryforwards, is considering a 5-year, $6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with five end-of-year payments. Sutton can also lease the equipment for five end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? a. The bank loan payment is $216,576 lower. b. The bank loan payment is $207,215 higher. c. The bank loan payment is $207,215 lower. d. The bank loan payment is $217,576 higher.

42. ABC Leasing has an after-tax cost of borrowing of 10%. The company is in the 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable. What is the net cost of this machine for the lessor as a legal owner receiving all tax benefits? a. $19,057 b. $29,318 c. $73,464 d. $100,000

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Chap 15_4ce 43. When will a lower lease payment possibly arise? a. when there is a lower tax rate for the lessee b. when there is a lower tax rate for the lessor c. when there is a lower purchase cost for the asset d. when there is a lower CCA tax shield 44. Ms. Daisy is deciding between buying a car or leasing it. The capitalized cost of the car is $30,000. The car dealer is offering lease terms of 36 months with a quoted APR of 3.5%. The estimated residual value of the car in 36 months is $10,000. What is the money factor on this car lease? a. 0.00125 b. 0.00133 c. 0.00146 d. 0.00157 45. A sale-and-leaseback arrangement is a type of which of the following? a. operating lease b. buyback loan c. financial, or capital, lease d. asset-based loan 46. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as which of the following? a. the lessee’s equity cash flows b. the lessee’s capital budgeting project cash flows c. the lessee’s debt cash flows d. the lessee’s pension fund cash flows 47. When a finance lease is capitalized in the financial statements, which of the following items is shown on the income statement? a. depreciation b. lease payment c. maintenance expenses d. CCA tax savings 48. Ms. Daisy is deciding between buying a car or leasing it. The capitalized cost of the car is $30,000. The car dealer is offering lease terms of 36 months with a quoted APR of 3.5%. The estimated residual value of the car in 36 months is $10,000. What is the monthly base payment on this car lease? a. $278 b. $333 c. $457 d. $556

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Chap 15_4ce 49. In a lease-versus-buy analysis, in order to compare the cost of leasing to the cost of owning we assume that the asset purchased is financed with which of the following? a. short-term debt b. long-term debt c. debt whose maturity matches the term of the lease d. retained earnings 50. International Financial Reporting Standards IFRS 16 requires that financial (or capital) leases must be included in the balance sheet. How should they be reported? a. residual value as a fixed asset b. sum of all lease payments as a liability c. right-of-use asset on the asset side and lease liability on the liability side d. undiscounted sum of future lease payments as an asset and as an offsetting liability

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Chap 15_4ce Answer Key 1. False 2. False 3. False 4. True 5. True 6. True 7. False 8. True 9. False 10. True 11. False 12. False 13. False 14. True 15. False 16. False 17. True 18. d 19. a 20. c 21. d 22. b 23. d 24. a 25. d 26. b

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Chap 15_4ce 27. d 28. d 29. d 30. a 31. b 32. c 33. d 34. b 35. b 36. d 37. d 38. b 39. c 40. d 41. c 42. c 43. c 44. c 45. c 46. c 47. a 48. d 49. c 50. c

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Chap 16_4ce Indicate whether the statement is true or false.

1. Convertible debt can be thought of as straight debt with detachable warrants. a. True b. False 2. Since warrants and convertibles give holders the right to exchange for the underlying stock, they should represent the same sources of financing. a. True b. False 3. Liquid assets such as bankers’ acceptances (BA) can never be used for securitization. a. True b. False 4. The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False 5. Diluted earnings per share are calculated based on market information. a. True b. False 6. Asset-backed commercial paper does not appeal to investors because little is known about the assets backing the securities. a. True b. False 7. Convertible bonds usually have higher credit ratings than basic nonconvertible bonds. a. True b. False 8. Credit default swaps help protection sellers transfer all interest rate risk to the protection buyers. a. True b. False 9. 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 10. The conversion price of a convertible security is fixed and independent of stock market conditions. a. True b. False

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Chap 16_4ce 11. Special purpose vehicles (SPVs) in asset securitization usually contain credit enhancements for their securities. a. True b. False 12. One warrant entitles the holder to purchase only one common share. a. True b. False 13. The “misused” asset securitizations, credit derivatives, and CDOs took the blame for creating the credit crisis of 2007. a. True b. False 14. The Bank of Canada is the primary guarantor of securitized assets in Canada. a. True b. False 15. Warrant holders are not entitled to vote, but they do receive any cash dividends paid on the underlying stock. a. True b. False 16. A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False 17. Warrants, convertible securities, and call and put options are similar in the sense that they have a value contingent upon the future value of the firm’s shares. a. True b. False 18. One of the main causes of the 2007 credit crisis was that errors were made in correlation assumptions in the pricing models for CDOs. a. True b. False 19. The ultimate credit risk of asset-backed securities lies with the special purpose vehicle that is the central payor. a. True b. False 20. A warrant is an option, and as such, it cannot be used as a “sweetener.” a. True b. False 21. Convertible debts without a net dilutive effect must still be included in the calculation of diluted EPS. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 16_4ce 22. The design of stepped-up exercise prices is to control the timing of equity capital raised for the firm. a. True b. False 23. When a convertible debt is converted into shares at the beginning of an accounting period, it will cause earnings to be higher at the end of that accounting period. a. True b. False 24. Convertible bonds typically have a call provision. a. True b. False 25. Asset securitizations allow investors to expand the scope of their investment choices. a. True b. False 26. If a zero correlation of default exists between the different securities and the loan, the equity tranche may have no hope of being paid. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

27. Which of the following is correct regarding the interaction of a firm’s share price and the value of issued warrants? a. The value of the warrant increases as the market price of the underlying shares rises. b. The value of the warrant decreases as the market price of the underlying shares eclines. c. The value of the warrant increases as the market price of the underlying shares declines. d. There is no relationship between the value of a warrant and its stock price.

28. Which of the following is correct regarding credit derivatives? a. If the expected recovery value increases, then the size of payment upon the occurrence of a credit event will increase. This will increase the protection payment. b. If the expected recovery value decreases, then the size of payment upon the occurrence of a credit event will decrease. This will increase the protection payment. c. If the expected recovery value decreases, then the size of payment upon the occurrence of a credit event will remain stable. This will increase the protection payment. d. If the expected recovery value decreases, then the size of payment upon the occurrence of a credit event will increase. This will increase the protection payment.

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Chap 16_4ce 29. Which of the following asset-backed securities must be renewed frequently? a. credit card receivables b. student loans c. commercial paper d. home mortgages 30. Chocolate Factory’s convertible debentures were issued at their $1,000 par value in 2007. At any time prior to maturity on February 1, 2027, 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 31. Which circumstance will decrease the protection payment for credit default swaps? a. expected recovery values decrease b. expected risk of default decreases c. an unexpected increase of borrowing from the underlying company d. an unexpected drop in share prices of the underlying company 32. What is the theoretical value of a warrant when the current price of the stock is $75 and the exercise price is $50? The exchange ratio is five shares for each warrant. a. $125 b. $115 c. $110 d. $105 33. Valdes Enterprises is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value.

The bonds would have an 8% 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%. The stock currently sells for $40 a share, has an expected dividend in the coming year of $2, and has an expected constant growth rate of 5%.

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

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Chap 16_4ce 34. Warren Corporation’s stock sells for $42 per share. The company wants to sell some 20-year, annual interest $1,000 par value bonds. 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 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% 35. Which of the following represents the major difference between warrants and convertible debt? a. Only the exercise of convertibles results in new equity capital. b. Only the exercise of warrants results in new equity capital. c. Only the exercise of convertibles results in new debt. d. Only the exercise of warrants results in new debt.

36. Upstate Water Company just sold a bond with 50 warrants attached. The bonds have a 20-year maturity, 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 37. What is the theoretical value of a warrant when the current price of the stock is $10 and the exercise price is $8?

The exchange ratio is three shares for each warrant. a. $20 b. $15 c. $10 d. $6 38. Which statement regarding a collateralized debt obligation (CDO) is true? a. It has no default risk exposure. b. It is tax free. c. It involves a credit default swap. d. It represents a claim on the cash flows of a loan.

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Chap 16_4ce 39. Which of the following statements best describes convertibles? a. One advantage of convertibles over warrants is that the issuer receives additional cash 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. 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.

40. How does home mortgage securitization benefit mortgage originators? a. They can improve the asset liquidity. b. They have additional funds for other investment. c. They are free from default and prepayment risks. d. They can improve asset liquidity, have additional funds for other investments, and are free from default and prepayment risks.

41. Which of the following is generally true of convertible issues? a. Firms generally call their convertibles when the conversion value is greater than the call price. b. Firms generally call their convertibles when the conversion value is less than the call price. c. Firms generally do not call their convertibles unless the conversion value is equal to the call price. d. Firms generally do not call their convertibles unless the conversion value is less than the call price.

42. Which of the following statements best describes warrants? 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.

43. ABC Bank enters into a credit default swap with XYZ Financial. The notional amount of the swap is $50 million.

The 5-year swap is based upon a 5-year loan to LMN Corp. The size of the protection payment is 3% per year.

As LMN bankrupts during the time this swap is still valid, XYZ has paid ABC $22.5 million for settlements.

What is the recovery ratio on the underlying loan? a. 60% b. 55% c. 45% d. 40%

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Chap 16_4ce 44. ABC Bank enters a credit default swap of $10 million for 5 years with XYZ Insurance. How much does ABC have to pay with a premium rate of 2.5% per year? a. $100,000 b. $150,000 c. $250,000 d. $500,000 45. Which of the following is true regarding mortgage-backed security tranches? a. Different tranches in a mortgage-backed security have the same default risk exposure. b. All tranches in a mortgage-backed security have the same default risk exposure. c. All tranches in a mortgage-backed security have the same returns on investment. d. Different tranches in a mortgage-backed security have different default risk exposure.

46. A convertible bond has a call price of $1,100. Its underlying stock is selling at $70 per share, and the conversion price is $50. If the company were to have a 50% stock dividend, what will be the new conversion ratio for the bond? a. 10 b. 20 c. 30 d. 40 47. Vanderbeez Corporation is considering issuing a 12-year convertible bond that would be priced at its $1,000 par value. The bonds would have a 6% annual coupon, and each bond could be converted into 16 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 8%. The stock currently sells for $50 a share, has an expected dividend in the coming year of $3, and has an expected constant growth rate of 5.25%. What is the estimated floor price of the convertible at the end of Year 2? a. $806.21 b. $865.80 c. $886.21 d. $926.10 Saunders The following data apply to Saunders Corporation’s convertible bonds: Maturity: Par value: Annual coupon:

10 $1,000 5%

Stock price: Conversion price: Straight-debt yield:

$30 $35 8%

48. Refer to Scenario: Saunders. What is the bond’s conversion value? a. $734.89 b. $773.57 c. $814.29 d. $857.14

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Chap 16_4ce 49. You have paid $5 to buy a warrant with an exercise price of $40. The stock is currently trading at $50. How much profit or loss would you make by exercising the warrant if one warrant entitles the owner to buy one share of stock? a. $5 b. $10 c. $40 d. $50 50. Who or what is (are) the legal asset owner(s) behind home mortgage securitization? a. special purpose vehicles (SPV) b. individual investors c. banks that originate the mortgages d. Canada Mortgage and Housing Corporation (CMHC) 51. Curry Corporation is setting the terms on a new issue of bonds with warrants. 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. A similar straight-debt 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% b. 7.11% c. 7.48% d. 7.88% 52. Which of the following best characterizes the position of borrowers in loan securitizations? a. Most borrowers of the sold loans are unaware that the lender has sold the loans. b. Most borrowers of the sold loans are notified that the lender has sold the loans. c. Most borrowers of the sold loans have the right to decline the securitization. d. Most borrowers of the unsold loans are aware that the lender has sold the loans.

53. Orient Airlines’ common stock 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 2017. What is the conversion value of the bond? a. $707.33 b. $744.56 c. $783.75 d. $825.00

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Chap 16_4ce 54. A convertible bond has a call price of $1,100. Its underlying stock is selling at $70 per share, and the conversion price is $50. If owners of the convertible bond convert and sell the stock, what is their profit or loss on each bond if the convertible is called by the company? a. –$100 b. –$200 c. –$300 d. +$300 55. A collateralized debt obligation (CDO) is best described as a security made up of corporate loans plus which of the following? a. common equity swaps b. preferred swaps c. credit default swaps d. accounts payable default swaps 56. Why is asset securitization advantageous to investors? a. It removes all risk of holding the assets. b. It results in higher returns. c. It increases investment choices. d. It eliminates the need for financing.

57. Which of the following best describes a detachable warrant? a. A detachable warrant is a warrant that can be detached and traded separately from the security with which it was issued. Most traded warrants are originally attached to common shares. b. A detachable warrant is a warrant that cannot be detached and traded separately from the security with which it was issued. Most traded warrants are originally attached to bonds or preferred shares. c. A detachable warrant is a warrant that can be detached and traded separately from the security with which it was issued. Most traded warrants are originally attached to bonds or preferred shares. d. A detachable warrant is a convertible bond that can be detached and traded separately from the security with which it was issued. Most traded warrants are originally attached to bonds or preferred shares.

58. What is the theoretical value of a warrant when the current price of the stock is $25 and the exercise price is $20? The exchange ratio is two shares for each warrant. a. $15 b. $10 c. $20 d. $5 59. Which of the following are frequent originators of asset securitizations? a. credit card companies b. technology companies c. retailers d. oil and gas companies

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Chap 16_4ce 60. ChemCom Inc. is considering issuing a 15-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8% annual coupon, and each bond could be converted into 20 shares of common stock. The bonds would be callable in 10 years. The required rate of return on an otherwise similar nonconvertible bond is 6%. The stock currently sells for $40 a share, has an expected dividend in the coming year of $2, and has an expected constant growth rate of 5%. What is the IRR on the convertible bond in 10 years’ time? a. 7.32% b. 8.00% c. 9.91% d. 10.00% 61. Which of the following statements best describes warrants? 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.

62. ABC Bank enters into a credit default swap with XYZ Financial. The swap runs for 5 years and is based upon a term loan to LMN Corp. The size of the protection payment is 5% per year. Unfortunately, LMN goes bankrupt a year after this swap agreement becomes effective. Even with a 75% recovery value on the underlying loan, XYZ has paid ABC $20 million for settlements. How much has ABC lent to LMN? a. $100 million b. $80 million c. $50 million d. $20 million

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Chap 16_4ce Canada Corp.

A firm has $10 million of outstanding convertible bonds. The coupon on these convertibles is $100 per bond, and each bond is convertible into common stock at a conversion price of $25.

The income statement of the firm before conversion is as follows and EBIT remains at $6 million after conversion. Assume the firm paid $2 million in interest on other outstanding debt in addition to the interest paid on the convertible bonds.

Millions of Dollars before Conversion 6.0 –3.0 3.0 –1.2 1.8

EBIT Interest @10% Earnings before taxes (EBT) Taxes @40% Earnings after taxes (EAT)

Shares outstanding (millions) Earnings per share (EPS) 63. Refer to Scenario: Canada Corp. What is the fully diluted EPS? a. $1.57 b. $1.59 c. $1.62 d. $1.71

1.0 $1.80

Saunders The following data apply to Saunders Corporation’s convertible bonds: Maturity: Par value: Annual coupon:

10 $1,000 5%

Stock price: Conversion price: Straight-debt yield:

$30 $35 8%

64. Refer to Scenario: Saunders. What is the bond’s straight-debt value? a. $684.78 b. $720.82 c. $758.76 d. $798.70 65. Which of the following is correct regarding securitization? a. Securitization can always improve liquidity with respect to fixed assets. b. Securitization does not always improve liquidity with respect to securitized assets. c. Securitization can always improve liquidity with respect to securitized assets. d. Securitization never improves liquidity with respect to securitized assets.

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Chap 16_4ce 66. Which of the following best describes the sale of warrants and their effects on shareholders’ earnings? a. The sale of warrants does not dilute shareholders’ earnings. b. The sale of warrants dilutes shareholders’ earnings to the extent that dividends are paid out. c. The sale of warrants does not dilute shareholders’ earnings to the extent that dividends are paid out. d. The sale of warrants dilutes shareholders’ earnings.

67. What is the theoretical value of a warrant when the current price of the stock is $50 and the exercise price is $45? The exchange ratio is four shares for each warrant. a. $20 b. $15 c. $10 d. $5 68. Which of the following best describes sub-prime mortgages? a. mortgages that are issued below the prime lending rate b. mortgages issued to homeowners with low credit scores who do not qualify for conventional mortgages c. mortgages issued to low-income homeowners d. mortgages issued to companies with low credit ratings 69. When warrants are exercised, what happens as a result? a. The security associated with the warrant drops in value depending on the exercise price of the warrant. b. Funds are transferred from the retained earnings account to the common shares account for the market value of the shares. c. The number of common shares outstanding changes. d. There is no new capital for the firm because the warrants are exchanged for the common shares.

Saunders The following data apply to Saunders Corporation’s convertible bonds: Maturity: Par value: Annual coupon:

10 $1,000 5%

Stock price: Conversion price: Straight-debt yield:

$30 $35 8%

70. Refer to Scenario: Saunders. What is the bond’s conversion ratio? a. 27.14 b. 28.57 c. 30.00 d. 31.50

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Chap 16_4ce 71. Refer to Scenario: Saunders. Based on your answers to the three preceding questions, what is the minimum price (or “floor” price) at which the Saunders bonds should sell? a. $734.89 b. $773.57 c. $814.29 d. $857.14 72. Which of the following is correct regarding the 2007 credit crisis? a. One of the causes of the 2007 credit crisis was the excess risk and leverage in the economy created by increased use of credit derivatives and CDOs. b. Canadian financial institutions were not affected by the 2007 credit crisis. c. The 2007 credit crisis was caused by the drastic drop in the price of oil. d. Significant income inequality led to the liquidity crunch, which in turn caused the 2007 credit crisis.

73. Which of the following best describes what happens to a bond after its accompanying warrant has been exercised? a. The bond remains outstanding even after the warrant has been exercised. b. The bond expires immediately after the warrant has been exercised. c. The bond becomes equity capital after the warrant has been exercised. d. The bond becomes preferred stock after the warrant has been exercised.

74. ABC Bank has a $10 million loan outstanding with DEF Inc. To reduce its default risk from this loan, ABC enters a credit default swap of $10 million for 5 years with XYZ Insurance for a premium rate of 2.5% per year.

If DEF can pay back only $6.5 million of its loan in 2 years’ time, what will be the net obligation for XYZ? a. $0.5 million b. $1.25 million c. $3.5 million d. $4.0 million 75. Kimberley Corporation’s convertible debentures were issued at their $1,000 par value in 2021. At any time prior to maturity on February 1, 2031, a debenture holder can exchange a bond for a pre-specified number of shares of common stock. If the conversion price is $50 per share, what is the conversion ratio, CR? a. 10 b. 15 c. 20 d. 25

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Chap 16_4ce Canada Corp.

A firm has $10 million of outstanding convertible bonds. The coupon on these convertibles is $100 per bond, and each bond is convertible into common stock at a conversion price of $25.

The income statement of the firm before conversion is as follows and EBIT remains at $6 million after conversion. Assume the firm paid $2 million in interest on other outstanding debt in addition to the interest paid on the convertible bonds.

Millions of Dollars before Conversion 6.0 –3.0 3.0 –1.2 1.8

EBIT Interest @10% Earnings before taxes (EBT) Taxes @40% Earnings after taxes (EAT)

Shares outstanding (millions) 1.0 Earnings per share (EPS) $1.80 76. Refer to Scenario: Canada Corp. After conversion, how much is the firm’s after-tax earnings? a. $1.71 million b. $2.04 million c. $2.40 million d. $3.17 million Indicate one or more answer choices that best complete the statement or answer the question.

77. Vanduzen Company is considering issuing a 15-year convertible bond that would be priced at its $1,000 par value.

The bonds would have a 10% annual coupon, and each bond could be converted into 20 shares of common stock.

The bonds would be callable in 10 years. The required rate of return on an otherwise similar nonconvertible bond is 8%. The stock currently sells for $40 a share, has an expected dividend in the coming year of $3, and has an expected constant growth rate of 6%. What is the relationship between the expected returns on the convertible bond, the straight bond, and the common stock in 10 years’ time? a. Expected return on the convertible bond is lower than both the expected return on the straight bond and the expected return on the common stock. b. Expected return on the convertible bond is greater than the expected return on the straight bond and lower than the expected return on the common stock. c. Expected return on the convertible bond is lower than the expected return on the straight bond and greater than the expected return on the common stock. d. Expected return on the convertible bond is greater than both the expected return on the straight bond and the expected return on the common stock.

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Chap 16_4ce Answer Key 1. False 2. False 3. False 4. True 5. False 6. False 7. False 8. False 9. True 10. True 11. True 12. False 13. True 14. False 15. False 16. False 17. True 18. True 19. False 20. False 21. False 22. True 23. True 24. True 25. True 26. False

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Chap 16_4ce 27. a 28. d 29. c 30. a 31. b 32. a 33. d 34. b 35. b 36. a 37. d 38. d 39. d 40. d 41. a 42. b 43. b 44. c 45. d 46. c 47. c 48. d 49. a 50. a 51. d 52. a 53. d 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 16_4ce 55. c 56. c 57. c 58. b 59. a 60. c 61. b 62. b 63. d 64. d 65. a 66. d 67. a 68. b 69. c 70. b 71. d 72. a 73. a 74. c 75. c 76. c 77. b

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Chap 17_4ce Indicate whether the statement is true or false.

1. Funds from short-term loans can generally be obtained faster than from long-term loans for two reasons: (1) when lenders consider long-term loans they must make a more thorough evaluation of the borrower’s financial health, and (2) long-term loan agreements are more complex. a. True b. False 2. Interest rates charged on loans vary depending on the risk of borrower, and the size of the loan, but not the economic conditions. a. True b. False 3. Commercial paper is used by large companies with investment-grade short-term credit ratings to borrow money at lower cost from large institutional investors such as pension funds. a. True b. False 4. The company that has written the term draft in a bankers’ acceptance is ultimately responsible for paying off the draft. a. True b. False 5. The inventory conversion period of the operating cycle terminates when the inventory is paid for with cash. a. True b. False 6. Long-term loan agreements always contain provisions, or covenants, that constrain the firm’s future actions.

Short-term credit agreements are just as restrictive in order to protect the interests of the lender. a. True b. False 7. 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 pays in 40 days than in 30 days. a. True b. False 8. The maturity matching, or “self-liquidating,” approach involves the financing of permanent net operating working capital with combinations of long-term capital and short-term capital that vary 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 and risk. a. True b. False

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Chap 17_4ce 9. One of the effects of not taking trade credit discounts when offered is that the firm’s use of accounts payable rises. a. True b. False 10. Stretching accounts payable is a widely accepted and costless financing technique. a. True b. False 11. If a firm is involuntarily stretching its accounts payable, then this is probably a sign that it is undercapitalized —that is, that it needs more working capital to support its operations. a. True b. False 12. Permanent net operating working capital reflects the fact that net operating working capital does not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent net operating working capital represents a minimum level of net operating working capital that must be financed. a. True b. False 13. When interest is calculated on an installment basis, the average usable funds are only about half of the stated loan value. a. True b. False 14. A firm that follows an aggressive working capital financing approach is more exposed to unexpected changes in the term structure of interest rates than is a firm that follows a conservative financing policy. a. True b. False 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 expected basis. a. True b. False 16. Discount interest loans are usually provided for terms of only 1 year or less. Their interest is paid together with the principal at the end of the loan. a. True b. False 17. Operating current assets include cash, accounts receivable, inventories, and accruals. a. True b. False

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Chap 17_4ce 18. Investors who purchase commercial paper will not receive any interest payments. a. True b. False 19. A firm’s peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption of uniform daily cash receipts and disbursements, but actual receipts are concentrated at the beginning of each month. a. True b. False 20. If a firm’s suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease. a. True b. False 21. When deciding whether or not to take a trade discount, the cost of borrowing from a bank should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False 22. 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 costs of credit from other sources. a. True b. False 23. The relative profitability of a firm that employs an aggressive working capital financing policy will improve when the yield curve changes from upward sloping to downward sloping. a. True b. False 24. Because money has time value, cash sales are always more profitable than credit sales. a. True b. False 25. If a firm takes actions that reduce its DSO, then, other things held constant, this will lengthen its CCC. a. True b. False 26. 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 subject to certain conditions, including the borrower’s maintaining its financial strength. a. True b. False

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Chap 17_4ce 27. A firm is said to be using costly trade credit when its accounts payable are extended beyond the discount period and an explicit cost is shown on the foregone discounts. a. True b. False 28. A conservative financing approach to working capital will result in most of the permanent net operating working capital being financed by long-term securities. a. True b. False 29. Under a public warehouse agreement, the inventory used as collateral for the loan is stored on the premises of a third party. a. True b. False 30. With a simple interest calculation, the more frequently interest payments are made on a loan, the lower will be its effective interest rate. a. True b. False 31. Firms must have high credit quality in order to issue commercial paper; therefore, all commercial paper is equally risky. a. True b. False 32. Accrued wages and deferred taxes belong in the cash budget but not in the supply chain process. a. True b. False 33. An increase in the holding of marketable securities must be accompanied by a corresponding increase in the net operating working capital. a. True b. False 34. When the accounts receivable turnover and payables deferral period are decreased, a firm’s cash conversion cycle will be lengthened. a. True b. False 35. Since depreciation is a noncash charge, it neither appears on, nor has any effect on, the cash budget. a. True b. False

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Chap 17_4ce 36. Companies that export most of their products and services are likely to use bankers’ acceptances for their short-term financing needs. a. True b. False 37. The fact that no explicit interest is paid on accruals, and that the firm can vary the level of these accounts, makes accruals an attractive and flexible source of funding to meet increased working capital needs. a. True b. False 38. Short-term financing is riskier than long-term financing since, during periods of tight credit, the firm may not be able to roll over (renew) its debt. This is especially true if the funds are used to finance long-term rather than short-term assets. a. True b. False 39. You receive some goods on April 1 with the following terms: 3/20, net 30. This means that you will receive a 3% discount if the bill is paid on or before April 20, and if not paid by then, the full amount must be paid in 30 days after receipt of the goods. a. True b. False 40. Other things held constant, if a firm stretches its accounts payable, this will lengthen its CCC. a. True b. False 41. If a firm’s customers are stretching their accounts payable, this may be a nuisance, but it does not represent a real financial cost to the firm as long as the customer periodically pays off its entire balance. a. True b. False 42. Offering trade credit discounts is costly and, as a result, firms that offer trade discounts are usually those that are performing poorly and need cash quickly. a. True b. False 43. The calculated cost of trade credit can be reduced by paying late. a. True b. False 44. The cash budget and the capital budget are handled separately and, although they are both important, they are developed independently of one another. a. True b. False

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Chap 17_4ce 45. In the financial press, working capital is often defined as current assets used in operations, and net working capital as current assets less current liabilities. a. True b. False 46. Under a revolving credit agreement, the risk to the firm of being unable to obtain funds when needed is lower than with an informal line of credit. a. True b. False 47. Due to the complexity of factoring procedures, factoring is rarely used as a source of short-term financing in Canada today. a. True b. False 48. If a firm fails to take trade credit discounts, then it may cost the firm some money, but generally such a policy has a negligible effect on the firm’s income statement and no effect on its balance sheet. a. True b. False 49. Determining a firm’s optimal investment in net operating working capital and how that investment is financed are elements of working capital policy. a. True b. False 50. Accruals are “free” capital in the sense that no explicit interest must be paid on accruals. a. True b. False 51. The face value of a discount interest loan is calculated as interest plus the amount received by the borrower. a. True b. False 52. While the maturity of most bank loans is short term, they are frequently repaid on demand rather than on a specific maturity date. a. True b. False 53. Minimizing cash holdings, inventories, or receivables and maximizing payables or accruals are the aims of relaxed working capital policies. a. True b. False

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Chap 17_4ce 54. The firm’s total capital requirement grows over time in amount, including the base level of fixed assets and current assets. There exists seasonal variation around the trend showing the required temporary working capital. a. True b. False 55. The trade credit that a firm receives during the discount period is referred to as free trade credit. a. True b. False 56. Shorter-term cash budgets, in general, are used for actual cash control, while longer-term cash budgets are used for planning purposes. a. True b. False 57. 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 58. With bankers’ acceptances, banks guarantee term drafts written by companies in return for 1% of the proceeds. a. True b. False 59. An informal line of credit and a revolving credit agreement are similar except that a line of credit creates a legal obligation for the bank. a. True b. False 60. Generally, the longer the normal inventory holding period of customers, the longer the credit period. One effect of lengthening the credit period to match the customer’s merchandise holding period is to increase the payables deferral period, which shortens the customer’s cash conversion cycle. a. True b. False 61. 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 working capital financing strategy because of the inherent risks of rolling over of short-term borrowing. a. True b. False 62. Companies in Canada use bankers’ acceptances as a financing source because they are unwilling to utilize the riskier financing option of issuing commercial paper. a. True b. False

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Chap 17_4ce 63. Commercial paper is the same as secured promissory notes issued by banks on behalf of companies with good credit ratings. a. True b. False 64. When analyzing net operating working capital, there is no difference between cash and short-term investments as both can be used for supporting current ongoing operations or held for future purposes. a. True b. False 65. The factoring of receivables involves the specific use of receivables as collateral for the loan. a. True b. False 66. The blanket inventory lien gives the lender a lien against all inventories of the borrower. However, the borrower is free to sell them. a. True b. False 67. 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 68. A bank’s loan application assessment process should focus exclusively on quantifiable data provided by the borrowing firm’s financial statements. a. True b. False 69. If a firm is offered credit terms on its purchases of 2/10, net 30, it is in the firm’s financial interest to pay as early as possible during the discount period. a. True b. False 70. A firm constructing a new manufacturing plant and financing it with short-term loans that are scheduled to be converted to mortgage bonds when the plant is completed would want to separate the construction loan from its other current liabilities associated with working capital management. a. True b. False 71. Pledging of receivables involves the sale of accounts receivable. a. True b. False

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Chap 17_4ce 72. The prime rate charged can vary greatly (e.g., as much as 2 to 4 percentage points) across banks due to banks’ ability to differentiate themselves and because particular banks develop particular clienteles, such as making loans to specialty retailers. a. True b. False 73. The risk to the firm of borrowing using short-term credit is usually greater than if it used long-term debt. Added risk stems from greater variability of interest costs on short-term debt. Even if its long-term prospects are good, the firm’s lender may not renew a short-term loan if the firm is even temporarily unable to repay it. a. True b. False 74. A revolving credit agreement is a formal line of credit often used by large firms. The firm generally must 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 Indicate the answer choice that best completes the statement or answers the question.

75. Which of the following best describes gross working capital? a. current assets used in operations b. fixed assets and retained earnings used in operation c. long-term assets used in operations d. current liabilities and inventory used in operation 76. Shahrokhi Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps 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 40%. 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. 4.3% b. 4.7% c. 5.3% d. 5.8% 77. Which of the following describes net working capital? a. current assets minus current liabilities b. current assets minus inventory c. current assets minus cash d. long –term assets minus current liabilities

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Chap 17_4ce 78. Your firm needs $1,000 for one quarter to finance a deficit. Your bank charges add-on interest of 12% and requires a quarterly payment. What is the quarterly payment that your firm must make to the bank? a. $230 b. $280 c. $320 d. $350 79. Which of the following borrowers benefits the most from a revolving line of credit? a. a local grocery retailer located in downtown Toronto b. an owner of a gift shop with the majority of its annual sales during Christmas season c. an ice cream seller whose business is located in a Niagara Falls resort d. a manufacturer of hand tools whose sales are generally evenly distributed throughout the year 80. Gorman Inc. arranged a $10,000,000 revolving credit agreement 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 9% during the year. If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of 1 year, what was its total dollar cost for the year? a. $617,500 b. $650,000 c. $682,500 d. $716,625 81. Miletkov Company’s total assets fluctuate between $320,000 and $410,000, while its fixed assets remain constant at $260,000. If the firm follows a maturity matching, or moderate, working capital financing policy, what is the likely level of its long-term debt and equity financing? a. $274,360 b. $288,800 c. $304,000 d. $320,000 82. What is the main difference between a firm’s free cash flows (FCFs) and the cash flows shown in its cash budget? a. FCFs reflect actual cash on hand, whereas cash budget cash flows reflect accounting numbers. b. FCFs reflect required investments for future operations, whereas cash budget cash flows reflect actual cash flows during a specific period. c. FCFs reflect actual cash flows during a specific period, whereas cash budget cash flows reflect required investments for future operations. d. FCFs are provided to shareholders, whereas cash budget cash flows are primarily used by management.

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Chap 17_4ce 83. A firm has a serious cash shortage due to a growing investment in accounts receivable. If this firm is incapable of dealing with such a high level of receivables, how would it likely benefit most? a. by securing any short-term credit with a blanket inventory lien b. by factoring its receivables c. by applying for a line of credit d. by pledging its receivables on a short-term loan 84. LMN Co. plans to enter into a secured term loan by assigning its receivables of $600,000 with an average maturity date of 30 days. The finance company will loan 75% of the receivables value at 11% interest plus a service fee of 0.05% of the total receivables pledged. What is the total cost of this financing arrangement? a. $3,039 b. $3,872 c. $4,049 d. $4,368 85. XYZ Inc. is planning a $200,000 90-day commercial paper issue. The issue is sold for $193,500. There is a flotation cost of $1,500. The corporate tax rate is 35%. (Assume a 365-day year.) Which of the following statements is correct? a. The before-tax cost is 16.77%. b. The before-tax cost is 15.71%. c. The after-tax cost is 10.21%. d. The after-tax cost is 10.06%.

86. A firm is offered trade credit terms of 2/8, net 45 days. The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? (Assume a 365-day year.) a. 13.35% b. 14.70% c. 15.89% d. 18.70% 87. Which of the following statements about discount interest loans is correct? a. A discount loan that matures in 3 months has a higher effective interest rate than one that matures in 6 months. b. A discount loan that matures in 3 months has a lower effective interest rate than one that matures in 6 months. c. A discount loan that matures in 3 months must pay a higher APR than one that matures in 6 months. d. All discount loans have the same effective interest rate regardless of their times to maturity.

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Chap 17_4ce 88. Carroll & King Corporation has $4.5 million of inventory and $2.4 million of accounts receivable. Its average daily sales are $120,000, and its cost of goods sold is 75% of sales. The company’s payables deferral period (accounts payable divided by daily purchases) is 30 days. Assume 365 days in a year. What is C&K’s cash conversion cycle? a. 20 b. 30 c. 40 d. 50 89. What type of operating current assets policy requires a company to hold a lot of current assets on hand? a. restricted policy b. relaxed policy c. aggressive policy d. moderate policy 90. Which of the following is the largest single category of current liabilities for the average nonfinancial corporation? a. accruals b. accounts payable c. short-term notes payable d. lines of credit

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Chap 17_4ce 91. Ski Lifts Inc. is in a highly seasonal business, and the following summary balance sheet data show its assets and liabilities at peak and off-peak seasons (in thousands of dollars):

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

Spontaneous liabilities Short-term bank debt Long-term debt Common equity Total claims

$ 30 50 300 310 $690

$ 10 0 300 310 $620

What can we conclude from this data? a. Ski Lifts’s working capital financing policy calls for exactly matching asset and liability maturities. b. Ski Lifts’s working capital financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. c. Ski Lifts follows a relatively conservative approach to working capital financing; that is, some of its shortterm needs are met by permanent capital. d. Without income statement data, we cannot determine the aggressiveness or conservatism of the company’s working capital financing policy.

92. Which action would be likely to lengthen the cash conversion cycle? a. adopting a new inventory system that reduces the inventory conversion period b. reducing the average DSO on its accounts receivable c. reducing the amount of time the company takes to pay its suppliers d. increasing sales while maintaining the same level of receivables 93. Which of the following best describes the pledging of accounts receivable? a. Lender has no recourse to borrower and buyers of goods are not informed. b. Lender has no recourse to borrower and buyers of goods are informed. c. Lender has recourse to borrower and buyers of goods are not informed. d. Lender has recourse to borrower and buyers of goods are informed.

94. Which of the following methods can be employed by lenders to control inventory that has been used as security for a loan? a. bankers’ acceptances b. demand deposits c. field warehousing d. compensating balance

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Chap 17_4ce 95. What type of repayment is made at the maturity of some amortized loans? a. balloon b. principal c. installment d. interest plus principal 96. Which statement best describes short-term financing? a. 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 the use of short-term debt would probably increase the firm’s risk. b. Conservative firms generally use no short-term debt and thus have zero current liabilities. c. 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. d. If a firm that can borrow from its bank 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.

97. A firm needs $45,000 to purchase inventory. The bank requires monthly payment of simple interest with a principal repayment at the end of each year. With a quoted annual interest rate of 15%, what is the effective annual interest rate? Assume 360 days per year and 30 days per month. a. 14.25% b. 15.00% c. 15.79% d. 16.08% 98. Which statement best describes cash budgets? a. Shorter-term cash budgets in general are used primarily for planning purposes, while longer-term budgets are used for actual cash control. b. The cash budget and the capital budget are planned separately and although they are both important to the firm they are independent of each other. c. Since depreciation is a noncash charge it does not appear on nor have an effect on the cash budget. d. The typical actual cash budget will reflect interest on loans and income from investment of surplus cash.

These numbers are expected values and actual results might vary from budgeted results.

99. Filbeck Company buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 30 days after the invoice date. Net purchases amount to $500,000 per year. On average, how much free trade credit does the firm receive during a 365-day year? a. $20,548 b. $21,575 c. $22,654 d. $23,787

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Chap 17_4ce 100. You were recently hired as CFO to improve the performance of Dennis Systems, which is highly profitable but has been experiencing cash shortages due to its high rate of growth. 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 Average accounts receivable Average accounts payable Total annual purchases a. 145.3 b. 152.6 c. 174.2 d. 192.3

$120,000 $600,000 $160,000 $25,000 $365,000

101. Which of the following statements best describes cash flows that would be shown on a cash budget? a. 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. b. If cash inflows from collections occur in equal daily amounts but most payments are made regularly on the 10th of each month, then it is not necessary to use a daily cash budget. A cash budget focused on the end of the month will suffice. c. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. d. The cash flows shown on the cash budget are the actual cash inflows and outflows and thus different from the firm’s free cash flows, because FCF reflects after-tax operating income and the investments required to maintain future operations.

102. What is one of the advantages of short-term debt financing? a. Firms can obtain short-term credit more quickly than long-term credit. b. Firms can obtain long-term credit more quickly than short-term credit. c. Firms can obtain short-term credit to pay preferred dividends in the short-run. d. Firms can obtain short-term credit to pay off accounts receivable in the short run at cheaper rates.

103. Which statement best describes cash budgets? a. Depreciation expense is not explicitly included, but depreciation effects are reflected in the estimated tax payments. b. Cash budgets do not include financial expenses such as interest and dividend payments. c. Cash budgets do not include cash inflows from long-term sources such as bond issues. d. Changes that affect the DSO do not affect the cash budget.

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Chap 17_4ce 104. Which of the following best describes accounts receivable factoring? a. Lender has no recourse to borrower and buyers of goods are not informed. b. Lender has no recourse to borrower and buyers of goods are informed. c. Lender has recourse to borrower and buyers of goods are not informed. d. Lender has recourse to borrower and buyers of goods are informed.

105. Westley Company’s average age of accounts receivable is 50 days, the average age of accounts payable is 45 days, and the average age of inventory is 72 days. Assuming a 365-day year, what is the length of its cash conversion cycle? a. 66 b. 69 c. 73 d. 77 106. Which item should a company report directly in its monthly cash budget? a. its monthly depreciation expense b. cash proceeds from selling one of its divisions c. accrued interest on zero coupon bonds that it issued d. new shares issued in a stock split 107. Which of the following are included in the cash conversion cycle? a. the inventory conversion period, the receivables collection period, and the payables deferral period b. the inventory conversion period, the receivables collection period, and the long-term assets cycle c. the acid test period, the receivables collection period, and the payables deferral period d. the inventory conversion period and the receivables deferral period 108. Margetis Inc. carries an average inventory of $1,000,000. Its annual sales are $10 million, its cost of goods sold is 80% of sales, and its receivables conversion period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. Its new CFO wants to decrease the cash conversion cycle by 10 days, based on a 365-day year. He believes he can reduce the average inventory to $863,000 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal of a 10-day reduction in the cash conversion cycle? a. $0 b. $102,723 c. $136,986 d. $333,520 109. Which of the following statements best describes bankers’ acceptances? a. In Canada, bankers’ acceptances are not as popular as commercial paper as a short-term financing source. b. Investors are the ultimate guarantors for payments of bankers’ acceptances. c. Bankers’ acceptances can be traded in the money markets prior to their maturities. d. Bankers’ acceptances are commonly used to finance goods purchased with long payment terms.

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Chap 17_4ce 110. Which of the following is a characteristic of factoring accounts receivable? a. A firm sells its accounts receivable to a finance company at a discount and buys it back at a later date for its full value. b. Receivables are sold without recourse. c. The firm incurs any losses from nonpayment. d. Maturity factoring and accrued factoring are the two basic ways of financing.

111. Ferson Inc. has annual sales of $36,500,000, or $100,000 a day on a 365-day basis. Its cost of goods sold is 80% of sales. On average, the company has $12,000,000 in inventory, $8,000,000 in accounts receivable, and $6,000,000 in accounts payable. The firm is looking for ways to shorten its cash conversion cycle, which is calculated on a 365-day basis. 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 accounts payable would remain unchanged. What effect would these policies have on the company’s cash conversion cycle? Round to the nearest whole day. a. –34 days b. –22 days c. +22 days d. +34 days 112. Viale Enterprises 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 cost of its trade credit?

(Assume a 365-day year.) a. 17.81% b. 19.66% c. 23.45% d. 27.43% 113. The purpose of the cash conversion cycle (CCC) is to show how long a firm must finance which of the following? a. its long-term capital b. its operating working capital c. its mortgage capital d. its inventories 114. Which of the following statements best describes commercial paper? a. Commercial paper generally carries an interest rate above the prime rate. b. Commercial paper is sold to money market mutual funds, as well as to other financial institutions and nonfinancial corporations. 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 a type of secured promissory note issued by banks on behalf of nonfinancial corporations.

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Chap 17_4ce 115. Which of the following statements best describes alternatives to short-term financing policies? a. Accruals are an expensive way to finance working capital. b. A conservative financing policy is one in which the firm finances all of its fixed assets with long-term capital and part of its permanent net operating working capital with short-term, nonspontaneous credit. c. If a company receives trade credit under terms 2/10, net 30, this implies the company has 10 days of free trade credit. d. A firm following an aggressive financing policy would finance all of its permanent NOWC with long-term capital.

116. Hefner Inc.’s business is booming, and it needs to raise more capital. 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, and the firm’s owner believes they could delay payment to 40 days without adverse effects. What would be the effective annual rate of funds raised by this action? (Assume a 365-day year.) a. 10.00% b. 11.75% c. 12.29% d. 13.01% 117. Canada Corp. needs $16,000 for one quarter to finance a deficit. Nominal interest charges are 4% per quarter.

The firm’s bank will loan $16,000 on a discount interest basis. How much must be borrowed in order to obtain the needed funds? a. $16,320 b. $17,392 c. $17,270 d. $19,900 118. Nagel Corporation’s budgeted monthly sales are $5,000, and they are constant from month to month. Its customers pay as follows: 40% 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 payments for wages, rent, and taxes, are 25% of sales for the month. Construct a cash budget for a typical month. What is the average cash gain during the month? a. $1,092 b. $1,150 c. $1,210 d. $1,271 119. Other things held constant, what happens with a short CCC? a. The firm’s working capital management is more effective. b. The firm’s working capital management is less effective. c. The firm’s inventory management is more effective.. d. The firm’s administrative costs are more effective.

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Chap 17_4ce 120. Gonzales Company currently 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 pays in 30 days. 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 40%. If the firm implements the plan, what is the expected change in net income after taxes? a. –$31,440 b. –$23,520 c. $23,520 d. $38,448 121. Which of the following best describes a risk for companies using short-term debt to finance their net operating working capital? a. disruptions to their supply chains caused by the pandemic b. a normal yield curve wherein short-term interest rates are lower than long-term interest rates c. the need to increase production capacities through purchases of fixed assets d. an inverted yield curve wherein short-term interest rates are higher than long-term interest rates 122. Which factor is typically NOT considered when constructing a cash budget? a. payments lag b. payment for plant construction c. cumulative cash d. writing off bad debts 123. Which of the following describes “free trade credit”? a. It is credit received during the discount period. b. It is credit received during the credit period. c. It is credit received from a long-time supplier, free of charge. d. It is a misnomer because all trade credits involve some levels of costs.

124. Which statement best describes short-term versus long-term financing? a. Flexibility is an advantage of short-term credit, but this is somewhat offset by the high flotation costs associated with the need to repeatedly renew short-term credit. b. A short-term loan can usually be obtained more quickly than a long-term loan, but the penalty for early repayment of a short-term loan is normally significantly higher than that for a long-term loan. c. The flexibility, cost, and riskiness of short-term versus long-term credit are dependent on the type of credit that is actually used. d. Short-term debt is often less costly than long-term debt, and the major reason for this is that short-term debt exposes the borrowing firm to much less risk than long-term debt.

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Chap 17_4ce 125. Bello Corp. has annual sales of $50,735,000, cost of goods sold of 90% of sales, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. 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 pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but average inventory can be lowered by $1,946,000 and average accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year? a. –14.0 days b. –18.8 days c. –25.6 days d. –39.6 days 126. Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days. Out of convenience, 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 not taking discounts and is paying on Day 25, what is the effective annual cost (NOT the nominal cost) of your firm’s current practice, using a 365-day year? a. 60.3% b. 63.5% c. 66.7% d. 70.0% 127. Tareque Inc. wants to increase its free cash flow by $180 million during the coming year, which should result in a higher EVA and share price. The CFO has made these projections for the upcoming year: – EBIT is projected to be $850 million.

– Gross capital expenditures are expected to total $360 million versus depreciation of $120 million, so its net capital expenditures should total $240 million.

– The tax rate is 40%.

– There will be no changes in cash or marketable securities, nor will there be any changes in notes payable or accruals.

Which of the following actions would enable the company to achieve its goal of generating $180 million in free cash flow? a. accounts receivable increase by $470 million, inventory increases by $230 million, and accounts payable increase by $790 million b. accounts receivable increase by $470 million, inventory increases by $230 million, and accounts payable increase by $610 million c. accounts receivable decrease by $500 million, inventory increases by $480 million, and accounts payable decline by $80 million d. accounts receivable decrease by $400 million, inventory increases by $480 million, and accounts payable increase by $80 million

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Chap 17_4ce 128. Which pair of items is used to calculate net cash increase or decrease in the cash budget? a. sales and cost of goods sold b. cash inflow and cash outflow c. total revenues and total expenses d. net income and dividends 129. Aggarwal Inc. buys 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 30-day month.) a. $223,333 b. $374,951 c. $457,443 d. $562,500 130. Incredible Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps to a relaxed policy. The firm’s annual sales are $3,600,000, its fixed assets turnover is 4.0, its target capital structure calls for 50% debt and 50% equity, its EBIT is $150,000, the interest rate on its debt is 10%, and its tax rate is 40%. Under the restricted policy, total assets turnover will be 2.5, whilst the total assets turnover under a relaxed policy will be 2.2. What is the difference in the projected ROEs under the restricted and relaxed policies? a. 2.24% b. 1.50% c. 1.00% d. 0.50% 131. Schoof Inc. expects to have sales of $30,000 in January, $35,000 in February, and $40,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month following the sale, and another 40% are credit sales paid 2 months following the sale, what are the cash receipts for the firm in March? a. $29,151 b. $30,685 c. $32,300 d. $34,000 132. Cambridge Corporation has a revolving line of credit of $30 million with Bank of New Scotia with a 0.35% commitment fee on any unused balance. For the current year, Cambridge has borrowed $7.5 million on the line of credit. The interest rate on the loan is prime plus 1%, and the average prime rate is 6%. How much commitment fee must Cambridge pay for the current year? a. $26,250 b. $78,750 c. $105,000 d. $525,000

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Chap 17_4ce 133. Shanklin Inc. purchases merchandise on terms of 2/15, net 40, and its total gross purchases (i.e., purchases before taking off the discount) are $800,000 per year. What is the maximum amount of costly trade credit Shanklin 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. $62,163 134. Incredible Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps to a relaxed policy. The firm’s annual sales are $3,600,000, its fixed assets turnover is 4.0, its target capital structure calls for 50% debt and 50% equity, its EBIT is $150,000, the interest rate on its debt is 10%, and its tax rate is 40%. Under the restricted policy, total assets turnover will be 2.5, whilst the total assets turnover under a relaxed policy will be 2.2. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy? a. $3,233 b. $6,175 c. $7,200 d. $9,818 135. BC Corp. needs $10,000 for one year to finance a deficit. Nominal interest charges are 10% per annum. The firm’s bank will loan $10,000 on a discount interest basis. How much must be borrowed in order to obtain the needed funds? a. $11,111 b. $8,888 c. $15,270 d. $11,000 136. Other things held constant, which strategy would tend to reduce the cash conversion cycle? a. maintaining the same level of receivables as sales decline b. placing larger orders for raw materials to take advantage of price breaks c. taking all discounts that are offered d. not taking all discounts that are offered to get more trade credit 137. Which of the following factors would prevent exact maturity matching of current assets and liabilities? a. uncertain lives of inventories b. uncertain maturities of short-term notes c. uncertain timing of payables d. uncertain levels of market interest rates 138. Under which type of interest calculations does the borrower receive less than the face value of the loan? a. simple interest b. discount interest c. add-on interest d. amortized interest Copyright Cengage Learning. Powered by Cognero.

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Chap 17_4ce 139. Your company has been offered credit terms of 4/30, net 90 days. What will be the nominal annual cost of trade credit if you pay 100 days after the purchase? (Assume a 365-day year.) a. 20.64% b. 21.73% c. 22.81% d. 23.95% 140. A firm buys on terms of 3/15, net 45 days. It does not take the discount, and it generally pays after 65 days.

What is the nominal annual cost of its non-free trade credit, based on a 365-day year? a. 22.58% b. 23.71% c. 24.89% d. 26.14% 141. What type of loans are regular interest or simple interest calculations based on? a. discounted loans b. amortized loans c. mortgages d. interest-only loans 142. Durham Cement Inc. buys on terms of 2/15, net 30 days. 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 cost of its non-free trade credit? (Assume a 365-day year.) a. 15.73% b. 16.55% c. 17.38% d. 18.25% 143. Helena Furnishings wants to reduce its cash conversion cycle sharply. Which action should the company take? a. increase its average inventory without increasing its sales b. reduce its DSO c. start paying its bills sooner, which reduces its average accounts payable without reducing its sales d. increase its DSO 144. Which of the following describes the three segments of the commercial lending market defined by the Canadian banking industry? a. small business loans of less than $250,000; medium business loans of $250,000 to $10 million; corporate loans of greater than $10 million b. small business loans of less than $250,000; medium business loans of $250,000 to $20 million; corporate loans of greater than $20 million c. small business loans of less than $250,000; medium business loans of $250,000 to $100 million; corporate loans of greater than $100 million d. small business loans of less than $250,000; medium business loans of $250,000 to $1 billion; corporate loans of greater than $1 billion Copyright Cengage Learning. Powered by Cognero.

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Chap 17_4ce 145. On average, Bragg Inc. has sales of $2,000,000 per month and its cost of goods sold is approximately 80% of sales. It keeps inventory equal to 50% of its monthly sales on hand at all times. Based on using a 365-day year, what is the inventory conversion period? a. 13.0 b. 14.4 c. 15.2 d. 19.0 146. Why do firms generally choose to finance temporary net operating working capital with short-term debt? a. Matching the maturities of assets and liabilities reduces risk. b. Short-term interest rates have traditionally been more stable than long-term interest rates. c. 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. d. The yield curve has traditionally been downward sloping.

147. Company X bought 1 million widgets from Company Y at the price of $5 per widget. Company X has 6 months to pay for the order. Company X then wrote a term draft on this purchase, which was “accepted” by Bank Z as a bankers’ acceptance. Which of the following parties is the ultimate guarantor for payments on this bankers’ acceptance? a. Company X b. Company Y c. Bank Z d. The Government of Canada 148. Which of the following statements on short-term financing is true? a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. b. Accruals are free in the sense that no explicit interest is paid on these funds. c. An aggressive approach to working capital will result in all permanent assets being financed with longterm capital. d. The risk to the firm of borrowing with short-term credit is usually lower than with long-term debt.

149. A large, well-established, highly rated firm needs to borrow money for the next 3 months. How would it likely get the best interest rate? a. by issuing commercial paper b. by obtaining a loan secured by its inventory c. by factoring its receivables d. by obtaining a discounted loan

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Chap 17_4ce 150. Cyree Inc. has annual sales of $80,000,000, its cost of goods sold is 80% of sales, its average inventory is $20,000,000, and its average accounts receivable is $16,000,000. The firm buys all raw materials on terms of net 35 days, and it pays on time. The firm is searching for ways to shorten the cash conversion cycle. If sales can be maintained at existing levels while lowering average inventory by $4,000,000 and average accounts receivable by $2,000,000, by how many days would the cash conversion cycle be changed? Use a 365-day year. a. 27.4 b. 28.7 c. 30.2 d. 31.9 151. Which of the following is an unsecured promissory note issued by large firms and sold primarily to institutional investors? a. line of credit b. bankers’ acceptance c. commercial paper d. corporate bond 152. What activities are covered under a company’s operating current assets financing policy? a. capital structure planning b. net operating working capital budgeting c. permanent and temporary current asset financing d. fixed asset financing 153. Incredible Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps to a relaxed policy. The firm’s annual sales are $3,600,000, its fixed assets turnover is 4.0, its target capital structure calls for 50% debt and 50% equity, its EBIT is $150,000, the interest rate on its debt is 10%, and its tax rate is 40%. Under the restricted policy, total assets turnover will be 2.5, whilst the total assets turnover under a relaxed policy will be 2.2. 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 is the difference between the projected ROEs under the restricted and relaxed policies? a. 2.24% b. 1.50% c. 1.00% d. 0.50%

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Chap 17_4ce 154. Which statement best describes working capital financing policy? a. Net working capital may be defined as current assets minus current liabilities, and an increase in the current ratio automatically indicates that net working capital has increased. b. 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 strategy because of the inherent risks of using shortterm financing. c. By minimizing financing of working capital, a company will maximize its free cash flows. d. If a company follows a policy of “matching maturities,” this means that it matches its use of common shares with its use of long-term debt as opposed to short-term debt.

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Chap 17_4ce Answer Key 1. True 2. False 3. True 4. False 5. False 6. False 7. True 8. False 9. True 10. False 11. True 12. True 13. True 14. True 15. True 16. False 17. False 18. True 19. True 20. True 21. True 22. True 23. False 24. False 25. False 26. True

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Chap 17_4ce 27. False 28. True 29. True 30. False 31. False 32. False 33. False 34. True 35. False 36. True 37. False 38. True 39. True 40. False 41. False 42. False 43. True 44. False 45. True 46. True 47. False 48. False 49. True 50. True 51. False 52. True 53. False 54. True Copyright Cengage Learning. Powered by Cognero.

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Chap 17_4ce 55. True 56. True 57. False 58. True 59. False 60. True 61. True 62. False 63. False 64. False 65. False 66. True 67. True 68. False 69. False 70. True 71. False 72. False 73. True 74. True 75. a 76. c 77. a 78. b 79. b 80. b 81. d 82. b Copyright Cengage Learning. Powered by Cognero.

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Chap 17_4ce 83. b 84. d 85. a 86. c 87. b 88. c 89. d 90. b 91. c 92. c 93. c 94. c 95. a 96. a 97. d 98. d 99. a 100. d 101. d 102. a 103. a 104. b 105. d 106. b 107. a 108. b 109. d 110. b Copyright Cengage Learning. Powered by Cognero.

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Chap 17_4ce 111. a 112. c 113. b 114. b 115. c 116. d 117. b 118. c 119. a 120. d 121. d 122. d 123. a 124. c 125. d 126. b 127. b 128. c 129. d 130. b 131. d 132. b 133. a 134. d 135. a 136. d 137. a

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Chap 17_4ce 138. b 139. b 140. a 141. d 142. b 143. b 144. b 145. d 146. a 147. c 148. b 149. a 150. d 151. c 152. c 153. a 154. b

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Chap 18_4ce Indicate whether the statement is true or false.

1. The aging schedule is a commonly used method for monitoring receivables. a. True b. False 2. Marketable securities are liquid assets. Holding too low an amount of these liquid assets may adversely affect a firm’s creditworthiness and lower its credit rating, resulting in higher future costs for securing both short- and long-term funds. a. True b. False 3. Although firms do not segregate funds for various motives of holding cash, they do consider them in setting their overall cash positions. a. True b. False 4. The four major elements in a firm’s credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy. a. True b. False 5. Holding marketable securities is better than holding cash because marketable securities have similar liquidity but higher returns than cash. a. True b. False 6. Net operating working capital, defined as current assets minus current liabilities, is also equal to the current ratio. a. True b. False 7. The loosening of credit policy will cause changes in the income statement (i.e., increasing in sales) but will have no effect on the balance sheet. a. True b. False 8. A company with higher working capital has a lower operating risk than a comparable company with lower working capital. a. True b. False 9. 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 Copyright Cengage Learning. Powered by Cognero.

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Chap 18_4ce 10. A lockbox plan is one method of speeding up the cheque-clearing process for customer payments, and as such, it decreases the firm’s net positive float position. a. True b. False 11. The EOQ model minimizes total inventory costs. a. True b. False 12. For a non-growth firm, it is possible to increase the percentage of sales that are made on credit sales 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 13. Synchronization of cash flows is an important cash management technique, as it can reduce the required cash balance and increase a firm’s profitability. a. True b. False 14. The goal of inventory management is to have sufficient inventories to satisfy demand while minimizing ordering and carrying costs. a. True b. False 15. A looser credit policy should increase sales and lower collection costs while possibly increasing other costs such as bad debts. a. True b. False 16. 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 17. The credit period is the amount of time it takes to do a credit search on a potential customer. a. True b. False 18. A firm that makes 90% of its sales on credit and 10% for cash is currently growing at a stable, steady rate of 10% annually. This firm’s accounts receivable can be kept at their current level, since the 10% cash sales can be used to support the 10% growth rate. a. True b. False

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Chap 18_4ce 19. If sales are seasonal, the DSO will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged. a. True b. False 20. Two methods for improving the collection process are the use of a lockbox system and moving funds by electronic transfer. a. True b. False 21. Holding working capital is costly and therefore companies should try to get working capital down as close to zero as possible. a. True b. False 22. If a firm loosened its credit policy from 1/10, net 20 to 2/10, net 30, the increase in sales would cause higher inventories and receivables, and therefore higher liabilities and/or equity. a. True b. False 23. Cash balances vary widely both among industries and among firms, depending upon specific conditions and on the owners’ and financial managers’ aversion to risk. a. True b. False 24. Constant demand, constant carrying costs, and constant ordering costs are the three key assumptions of the EOQ model. a. True b. False 25. Collections float tends to offset disbursement float. If a firm’s average collections float exceeds its average disbursement float, then it is said to be operating with positive net float. a. True b. False 26. A firm on average collects cheques totalling $250,000 per day. It takes the firm approximately 4 days to convert the cheques into usable cash. Assume (1) a lockbox system could be employed that would reduce the cash conversion procedure to 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 only $25,000 annually. a. True b. False 27. Depreciation and obsolescence are inventory carrying costs. a. True b. False

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Chap 18_4ce 28. Cash is considered a nonearning asset and cash holdings must be financed at some cost with debt and/or equity. a. True b. False 29. If a company increases its safety stock, then its average inventory will go up. a. True b. False 30. If a firm’s terms are 2/10, net 30 days, and its DSO is 28 days, we can be certain that the credit department is functioning efficiently and that the percentage of past due accounts is minimal. a. True b. False 31. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly. a. True b. False 32. Changes in a firm’s collection policy can affect sales, working capital, and even additional funds needed. a. True b. False 33. The target cash balance should be set so that it need not be adjusted for either seasonal patterns or unanticipated fluctuations, although it should be adjusted to reflect long-term changes in the firm’s operations. a. True b. False 34. The addition of a safety stock to the EOQ model increases the EOQ proportionately. a. True b. False 35. The general operating goal of a cash manager is to maximize profits at all costs. a. True b. False 36. 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 37. Credit standards refer to the financial importance of a potential customer to the firm in order to qualify for credit. a. True b. False

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Chap 18_4ce 38. A firm’s collection policy—that is, 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 39. A JIT system is designed to stretch accounts payable as long as possible. a. True b. False 40. Two methods for easing a firm’s credit policy are to shorten the credit period and to relax the credit standards. a. True b. False 41. 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 42. Since a tighter collection policy is very likely to reduce sales, such a change in policy should not be considered. a. True b. False 43. Inventory management is largely self-contained in the sense that very little coordination among the sales, purchasing, and production personnel is required for successful inventory management. a. True b. False 44. Outsourcing is a practice of selling a significant percentage of intermediate components to outside suppliers from the in-house productions. a. True b. False 45. If your firm’s DSO and/or aging schedule deteriorates from the first quarter of the year to the second quarter, this is proof positive that your firm’s credit policy has weakened. a. True b. False 46. If a firm’s sales and those of its customers are closely correlated with economic conditions, it is possible for the firm’s total investment in accounts receivable to decline while its DSO increases. a. True b. False

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Chap 18_4ce 47. When sales rise, inventory as a percentage of sales will also increase, even with a computerized inventory control. a. True b. False 48. 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 49. Marketable securities aim for long-term investments, but firms may temporarily hold them to convert into cash quickly. a. True b. False 50. Because money has time value, cash sales are always more profitable than credit sales. a. True b. False 51. The global clearing system for retail payments is called the Automated Clearing Settlement System (ACSS). a. True b. False 52. The principal goal of most inventory management systems is to balance the costs of ordering, shipping, and receiving goods against the cost of carrying those goods, while simultaneously meeting the firm’s policy with respect to avoiding running short of stock and thus disrupting production schedules or losing sales. a. True b. False 53. You receive some goods on April 1 with the following terms: 3/20, net 30, June 1 dating. This means that you will receive a 3% discount if the bill is paid on or before June 20 and also that the full amount must be paid 30 days after receipt of the goods. a. True b. False 54. The collection process is a fairly inexpensive component of doing business, although sometimes difficult to implement. a. True b. False 55. The addition of a safety stock to the EOQ model does not change the total inventory costs. a. True b. False

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Chap 18_4ce 56. A cash management system helps a firm to coordinate inflows and outflows of funds, arrange loans to cover shortfalls, and invest surpluses when applicable. a. True b. False 57. The just-in-time (JIT) system was developed to reduce inventories and improve economic efficiency. a. True b. False 58. The average collection period is calculated by dividing total sales by accounts receivable. It is an effective measure for internal use in monitoring a firm’s collections. a. True b. False 59. Providing much higher yields than operating assets, marketable securities are often held in sizable amounts. a. True b. False 60. 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. a. True b. False 61. A firm’s investment in accounts receivable is largely influenced by production process and the requirements imposed by competition. a. True b. False 62. Firms with many growth opportunities tend to hold low levels of marketable securities. a. True b. False 63. If a firm has a large percentage of accounts receivable over 30 days old, this is solid proof that its receivables manager is not doing a good job. a. True b. False 64. Compensating balances are maximum balance deposits required by banks to offset the costs of providing banking services to companies. a. True b. False

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Chap 18_4ce Indicate the answer choice that best completes the statement or answers the question.

Canuck Ltd. Assume that Canuck Ltd. has sales of 5,000 tonnes per year. Further, assume that Canuck can order the material at a cost of $16 per order, plus fixed ordering costs of $7.50 per order. The firm’s carrying cost is 15% of the inventory value, at cost.

65. Refer to Scenario: Canuck Ltd. What is Canuck’s EOQ? a. 828 b. 168 c. 177 d. 430

66. What is the main expected impact from the easing of credit policy? a. lower interest expenses b. increased sales c. higher equity d. lower EBIT Aberwald Aberwald Corporation 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% of the purchase price. (Assume a 360-day year.)

67. Refer to Scenario: Aberwald. How many orders should Aberwald place during the year? a. 12 b. 25 c. 30 d. 40 68. Which statement best describes compensating balances? a. Compensating balance requirements apply only to businesses, not to individuals. b. Compensating balances are essentially costless to most firms, because those firms would normally have such funds on hand to meet transactions needs anyway. c. If the required compensating balance is larger than the transactions balance the firm would ordinarily hold, then the effective cost of any loan requiring such a balance is increased. d. Banks are prohibited from earning interest on the compensating balances they hold.

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Chap 18_4ce Aberwald Aberwald Corporation 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% of the purchase price. (Assume a 360-day year.)

69. Refer to Scenario: Aberwald. What is the economic ordering quantity for chips? a. 3,175 b. 6,243 c. 12,088 d. 13,675 70. Which of the following formulas is used to calculate the inventory level? a. sales × inventory turnover b. sales / inventory period c. cost of goods sold × inventory turnover d. cost of goods sold / inventory turnover 71. Crystal Clear Company purchases 50,000 litres of distilled water each year. Ordering costs are $100 per order, and the carrying cost, as a percentage of inventory value, is 80%. The purchase price to CCC is $0.50 per litre.

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 litre if CCC orders 10,000 litres at a time. Should CCC take the discount? a. No, the cost exceeds the benefit by $500. b. No, the cost exceeds the benefit by $1,000. c. Yes, the benefit exceeds the cost by $500. d. Yes, the benefit exceeds the cost by $1,120.

72. Which statement best describes receivables management? a. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant rate of 10% annually. This firm will be able to keep its accounts receivable at the current level, since the 10% cash sales can be used to support the 10% growth rate. b. 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). c. If a firm has a high percentage of accounts over 30 days old, this is a sure sign that the credit manager is not doing their job well. d. 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.

73. Which of the following is the delay in clearing a customer’s cheques through the banking system? a. mail float b. processing float c. availability float d. net float

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Chap 18_4ce 74. When a firm has a stated credit policy of “2/10, net 45,” what does the number “10” refer to? a. credit term b. credit standard c. cash discount d. credit period 75. Suppose you have $10,000 in your chequing account. You write a cheque for $2,000 and deposit $3,000. What is your disbursement float? a. $2,000 b. $3,000 c. $7,000 d. $8,000 76. Which of the following best describes one of the goals of cash management, given that it is referred to as a “nonearning” asset? a. to maximize the amount of cash necessary to conduct business b. to minimize the amount of cash necessary to conduct business c. to optimize the amount of cash needed to pay dividends d. to minimize the amount of cash necessary to pay interest expense BC Corp Assume that BC Corp has sales of 10,000 units per year. Further, assume that BC Corp can order the material at a cost of $3.50 per order, plus fixed ordering costs of $3.75 per order. The firm’s carrying cost is 50% of the inventory value, at cost.

77. Refer to Scenario: BC Corp. What is BC Corp’s EOQ? a. 207 b. 197 c. 1,197 d. 4,000 78. If easing a firm’s credit policy lengthens the collection period and results in a worsening of the aging schedule, then why might a firm take this action? a. to slow down an unsustainable growth in sales b. to meet competitive pressures c. to increase the payments deferral period d. to shorten the cash collection cycle 79. Seligstine Inc.’s DSO was 31 days in March, and 45 days in April. Which of the following is the most likely? a. Sales increased from March to April. b. Sales decreased from March to April. c. May’s quarterly uncollected balances schedule showed a higher percent of April’s sales as uncollected than March’s sales. d. Some receivables were at least 45 days old.

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Chap 18_4ce 80. The DSO and the aging schedule are two common methods for monitoring receivables. When are they misleading? a. when customers’ payments patterns are changing b. when sales fluctuate seasonally c. when some customers take the discount and others do not d. when sales are relatively constant, both seasonally and cyclically 81. Other things held constant, which circumstance will cause an increase in net operating working capital? a. Cash is used to buy marketable securities. b. A cash dividend is declared and paid. c. Merchandise is sold at a profit, but the sale is on credit. d. Missing inventory is written off against retained earnings.

82. Which of the following best describes the effect on liabilities and/or equity when sales are increased due to the relaxation of credit standards and collection policy? a. Liabilities and/or equity will increase due to increases in accounts receivable on the asset side. b. Liabilities and/or equity will decrease due to increases in accounts receivable on the asset side. c. Liabilities and/or equity will increase due to decreases in accounts receivable on the asset side. d. Liabilities and/or equity will decrease due to decreases in accounts receivable on the asset side.

Ontario Corp Assume that Ontario Corp has sales of 1,000 units per year. Further, assume that Ontario Corp can order the material at a cost of $0.50 per order, plus fixed ordering costs of $0.75 per order. The firm’s carrying cost is 3% of the inventory value, at cost.

83. Refer to Scenario: Ontario Corp. What is Ontario Corp.’s EOQ? a. 207 b. 197 c. 316 d. 410 Fashion Clothiers Assume that Fashion Clothiers Inc. uses 1,440,000 metres of material each year. Further, assume that Fashion can order the material at a cost of $2 per metre, plus fixed ordering costs of $100 per order. The firm’s carrying cost is 20% of the inventory value, at cost.

84. Refer to Scenario: Fashion Clothiers. Now, suppose the manufacturer offers a discount of 0.5% for orders of a least 40,000 metres. Should Fashion Clothiers 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 $13,573 if it takes the discount. d. No; it will lose $13,573 if it takes the discount.

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Chap 18_4ce 85. Fogel’s Pumps offers its customers credit terms of 2/10, net 30, while Larry’s Pumps offers terms of 2/10, net 45 days. The aging schedules for the two companies’ receivables are shown below: Fogel’s Age of Account(Days)

Value of Account

0–10 11–30 31–45 46–60 Over 60 Total receivables

$58,800 19,600 14,700 2,940 1,960 $98,000

Percentage of Total Value 60% 20 15 3 2 100%

Larry’s Value of Account $ 73,500 29,400 29,400 10,290 4,410 $147,000

Percentage of Total Value 50% 20 20 7 3 100%

Which company has the higher percentage of overdue accounts, and what is its percentage of overdue accounts? a. Larry’s: 50% overdue b. Larry’s: 40% overdue c. Fogel’s: 30% overdue d. Fogel’s: 20% overdue 86. Which statement best describes the cash position of a typical Canadian company? a. A large portion of its assets is held in the form of cash, defined as demand deposits and foreign currencies. b. A small portion of its assets is held in the form of cash, defined as demand deposits and currency. c. A small portion of its assets is held in the form of cash, defined as common stock. d. A small portion of its assets is held in the form of cash, defined as demand deposit bonds.

Aberwald Aberwald Corporation 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% of the purchase price. (Assume a 360-day year.)

87. Refer to Scenario: Aberwald. If the lead time for placing an order is 5 days, and Aberwald 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. 13,675 c. 12,250 d. 3,175

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Chap 18_4ce 88. London Inc. expects to have sales this year of $15 million under its current credit policy. The present terms are net 60; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, London Inc.’s cost of capital is 15%, and its variable costs total 60% of sales. The credit committee proposes to tighten the credit term to net 30. The consultants predict that sales would decrease by $500,000. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 3%. What are the incremental pre-tax profits from this proposal? a. $181,250 b. $206,500 c. $231,250 d. $256,250 89. Which of the following terms refers to extra inventory held to avoid shortages due to unexpected sales increases or shipping delays? a. extra inventory b. safety stock c. safety inventory d. excess stock 90. Which statement best describes cash management? a. A cash management system that minimizes collections float and maximizes disbursement float is better than one with higher collections float and lower disbursement float. b. A cash management system that maximizes collections float and minimizes disbursement float is better than one with lower collections float and higher disbursement float. c. The use of a lockbox is designed to minimize cash theft losses in retail stores. If the cost of the lockbox is less than theft losses saved, then the lockbox should be installed. d. Other things held constant, a firm will need an identical line of credit regardless of whether it must pay its bills by the 5th of each month or pay its bills due uniformly during the month.

91. Which of the following is an assumption in the economic ordering quantity (EOQ) model? a. Sales are distributed evenly throughout the year. b. Sales are made only on credit. c. Sales are final and no returns of goods are permitted. d. Sales are made at full price without any trade or cash discounts.

Canada Manu Assume that Canada Manu Inc. uses 2,000,000 tonnes of material each year. Further, assume that Canada Manu can order the material at a cost of $10 per tonne, plus fixed ordering costs of $100 per order. The firm’s carrying cost is 5% of the inventory value, at cost.

92. Refer to Scenario: Canada Corp. What is Canada Corp.’s EOQ? a. 28,285 b. 26,833 c. 30,040 d. 43,987

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Chap 18_4ce 93. Which one of the following has nothing to do with inventory management? a. EOQ b. JIT c. FIFO d. DSO BC Prints BC Prints expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, BC Prints’ cost of capital is 15%, and its variable costs total 60% of sales. Since BC Prints wants to improve its profitability, a proposal has been made to offer a 2% 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% 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%.

94. Refer to Scenario: BC Prints. What would be the incremental bad debt losses if the change were made? a. $250,000 b. $130,000 c. –$130,000 (bad debt losses would decline) d. –$250,000 (bad debt losses would decline) 95. Which of the following has to do with inventory management? a. economic ordering quantity b. in the nick of time c. few in, lots out d. red-line 96. Suppose a firm has seasonal sales and customers that all pay promptly at the end of 30 days. Which of the following statements is correct? a. DSO will be constant from month to month. b. The quarterly uncollected balances will be the same in each quarter. c. The level of accounts receivable will be constant from month to month. d. The ratio of accounts receivable to sales will vary from month to month.

97. What kind of uncertainties are associated with a change in credit policy? a. changes in collection policy b. changes in the number of customers taking cash discounts c. changes in credit standards d. changes in accounts payable policy

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Chap 18_4ce 98. Which of the following statements is correct? a. Collection policy is how a firm goes about collecting all customer accounts. b. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales. c. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased. d. Typically, a firm will turn over an account to a collection agency two months after the initial sale.

99. Marketable securities are a substitute for which of the following? a. cash balances b. long-term debt c. holding accounts payable d. investments in inventory 100. Carmakers such as Ford and GM used to fabricate radiators and axles as part of their manufacturing process.

These companies are now purchasing these intermediate products from external suppliers. What is this practice of external purchasing of key components of the manufacturing process called? a. cost-sharing b. outsourcing c. just-in-time (JIT) system d. optimization process 101. Bello Inc. had sales of $2,500,000 per year (all credit), and its DSO was 35 days. What was its average amount of accounts receivable outstanding, based on a 365-day year? a. $239,726 b. $251,712 c. $264,298 d. $277,513 102. Which items does a firm’s credit policy consist of? a. credit period, cash discounts, credit standards, receivables monitoring b. credit period, cash discounts, credit standards, collection policy c. credit period, cash discounts, receivables monitoring, collection policy d. cash discounts, credit standards, receivables monitoring, collection policy 103. Which firms benefit most from a lockbox plan? a. those with widely disbursed manufacturing facilities b. those that have a large marketable securities portfolio and cash to protect c. those that hold inventories at many different sites d. those that have customers who operate in many different parts of the country

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Chap 18_4ce 104. Which of the following is normally responsible for establishing a firm’s credit policy? a. chief executive officer (CEO) b. credit manager c. executive committee d. vice president of finance (VP Finance) 105. Which of the following is likely to be a proper investment for temporarily idle cash? a. Treasury bills b. shares in other Canadian companies c. recently issued long-term AAA corporate bonds d. credit default swaps Aberwald Aberwald Corporation 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% of the purchase price. (Assume a 360-day year.)

106. Refer to Scenario: Aberwald. If Aberwald holds a safety stock equal to a 30-day supply of chips, what is its average inventory level? a. 3,175 b. 12,088 c. 13,675 d. 15,750 107. Refer to Scenario: Aberwald. Assume that Aberwald holds a safety stock equal to a 30-day supply of chips.

What is the maximum amount of inventory that Aberwald will have on hand at any time, i.e., what will be the inventory level right after a delivery is made? a. 3,175 b. 6,243 c. 9,216 d. 13,675 108. Martell-Webb Inc. sells to customers all over Canada, and payment cheques come in to its headquarters in Toronto. 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 is considering a regional lockbox system to speed up collections, and it believes the lockboxes will reduce receivables by 20%. If the annual cost of the system is $15,000, what would the estimated pre-tax net annual savings be if the firm implements the lockbox system? a. $500,000 b. $60,000 c. $55,000 d. $40,000

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Chap 18_4ce 109. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ. a. If the fixed per order cost increases by 20%, then EOQ will increase by 20%. b. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%. c. If the average inventory increases by 20%, then the total carrying costs will increase by 20%. d. If the average inventory increases by 20% the total order costs will increase by 20%.

110. Which statement best describes float? a. A lack of synchronization of cash inflows and outflows will result in larger cash balances than would be necessary with better synchronization, but the cash balances can be reduced by increasing disbursement float and decreasing collections float. b. The size of a firm’s net float is primarily a function of its natural cash flow synchronization and how it clears its cheques. c. Lockbox systems are used both for security purposes and to decrease the firm’s net float. d. If a firm speeds up its collections and slows down its disbursements, this will reduce its net float.

111. If XYZ Company changes from “3/10, net 45” to “2/10, net 30,” what has happened to its credit policy? a. it has tightened b. it has eased c. it has lengthened d. it has been optimized 112. What type of balances allows a firm to take advantage of bargain purchases and growth opportunities? a. transactional balances b. speculative balances c. marketable balances d. compensating balances 113. Which circumstance is consistent with efficient inventory management? a. a low inventory turnover ratio b. a low incidence of production schedule disruptions c. a low total assets turnover d. a high payable turnover ratio 114. Suppose you have $10,000 in your chequing account. You write a cheque for $2,000 and deposit $3,000. What is your collection float? a. –$2,000 b. –$3,000 c. –$7,000 d. –$8,000

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Chap 18_4ce BC Prints BC Prints expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, BC Prints’ cost of capital is 15%, and its variable costs total 60% of sales. Since BC Prints wants to improve its profitability, a proposal has been made to offer a 2% 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% 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%.

115. Refer to Scenario: BC Prints. What would be the incremental cost of carrying receivables if the change were made? Assume 360 days in a year. a. –$108,750 (carrying costs would decline) b. –$225,000 (carrying costs would decline) c. $116,250 d. $157,900 116. Which of the following terms is defined as the manufacturing practice of minimizing inventories by coordinating closely with suppliers who are located nearby and who can deliver quality parts within a few hours? a. cost-sharing b. outsourcing c. just-in-time (JIT) system d. optimization process Fashion Clothiers Assume that Fashion Clothiers Inc. uses 1,440,000 metres of material each year. Further, assume that Fashion can order the material at a cost of $2 per metre, plus fixed ordering costs of $100 per order. The firm’s carrying cost is 20% of the inventory value, at cost.

117. Refer to Scenario: Fashion Clothiers. What is the firm’s EOQ? a. 13,563 b. 26,833 c. 30,040 d. 43,987 118. Which statement best describes DSO and aging? a. If a firm’s volume of credit sales declines, then its DSO must also decline. b. If a firm changes its credit terms from 1/20, net 40, to 2/10, net 60, the impact on sales can’t be determined because the increase in the discount is offset by the longer net terms, which tends to reduce sales. c. The DSO of a firm with seasonal sales can vary. While the sales per day calculation is usually based on the total annual sales, the accounts receivable balance will be high or low depending on the season. d. An aging schedule is used to determine what portion of customers pay cash and what portion buy on credit.

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Chap 18_4ce 119. Which statement best describes cash balances? a. Most firms’ cash balances consist of transactions and compensating and precautionary balances. The total desired cash balance can be determined by calculating the amount needed for each purpose and then summing them. b. 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. c. For some firms, holding highly liquid marketable securities is a substitute for holding cash, because the marketable securities accomplish the same objective as cash. d. All companies hold the same percentage of funds for transaction balances.

120. Which statement best describes DSO? a. Other things held constant, the higher a firm’s DSO, the better its credit department. b. 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. c. If a firm sells on terms of 2/10, net 30, and its DSO is 30 days, then its aging schedule would probably show some past due accounts. d. DSO indicates the maximum number of days it takes a firm’s customers to pay their bills.

Canada Corp Assume that Canada Corp has sales of 5,000,000 gallons per year. Further, assume that Canada Corp can order the material at a cost of $160 per order, plus fixed ordering costs of $75 per order. The firm’s carrying cost is 25% of the inventory value, at cost.

121. Refer to Scenario: Canada Corp. What is Canada Corp’s EOQ? a. 8,285 b. 6,833 c. 30,040 d. 4,330 122. Suppose you have $10,000 in your chequing account. You write a cheque for $2,000 and deposit $3,000. What is your net float? a. $5,000 b. $1,000 c. –$1,000 d. –$5,000 123. What is the purpose of a lockbox plan? a. It is used for safekeeping cash and marketable securities. b. It is used to identify inventory safety stocks. c. It is used to slow down the collection of cheques a firm writes. d. It is used to speed up the collection of cheques received.

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Chap 18_4ce 124. Which of the following is an adverse effect from an easing of credit policy? a. higher income taxes b. lower accounts payable c. higher bad debts d. lower inventory Fashion Clothiers Assume that Fashion Clothiers Inc. uses 1,440,000 metres of material each year. Further, assume that Fashion can order the material at a cost of $2 per metre, plus fixed ordering costs of $100 per order. The firm’s carrying cost is 20% of the inventory value, at cost.

125. Refer to Scenario: Fashion Clothiers. What is Fashion Clothiers’ minimum costs of ordering and holding inventory? a. $ 6,254 b. $10,733 c. $11,560 d. $13,563 126. Which of the following best describes the float maintained by firms? a. Float refers to the difference between the firm’s available or collected balance at its bank and the firm’s net income statement. b. Float refers to the difference between the firm’s available or collected balance at its bank and the firm’s balance sheet. c. Float refers to the difference between the firm’s available or collected balance at its bank and the firm’s book, or ledger, balance d. Float refers to the difference between the firm’s available or collected accounts receivable balance at its bank and the firm’s book, or ledger, balance.

Aberwald Aberwald Corporation 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% of the purchase price. (Assume a 360-day year.)

127. Refer to Scenario: Aberwald. If Aberwald holds a safety stock equal to a 30-day supply of chips, what is Aberwald’s minimum cost of ordering and carrying inventory? a. $15,950 b. $28,500 c. $34,220 d. $68,440

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Chap 18_4ce BC Prints BC Prints expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, BC Prints’ cost of capital is 15%, and its variable costs total 60% of sales. Since BC Prints wants to improve its profitability, a proposal has been made to offer a 2% 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% 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%.

128. Refer to Scenario: BC Prints. What would be the cost to BC Prints of the discounts taken? a. –$108,750 b. $116,750 c. $155,000 d. $225,000 Canada Manu Assume that Canada Manu Inc. uses 2,000,000 tonnes of material each year. Further, assume that Canada Manu can order the material at a cost of $10 per tonne, plus fixed ordering costs of $100 per order. The firm’s carrying cost is 5% of the inventory value, at cost.

129. Refer to Scenario: Canada Manu. What is Canada Manu’s total inventory costs at its EOQ? a. $7,071 b. $14,142 c. $21,213 d. $28,285 130. An increase in which variable will cause the economic ordering quantity to rise? a. product demand (sales) b. current level of inventory c. purchase price d. carrying cost 131. London Inc. expects to have sales this year of $15 million under its current credit policy. The present terms are net 60; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, London Inc.’s cost of capital is 15%, and its variable costs total 60% of sales. The credit committee proposes to tighten the credit term to net 30. The consultants predict that sales would decrease by $500,000. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 3%. What would be the incremental cost of carrying receivables if this change were made? Assume 360 days in a year. a. $157,900 b. $108,750 c. –$116,250 (carrying costs would decline) d. –$225,000 (carrying costs would decline)

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Chap 18_4ce 132. London Inc. expects to have sales this year of $15 million under its current credit policy. The present terms are net 60; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, London Inc.’s cost of capital is 15%, and its variable costs total 60% of sales. The credit committee proposes to tighten the credit term to net 30. The consultants predict that sales would decrease by $500,000. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 3%. What would be the incremental bad debt 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) 133. Which statement best describes cash management? a. A good cash management system minimizes disbursement float and maximizes collections float. b. If a firm begins to use a well-designed lockbox system, this will reduce its customers’ net float. c. If Firm A can get its suppliers to permit it to pay by wire transfers rather than sending cheques through the mail, this would increase Firm A’s net float and thus reduce its investment in cash. d. A highly efficient cash management system can enable a firm to always have a positive net float and a negative chequebook balance, and still not have its cheques bounce.

134. What type of company would typically have higher levels of marketable securities as short-term investments? a. large mature companies b. companies with stable cash flows c. companies with few growth opportunities d. companies with volatile cash flows 135. Fullerton Wine Company is a retailer that sells vintage wines. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered Fullerton’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? Assume 360 days in a year.

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. d. Total costs under the current policy exceed those under the EOQ by $10.

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Chap 18_4ce 136. One benefit of a lockbox arrangement is as a way to speed up which of the following? a. payments to suppliers b. collection of payments from customers c. collection of DRIP payments from investors d. collection of payments from customers and payments to suppliers 137. Wintoki Company writes cheques averaging $15,000 a day, and it takes 5 days for these cheques to clear. The firm also receives cheques in the amount of $17,000 per day, and it takes 3 days for these cheques to be deposited and cleared. What is the firm’s net float, in dollars? a. $20,577 b. $21,660 c. $22,800 d. $24,000 138. Which circumstance would cause average inventory holdings to decrease, other things held constant? a. Fixed order costs double. b. The purchase price of inventory items decreases by 50%. c. The carrying price of an item decreases as a percentage of purchase price. d. The sales forecast is revised downward by 10%.

139. Which of the following best describes the two key drivers in a just-in-time inventory system? a. The just-in-time inventory control requires firms to maintain little to no inventory; however, it requires total quality management in all areas of operations. b. The just-in-time inventory control requires firms to maintain large amounts of inventory; however, it requires total quality management in all areas of operations. c. The just-in-time inventory control requires firms to maintain little to no inventory because it requires virtually no total quality management in all areas of operations. d. The just-in-time inventory control requires firms to maintain little to no inventory and large accounts payable.

140. Which of the following correctly describes the relationship between EOQ and sales? a. Each unit increase in sales will increase EOQ by one unit. b. Each unit increase in sales will increase EOQ by half a unit. c. EOQ increases with the square root of sales. d. EOQ decreases with the square root of sales.

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Chap 18_4ce BC Prints BC Prints expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the DSO is 60 days; and the bad debt loss percentage is 5%. Also, BC Prints’ cost of capital is 15%, and its variable costs total 60% of sales. Since BC Prints wants to improve its profitability, a proposal has been made to offer a 2% 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% 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%.

141. Refer to Scenario: BC Prints. What are the incremental pre-tax profits from this proposal? a. $250,500 b. $283,750 c. $303,250 d. $493,750 142. Which of the following is commonly regarded as a credit policy variable? a. seller’s credit ratings b. aging schedule c. cash discounts d. payments deferral period 143. Which situation is likely to lead a firm to hold marketable securities? a. The firm has replaced an obsolete machine with a new model; a large write-off must be taken on the old machine. b. The firm must meet a known financial commitment, such as financing an ongoing construction project. c. The firm must finance the acquisition of another company. d. The firm has just awarded employee stock options.

144. Suppose the Campus Bookstore purchases 50,000 boxes of writing tablets 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 tablets 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 b. $1,000 benefit c. $ 500 loss d. $ 500 benefit

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Chap 18_4ce 145. Which describes the variables that determined the average accounts receivable balance? a. The average accounts receivable balance is determined jointly by the volume of credit sales, and the accounts payable days outstanding. b. The average accounts receivable balance is determined jointly by the volume of credit sales, and the days’ sales outstanding. c. The average sales balance is determined jointly by the volume of credit sales, and the days’ sales outstanding. d. The average inventory balance is determined jointly by the volume of credit sales and the days’ sales outstanding.

146. Which of the following statements is correct? a. 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. b. It is possible for a firm to overstate profits by offering very lenient credit terms that encourage additional sales to financially weak firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts. 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 1, the customer can take the discount up until March 15, but must pay the net invoice amount by April 1.

147. Which of the following best describes why firms hold cash balances? a. Firms hold cash balances in order to complete transactions that are necessary in business operations and as compensation to banks for providing loans and services. b. Firms hold cash balances in order to pay dividends and repay long-term debt. c. Firms hold cash balances in order to complete transactions that are necessary in business operations. d. Firms hold cash balances solely as compensation to banks for providing loans and services.

148. If the yield curve is upward sloping, then which type of marketable securities, assumed to be held for emergencies, should be held in a firm’s portfolio? a. Mainly long-term securities, because those pay higher rates. b. Mainly short-term securities, because those pay higher rates. c. Mainly government securities, to minimize interest rate risk. d. Mainly short-term securities, to minimize interest rate risk.

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Chap 18_4ce Answer Key 1. True 2. True 3. True 4. True 5. True 6. False 7. False 8. True 9. True 10. False 11. True 12. True 13. True 14. True 15. True 16. False 17. False 18. False 19. True 20. True 21. False 22. True 23. True 24. True 25. False 26. False

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Chap 18_4ce 27. True 28. True 29. True 30. False 31. True 32. True 33. False 34. False 35. False 36. True 37. False 38. True 39. False 40. False 41. False 42. False 43. False 44. False 45. False 46. True 47. False 48. False 49. False 50. False 51. False 52. True 53. False 54. False Copyright Cengage Learning. Powered by Cognero.

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Chap 18_4ce 55. False 56. True 57. True 58. False 59. False 60. False 61. False 62. False 63. False 64. False 65. c 66. b 67. d 68. c 69. a 70. d 71. d 72. b 73. c 74. d 75. a 76. b 77. a 78. b 79. d 80. b 81. c 82. a Copyright Cengage Learning. Powered by Cognero.

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Chap 18_4ce 83. c 84. c 85. d 86. b 87. c 88. c 89. b 90. a 91. a 92. a 93. d 94. c 95. a 96. d 97. b 98. b 99. a 100. b 101. a 102. b 103. d 104. c 105. a 106. b 107. d 108. d 109. c 110. a Copyright Cengage Learning. Powered by Cognero.

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Chap 18_4ce 111. a 112. b 113. b 114. b 115. a 116. c 117. b 118. c 119. c 120. c 121. d 122. c 123. d 124. c 125. b 126. c 127. d 128. c 129. b 130. a 131. c 132. d 133. d 134. d 135. c 136. b 137. d

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Chap 18_4ce 138. d 139. a 140. c 141. b 142. c 143. b 144. d 145. b 146. b 147. a 148. d

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Chap 19_4ce Indicate whether the statement is true or false.

1. 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 2. 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 3. If the market is in equilibrium, then a call option contract 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 4. All else being equal, a put option with a longer time to maturity will have a higher price than one with a shorter time to maturity. a. True b. False 5. 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 6. Shareholders of a company can be thought of as owners of call options on the residual value of the company after all debts are accounted for. a. True b. False 7. The difference between a call option’s price and its time value is its exercise value. a. True b. False 8. The option to abandon a project is an example of a real option available to financial managers. a. True b. False 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

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Chap 19_4ce 10. In a single-period binomial model, it is assumed that there are only two possible states of the world at the end of the period of concern. a. True b. False 11. 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 12. Managers in companies that do not issue employee options as part of their compensation packages need not be concerned with option pricing techniques. a. True b. False 13. 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 increased. a. True b. False 14. A person who buys a put option on XYZ common stock has the right to sell XYZ shares at a specified price on or before a specified date. a. True b. False 15. A hedge portfolio is a portfolio that is exposed only to upside potential and that has no downside risk. a. True b. False 16. When the underlying stock price exceeds a call option’s exercise price, the option’s price will move toward its exercise value. a. True b. False 17. 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

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Chap 19_4ce Indicate the answer choice that best completes the statement or answers the question.

18. Which of the following statements is correct? a. Put options give investors the right to buy a stock at a certain strike price before a specified date. b. Call options give investors the right to sell a stock at a certain strike price before a specified date. c. LEAPS are very short-term options that were created relatively recently and now trade in the market. d. An American call option writer has agreed to sell the underlying security to the call option buyer at a specified price on or before a specified date.

19. The current price of a stock is $22, and at the end of 1 year its price will be either $27 or $17. The annual riskfree rate is 6%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option’s value? a. $2.43 b. $2.70 c. $2.99 d. $3.29 20. Call options on XYZ Corporation’s common stock trade in the market. Which statement regarding XYZ Corporation’s options is true, other things held constant? a. The price of these call options is likely to rise if XYZ’s stock price rises. b. The higher the strike price on XYZ’s options, the higher the option’s price will be. c. Assuming the same strike price, an XYZ call option that expires in 1 month will sell at a higher price than one that expires in 3 months. d. If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase.

21. Which of the following statements is correct? a. Call options generally sell at a price less than their exercise value. b. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. c. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, 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.

22. Which term refers to an option that gives the holder the right to sell a stock at a specified price at some future time? a. a call option b. a put option c. a naked option d. a covered option

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Chap 19_4ce 23. Suppose you believe that Delva Corporation’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva’s stock price actually rises to $100, what would be your pre-tax net profit? a. –$510.25 b. –$2,010.25 c. $2,010.25 d. $2,193.70 24. Suppose you believe that Delva Corporation’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva’s stock price actually drops to $60, what would be your pre-tax net profit? a. –$510.25 b. $1,989.75 c. $2,089.24 d. $2,193.70 25. Suppose you believe that Johnson Company’s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call option giving you the right to buy 100 shares at a price of $25 per share. If you buy this option for $310.25 and Johnson’s stock price actually rises to $45, what would your pre-tax net profit be? a. –$310.25 b. $1,689.75 c. $1,774.24 d. $1,862.95 26. Which of the following best describes the strike price on an option contract? a. The strike price is the price that must be paid for a common share when it is bought by exercising a conversion warrant. b. The strike price is the price that must be paid for an option contract when it is bought or sold. c. The strike price is the price that must be paid for a common share when it is bought by exercising a right. d. The strike price is the price that must be paid for a common share when it is bought by exercising the option.

27. Which term refers to an option that gives the holder the right to buy a stock at a specified price at some future time? a. a call option b. a put option c. a naked option d. a covered option

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Chap 19_4ce 28. Which of the following statements is correct? a. American call options always sell at a price greater than or equal to their exercise value. b. 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. c. 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. d. 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.

29. Suppose you believe that Smithson Inc.’s stock price is going to increase from its current level of $50 sometime during the next 5 months. For $410.25 you can buy a 5-month call option giving you the right to buy 100 shares at a price of $55 per share. If you buy this option for $410.25 and Smithson’s stock price actually drops to $45, what would your pre-tax net profit be? a. –$410.25 b. –$1,410.25 c. $1,410.25 d. $1,862.95 30. The current price of a stock is $75, the annual risk-free rate is 7%, and a 1-year call option with a strike price of $95 sells for $15. What is the value of a put option, assuming the same strike price and expiration date as for the call option? a. $13.71 b. $28.58 c. $38.55 d. $29.00 31. Which of the following best describes an option contract in principle? a. An option is a contract that gives its holder the obligation to buy or sell an asset at a predetermined price within a specified period of time. b. An option is a contract that gives its seller the right to buy or sell an asset at a predetermined price within a specified period of time. c. 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. d. An option is a contract that gives its writer the right to buy or sell an asset at a predetermined price within a specified period of time.

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Chap 19_4ce 32. Which of the following statements best describes options? a. An option’s value is determined by its exercise value, which is the market price of the stock less its strike price. Thus, an option can’t sell for more than its exercise value. b. 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. 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.

33. Which of the following does NOT affect the value of an option, other things held constant? a. the strike price b. the variability of the stock price c. the option’s time to maturity d. the stock’s beta 34. Deeble Construction Co.’s 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 3 months. Which statement regarding the value of these options is true? 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 Deeble’s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.

35. GCC Corporation is planning to issue options to its key employees, and it is now discussing the terms to be set on those options. Which circumstance would decrease the value of the options, other things held constant? a. GCC’s stock price becomes more risky (higher variance) b. the exercise price of the option is increased c. the life of the option is increased (i.e., the time until it expires is lengthened) d. the government takes actions that increase the risk-free rate 36. The current price of a stock is $25, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $35 sells for $5.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option? a. $13.16 b. $18.12 c. $18.55 d. $19.00

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Chap 19_4ce 37. An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. 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. What is the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 38. 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. $7.71 b. $8.12 c. $8.55 d. $9.00 39. Which term refers to the type of options sold by an investor who writes standard call options against stock held in their portfolio? a. in-the-money b. naked c. covered d. out-of-the-money 40. Warner Motors’ stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. What will happen if the stock price increases 10%, to $22 a share? a. The price of the call option will increase by $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%.

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Chap 19_4ce 41. Which of the following best describes the exercise value of a call option? a. The exercise value of a call option is the positive difference between the current price of the stock and the strike price. The exercise value is zero if the stock’s price is below the strike price. b. The exercise value of a call option is the positive difference between the current price of the stock and the strike price. The exercise value is greater than zero if the stock’s price is below the strike price. c. The exercise value of a call option is the positive difference between the current price of the stock and the strike price. The exercise value is negative if the stock’s price is below the strike price. d. The exercise value of a call option is the positive difference between the current price of the stock and the option price. The exercise value is zero if the stock’s price is below the strike price.

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Chap 19_4ce Answer Key 1. False 2. False 3. False 4. False 5. False 6. True 7. False 8. True 9. False 10. True 11. False 12. False 13. True 14. True 15. False 16. True 17. False 18. d 19. c 20. a 21. c 22. b 23. a 24. b 25. b 26. d

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Chap 19_4ce 27. a 28. a 29. a 30. b 31. c 32. c 33. d 34. d 35. b 36. a 37. c 38. d 39. c 40. c 41. a

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Chap 20_4ce Indicate whether the statement is true or false.

1. A forward contract gives the buyer the obligation to buy a specified amount of a good at a specified price on a specified date. a. True b. False 2. Risk can be classified as pure risk or speculative risk, where the former has both positive and negative potential outcomes, and the latter has only negative potential outcomes. a. True b. False 3. The Framework for Enterprise Risk Management (ERM) promoted by the Committee of Sponsoring Organizations (COSO) stipulates that ERM be an ongoing process that is integral to a company’s operations. a. True b. False 4. Linear risks are risks that result in losses when prices are high and gains when prices are low. a. True b. False 5. One objective of risk management can be to reduce the volatility of a firm’s cash flows. a. True b. False 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 7. Nonfinancial companies use credit evaluation, factoring, and insurance as the three primary tools to manage their credit risk. a. True b. False 8. The seller of interest rate futures contracts must put up initial margins with the futures exchange, as well as keep the maintenance margin on the values on their margin accounts. a. True b. False 9. All corporate risk management decisions can be framed in terms of cost-benefit analysis on feasible outcomes. a. True b. False

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Chap 20_4ce 10. A common factor in the financial crises and scandals in the late 20th century and the 2000s was the lack of an adequate system to identify improper activities in both financial and nonfinancial companies. a. True b. False 11. In the performance component of the COSO framework for ERM, firms can either avoid, reduce, transfer, accept, or embrace risks, and the selected response will depend on each firm’s risk appetite. a. True b. False 12. When ABC Co. enters a foreign exchange forward contract with XYZ Co., each company is exposed to default by the other. This is an example of foreign exchange risk. a. True b. False 13. An option is a definite agreement leading to a firm completion of the transaction. a. True b. False 14. 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 15. Risk management, by increasing expected future cash flows and decreasing the WACC, will always benefit a company’s shareholders. a. True b. False 16. Credit default swaps (CDS) are used exclusively by financial institutions (e.g., banks) to manage their credit risk. a. True b. False 17. The Committee of Sponsoring Organizations (COSO) defines enterprise risk management (ERM) as any activity that will prevent losses to a company. a. True b. False

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Chap 20_4ce Indicate the answer choice that best completes the statement or answers the question.

18. A swap is a method used to reduce financial risk. Which statement about swaps is correct? a. A swap involves the exchange of cash payment obligations only on the expiration date of the contract. b. The earliest swaps were plain vanilla interest rate swaps in which companies traded debt denominated in different currencies, for example dollars and pounds. c. Swaps are very often arranged by a financial intermediary, which may or may not take the position of one of the counterparties. d. A problem with swaps is the short maturities, which has prevented the development of a secondary market.

19. Which of the following belongs to the control and compliance risk category for a corporation? a. The risk of being sued for defective products. b. The risk of a fire breaking out in a factory. c. The risk of down time due to issues with IT software updates. d. The risk of bad debts due to nonpayment of accounts receivable.

20. Which of the following describes a situation in which a company will decide to accept a specific risk? a. The company expects benefits from the risk event to be greater than its potential costs, and the risk is within the limits of the company’s risk appetite. b. The company has experience and expertise dealing with the same type of risk. c. The company can purchase derivatives in the secondary market to share the risk. d. The company can reduce the probability and/or level of adverse outcomes from the risk event.

21. Which of the following best describes counterparty risk? a. the risk that one party defaults on its counterparty risk b. the risk that one party defaults on its bond coupon payments c. the risk that one party defaults on its derivatives contract obligations d. there is no such thing as counterparty risk in derivatives markets 22. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which strategy would protect the bank against rising interest rates? a. buying credit default swaps b. 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 c. entering into a short hedge where the bank agrees to sell interest rate futures d. selling some of the bank’s floating-rate loans and using the proceeds to make fixed-rate loans 23. A credit default swap is structured similar to which of the following? a. a fixed rate mortgage b. a common stock investment c. a coupon bond d. an insurance contract

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Chap 20_4ce 24. Suppose the quoted price for a June 2008 10-year CGB futures contract has changed from 118.72 to 118.77.

What is the corresponding change in value in this futures contract? a. $70 b. $60 c. $50 d. $30 25. Which statement best describes forward and/or futures contracts? a. One advantage of forward contracts is that they are default free. b. Futures contracts generally trade on an organized exchange and are marked to market daily. c. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts. d. While futures contracts can be constructed to accommodate both parties, forward contracts are standardized.

26. Which of the following statements best describes a reason for companies to actively manage risks? a. Firms generally have lower transaction costs due to a larger volume of hedging activities. b. Nowadays most investors hold well-diversified portfolios. c. Firms can lower their cost of equity capital by hedging their business and financial risk. d. Firms can improve their free cash flows by hedging.

27. Which of the following best describes a natural hedge? a. a situation in which only farm products are hedged b. a situation in which total risk is reduced by a derivatives transaction between two parties c. a hedge on two strongly related currencies, such as the USD and the CAD d. a hedge transaction in which arbitrage profits are naturally occurring 28. Which of the following is correct regarding futures contracts? a. Futures contracts are marked-to-market on a daily basis. b. Futures contracts are marked-to-market on a monthly basis. c. Futures contracts are not marked-to-market. d. Futures contracts are marked-to-market semiannually.

29. Suppose the standard size of a copper futures contract is 25,000 pounds each. At initiation of a futures contract, the futures price is $22.50 per pound. At expiration of the futures contract, the copper price is $19.50 per pound.

Which of the following is true? a. The short (seller) side profits by $3 per pound. b. The long (purchaser) side profits by $3 per pound. c. Demand for copper has risen relative to its supply. d. The two parties split the profit.

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Chap 20_4ce 30. Which of the following best describes the regulatory requirement for Canadian companies whose shares are cross-listed on both Canadian and U.S. stock exchanges? a. They need only adhere to Canadian securities laws. b. They need only adhere to U.S. securities laws. c. They need to adhere to both Canadian and U.S. securities laws. d. They need to adhere to whichever country’s securities laws are more stringent.

31. Suppose the quoted price for a June 2032 10-year CGB futures contract is 118.35. The 6%, 10-year Government of Canada bonds make semiannual coupon payments. What is the implied annual yield on the futures contract? a. 1.89% b. 3.00% c. 3.78% d. 6.00% 32. Which of the following are 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 leverage. c. Risk management can help firms maximize taxes. d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

33. Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed-rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issues floatingrate 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. 34. Which of the following statements best describes the relationship between derivative types and linear vs. nonlinear risk? a. Futures contracts are ideal for use in managing linear risks due to their ability to produce symmetric hedges. b. Option contracts are ideal for use in managing linear risks due to their ability to produce symmetric hedges. c. Futures contracts are ideal for use in managing nonlinear risks due to their ability to produce symmetric hedges. d. Option contracts are ideal for use in managing nonlinear risks due to their ability to produce symmetric hedges.

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Chap 20_4ce Answer Key 1. True 2. False 3. True 4. False 5. True 6. False 7. True 8. False 9. False 10. True 11. True 12. False 13. False 14. False 15. False 16. False 17. False 18. c 19. a 20. a 21. c 22. c 23. d 24. c 25. b 26. a

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Chap 20_4ce 27. b 28. a 29. a 30. c 31. c 32. a 33. b 34. a

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Chap 21_4ce Indicate whether the statement is true or false.

1. Multinational corporations are companies with many independently operated subsidiaries in different countries. a. True b. False 2. The eurocurrency market is essentially a long-term market; most loans and deposits in this market have maturities longer than 1 year. a. True b. False 3. Canada and most other major industrialized nations currently operate under a system of floating exchange rates. a. True b. False 4. 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 5. 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 6. On average, foreign currency will depreciate against the Canadian dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of Canada. a. True b. False 7. Credit policy for international firms is generally riskier than for domestic firms, due in part to the additional consideration of exchange rates and also due to uncertainty regarding the creditworthiness of many foreign customers. a. True b. False 8. When the Canadian dollar appreciates against another country’s currency, we may purchase more of the foreign currency with a dollar. a. True b. False 9. Countries with higher inflation rates than Canada will tend to see their currencies appreciate against the Canadian dollar. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 21_4ce 10. If an investor can obtain more of a foreign currency for a dollar in the forward market than in the spot market, then the foreign currency is said to be selling at a discount to the spot rate. a. True b. False 11. One year ago, the Canadian dollar–Thai baht exchange rate was CAD0.0377. Today, the exchange rate is CAD0.0364. This tells us that the Canadian dollar has depreciated. a. True b. False 12. Two factors that affect demand for a country’s currency are its trade balance with other countries and capital movements in and out of the country. a. True b. False 13. In general, the times-interest-earned ratio for multinational corporations will be higher than in Canada. a. True b. False 14. LIBOR is an acronym for London Interbank Offer Rate, which is an average of interest rates offered by London banks to smaller North American corporations. a. True b. False 15. A Canadian exporter can enter into a forward exchange contract to reduce or eliminate the impact of potential exchange rate changes between the time the order is placed and when payment is received for the order. a. True b. False 16. 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 17. 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 18. Exchange rates influence a multinational firm’s inventory policy because changing currency values can affect the value of inventory. a. True b. False

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Chap 21_4ce 19. 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. a. True b. False 20. Because political risk is seldom negotiable, it cannot be explicitly addressed in international corporate financial analysis. a. True b. False 21. Central banks determine the premiums or discounts on forward exchange contracts traded in the market. a. True b. False 22. Canada and Brazil are countries with free market economies, i.e., economies with few restrictions on business activities. a. True b. False 23. The law of one price is sometimes referred to as the absolute purchasing power parity (PPP). a. True b. False 24. Exchange rate risk refers to the risk that 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 fluctuations. a. True b. False 25. If Canada 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 Canadian dollar. a. True b. False 26. Since 2011, foreign multinationals operating in Canada have provided greater employment gains in Canada than Canadian multinationals have done in foreign countries. a. True b. False 27. The interest rate paid on eurocurrency deposits depends on the particular bank’s lending rate and on rates available on its domestic money market instruments. a. True b. False 28. A eurocanadian deposit refers to Canadian dollars deposited in a bank outside Canada. a. True b. False Copyright Cengage Learning. Powered by Cognero.

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Chap 21_4ce 29. Due to the global standardization of accounting rules via the International Financial Reporting Standards (IFRS), it is now easy to compare capital structure ratios such as debt to total assets across different countries. a. True b. False 30. Exchange rate quotations consist solely of direct quotations. a. True b. False 31. Multinational corporations generally have different cash management goals relative to domestic corporations. a. True b. False 32. 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 33. In real life, there are frequently substantial transaction costs and import restrictions in trades between countries.

As such, purchasing power parity (PPP) should not be used for decision making by companies and investors. a. True b. False 34. When we receive a quote of U.S. dollar (USD) 0.77 per Canadian dollar (CAD), this is called a direct quotation. a. True b. False 35. 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 36. If a dollar will buy fewer units of a foreign currency in the forward market than in the spot market, then the foreign currency is said to be selling at a premium to the spot rate. a. True b. False

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Chap 21_4ce Indicate the answer choice that best completes the statement or answers the question.

37. Chen Transport, a Canadian company, is considering expanding its operations into a foreign country for 5 years.

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. Due to political risk factors, Chen 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. In addition, 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. Chen’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 c. $3.09 million d. $5.96 million 38. Suppose that currently 1 British pound equals 1.98 Canadian dollars and 1 Canadian dollar equals 1.04 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 2.0592 Swiss francs. c. 1 British pound equals 1.9037 Swiss francs. d. 1 British pound equals 1.0000 Swiss francs.

39. From an importer’s point of view, which of the following may result in a longer cash conversion cycle? a. longer shipping time b. shorter days’ sales outstanding c. higher shipping costs d. higher payables deferral period 40. Which of the following is one of the requirements of international financial management? a. that the effects of changing currency values be excluded in financial analyses b. that legal and economic differences be disregarded in financial decisions c. that markets be considered to be efficient d. that unique cultural heritages be respected in the conduct of business 41. Suppose 104 yen could be purchased in the foreign exchange market for one Canadian dollar today. If the yen depreciates by 8% tomorrow, how many yen could one Canadian dollar buy tomorrow? a. 123.5 yen b. 112.3 yen c. 104.0 yen d. 95.7 yen

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Chap 21_4ce 42. In Japan, 90-day securities have a 4% annualized return and 180-day securities have a 5% annualized return. In Canada, 90-day securities have a 4% annualized return and 180-day securities have a 4.5% annualized return.

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 statement about the exchange rate is true? a. The yen–dollar spot exchange rate equals the yen–dollar exchange rate in the 90-day forward market. b. The yen–dollar spot exchange rate equals the yen–dollar exchange rate in the 180-day forward market. c. The yen–dollar exchange rate in the 90-day forward market equals the yen–dollar exchange rate in the 180-day forward market. d. The yen–dollar exchange rate equals the dollar–yen exchange rate.

43. Which of the following is a model specifying the general relationship between spot and forward exchange rates? a. law of one price b. relative purchasing power parity c. interest rate parity d. Modigliani and Miller theorem 44. The current exchange rate between the Canadian dollar and the Chinese yuan is 5.25 yuan to 1 dollar. The inflation rates in Canada and China are 8% and 2.5%, respectively. According to the relative purchasing power parity, what should we expect to happen to the Canadian dollar? a. The Canadian dollar will appreciate against the Chinese yuan as the expected spot rate is greater than $0.19 per yuan. b. The Canadian dollar will depreciate against the Chinese yuan as the expected spot rate is greater than $0.19 per yuan. c. The Canadian dollar will appreciate against the Chinese yuan as the expected spot rate is lower than $0.19 per yuan. d. The Canadian dollar will depreciate against the Chinese yuan as the expected spot rate is lower than $0.19 per yuan.

45. Which of the following refers to a Canadian-dollar bond issued by foreign companies that is sold in Canada? a. Hockey bond b. Eurobond c. Maple bond d. Goose bond 46. Suppose one British pound can purchase 2.12 U.S. dollars today in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 22% against the pound over the next 30 days. How many dollars will a pound buy in 30 days? a. 2.59 b. 2.63 c. 1.74 d. 2.04

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Chap 21_4ce 47. Which of the following accounting issues may cause difficulties when interpreting corporate capital structure ratios such as total liabilities to total assets? a. treatment of operating income b. different income tax rates c. treatment of leased assets d. different cultures and languages 48. Multinational financial management requires that financial analysts consider the effects of changes in which of the following? a. currency values b. public policy values c. languages d. values of commodity prices 49. Suppose 6 months ago a British investor bought a 6-month Canadian Treasury bill at a price of $9,708.74, with a maturity value of $10,000. The exchange rate at that time was 1.9516 dollars per pound. Today, at maturity, the exchange rate is 2.0751 dollars per pound. What is the annualized rate of return to the British investor? a. –6.26% b. –3.13% c. 6.00% d. 8.25% 50. Suppose hockey skates sell in Canada for 105 Canadian dollars, and 1 Canadian dollar equals 0.9423 U.S. dollars. If absolute purchasing power parity (PPP) holds, what is the price of hockey skates in the United States? a. $63.00 b. $74.55 c. $85.88 d. $98.94 51. If the inflation rate in Canada is greater than the inflation rate in Britain, other things held constant, what will happen to the British pound? a. It will appreciate against the Canadian dollar. b. It will depreciate against the Canadian dollar. c. It will remain unchanged against the Canadian dollar. d. It will appreciate against other major currencies.

52. Which of the following best describes a transfer price in a scenario where ABC Corporation is the parent company of XYZ Company operating in another country? a. ABC adjusts its quarterly income statement for XYZ’s sales and expenses b. XYZ remits profits to ABC at its year-end c. ABC pays for raw materials purchased by XYZ d. XYZ pays for raw materials received from ABC

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Chap 21_4ce 53. 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 what is the forward rate for the Israeli shekel selling at? a. a premium of 8% to the spot rate b. a premium of 18% to the spot rate c. a discount of 18% to the spot rate d. a discount of 8% to the spot rate 54. Suppose DeGraw Corporation, a Canadian exporter, sold a solar heating station to a Japanese customer at a price of 106.0875 million yen, when the exchange rate was 103.5 yen per dollar. In order to close the sale, DeGraw 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 110.2 yen when the invoice was paid, what dollar amount would DeGraw actually receive after it exchanged yen for Canadian dollars? a. $1,060,875 b. $1,025,000 c. $962,681 d. $929,404 55. An American citizen is travelling to Canada for 6 months. If the exchange rate is $1USD to $1.33CAD, what is the value (in CAD) of their travel spending money (assume they have saved US$25,000 for the trip to Canada)? a. $25,000 CAD b. $33,250 CAD c. $18,797 CAD d. $33,250 USD 56. Which of the following is likely to be a reason that companies move into international operations? a. to take advantage of relatively lax anti-corruption laws b. to develop new markets for the firm’s products c. to purchase real estate before economic development causes real estate prices to skyrocket d. to diversify the risk of global terrorist attacks 57. Which of the following countries’ currencies is pegged to the U.S. dollar? a. Saudi Arabia b. Denmark c. Kenya d. Cuba 58. Which of the following statements is correct? a. Any bond sold outside the country of the lender is called an international bond. b. Foreign bonds and eurocurrencies are two important types of international bonds. c. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. d. The term “eurobond” applies only to foreign bonds denominated in U.S. currency.

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Chap 21_4ce 59. Suppose 1 year ago Hein Company had inventory in Britain valued at 240,000 pounds. The exchange rate for dollars to pounds was £1 = 2 Canadian dollars. This year, the exchange rate is £1 = 1.82 Canadian dollars. The inventory in Britain is still valued at 240,000 pounds. What is the gain or loss in inventory value in Canadian dollars as a result of the change in exchange rates? a. –$240,000 b. –$43,200 c. $0 d. $43,200 60. Blenman Corporation, based in Canada, arranged a 2-year, $1,000 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 10.1366 pesos per dollar, but it dropped to 9.5511 pesos per dollar before the first payment came due. The loan was not hedged in the foreign exchange market. Thus, Blenman must convert Canadian dollars into Mexican pesos to make its payments. If the exchange rate remains at 9.5511 pesos per dollar through the end of the loan period, what effective interest rate will Blenman end up paying on the loan? a. 11.50% b. 12.44% c. 13.00% d. 15.80% 61. Stover Corporation, a Canadian importer, makes a purchase of crystal glassware from a firm in Switzerland for 39,960 Swiss francs, or $38,609, at the spot rate of 1.035 francs per dollar. The terms of the purchase are net 90 days, and the Canadian 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 1.099 francs. If the spot rate in 90 days is actually 1.062 francs, how much will the Canadian firm have saved or lost in Canadian dollars by hedging its exchange rate exposure? a. $2,557 b. $1,267 c. –$1,079 d. –$1,243 62. A product sells for $750 in Canada. The exchange rate is $1 to 9.55 pesos. If the law of one price holds, what is the price of the product in Mexico? a. 4,375.00 pesos b. 5,545.50 pesos c. 6,750.00 pesos d. 7,162.50 pesos

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Chap 21_4ce 63. If one U.S. dollar buys 1.0613 Canadian dollars, how many U.S. dollars can you purchase for one Canadian dollar? a. 0.37 b. 0.61 c. 0.94 d. 1.00 64. Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return. In Canada, 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 $1.96. If interest rate parity holds, what is the spot exchange rate? a. 1 pound = $1.9697 b. 1 pound = $1.8582 c. 1 pound = $1.4308 d. 1 pound = $0.8500 65. Suppose a foreign investor who holds tax-exempt eurobonds paying 9% is considering investing in an equivalentrisk 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% 66. Which of the following best describes how one would determine a currency cross rate? a. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a widely held commodity index as a base. b. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a third currency as a base. c. Calculating a currency cross rate involves determining the exchange rate for two currencies by using two other currencies as a base. d. Calculating a currency cross rate involves determining the exchange rate for a basket of currencies by using a third currency as a base.

67. Suppose one British pound can purchase 1.82 U.S. dollars today in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 12% 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

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Chap 21_4ce 68. A box of candy costs 12.80 euros in Germany and $20 in Canada. Assuming that the law of one price holds, what is the current exchange rate? a. 1 Canadian dollar equals 0.64 euros b. 1 Canadian dollar equals 0.85 euros c. 1 Canadian dollar equals 1.21 euros d. 1 Canadian dollar equals 1.56 euros 69. Suppose in the spot market 1 U.S. dollar equals 1.0613 Canadian dollars. Six-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 = 1.0587 Canadian dollars d. 1 U.S. dollar = 1.5961 Canadian dollars 70. Which of the following statements best describes the relationship between a country’s foreign exchange rate and its trade balance? a. A country with a high currency rate will see an increase in both imports and exports. b. A country with a high currency rate will see a decrease in both imports and exports. c. A country with a high currency rate will see an increase in imports and a decrease in exports. d. A country with a high currency rate will see a decrease in imports and an increase in exports.

71. If one Swiss franc can purchase 0.966 Canadian dollars, how many Swiss francs can one Canadian dollar buy? a. 0.50 b. 0.71 c. 1.00 d. 1.04 72. A product sells for $7,500 in Canada. The exchange rate is $1USD to $1.33CAD. If the law of one price holds, what is the price of the product in the United States? a. $5,639 USD b. $9,975 USD c. $6,750 USD d. $7,162 USD 73. Suppose the exchange rate between Canadian dollars and Swiss francs is SFr 1.10 = $1.00, and the exchange rate between the Canadian dollar and the euro is $1.00 = 0.68 euros. What is the cross rate of Swiss francs to euros? a. 0.43 b. 0.86 c. 1.41 d. 1.62

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Chap 21_4ce 74. In which of the following situations would the Canadian dollar sell at a forward premium against another currency? a. When a Canadian dollar buys more of a foreign currency in the spot market than in the forward market. b. When a Canadian dollar buys less of a foreign currency in the spot market than in the forward market. c. When a Canadian dollar buys more of a foreign currency in both the spot market and the forward market. d. When a Canadian dollar is depreciating.

75. In 1997, a certain 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 110 yen per dollar, what would the car be selling for today in Canadian dollars? a. $8,200 b. $10,250 c. $12,628 d. $13,418 76. Which of the following models purports that exchange rates and prices must adjust so that identical goods must cost the same in different countries? a. absolute purchasing power parity b. relative purchasing power parity c. interest rate parity d. Modigliani and Miller theorem

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Chap 21_4ce Answer Key 1. False 2. False 3. True 4. False 5. True 6. True 7. True 8. True 9. False 10. True 11. False 12. True 13. True 14. False 15. True 16. True 17. False 18. True 19. True 20. False 21. False 22. False 23. True 24. True 25. False 26. True

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Chap 21_4ce 27. True 28. True 29. False 30. False 31. False 32. False 33. False 34. False 35. False 36. True 37. b 38. b 39. a 40. d 41. b 42. a 43. c 44. b 45. c 46. a 47. c 48. a 49. a 50. d 51. a 52. d 53. d 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 21_4ce 55. b 56. b 57. a 58. c 59. b 60. d 61. b 62. d 63. c 64. a 65. d 66. b 67. d 68. a 69. c 70. c 71. d 72. a 73. d 74. b 75. d 76. a

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Chap 22_4ce Indicate whether the statement is true or false.

1. The dividend growth model can be used to calculate values of all firms except those that do not pay dividends. a. True b. False 2. The two most 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 3. A company’s value is calculated as the present value of all its expected future free cash flows from its operating assets plus the value of its nonoperating assets. a. True b. False 4. Agency conflicts arise when the interests and motivations of the agents diverge from those of the shareholders. a. True b. False 5. Assets-in-place include only tangible assets such as land, building, and inventory. a. True b. False 6. The corporate valuation model cannot be used unless a company doesn’t pay dividends. a. True b. False 7. The CEO of BMI Industries has been granted some stock options that have provisions similar to most other executive stock options. If BMI’s stock underperforms the market, these options will necessarily be worthless. a. True b. False 8. The value of a company left for its common shareholders is calculated as the present value of the expected future free cash flows from its operating assets, plus the value of its nonoperating assets, less the values of its notes payable, long-term debt, and preferred stock. a. True b. False 9. From the point of view of a firm’s creditors, asset switching is a risk that can be mitigated only by charging the firm a higher interest rate on its debt. a. True b. False

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Chap 22_4ce 10. A poison pill is also known as a corporate restructuring. a. True b. False 11. Leverage has an unclear impact on corporate value as debt can reduce one aspect of agency costs (wasteful spending), but it may increase another (underinvestment). a. True b. False 12. Value-based management focuses on sales growth, profitability, capital requirements, the weighted average cost of capital, and the dividend growth rate. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

13. Which of the following are agency relationships in a company? a. shareholders and creditors b. employees and unions c. outside owners and inside owner/managers d. both a and c 14. Which action can be an adverse move for corporate governance? a. making the CEO the chairman of the board b. decreasing the board size c. increasing the seats of independent directors in the board up to 80% d. paying board members with stock rather than salary 15. Suppose Yon Sun Corporation’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 16. Based on the corporate valuation model, Bernile Inc.’s value of operations is $750 million. 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, and $160 million of retained earnings. What is the best estimate for the firm’s value of equity, in millions? a. $450 b. $475 c. $500 d. $525

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Chap 22_4ce 17. Which statement regarding the corporate valuation model is correct? a. The corporate valuation model cannot be used for companies that pay dividends. b. The corporate valuation model discounts free cash flows by the required return on equity. c. The corporate valuation model cannot be used to find the value of a division. d. An important step in applying the corporate valuation model is forecasting the firm’s pro forma financial statements.

18. Leak Inc. forecasts the free cash flows (in millions) shown below. 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 (do not make any half-year adjustments).

Year: Free cash flow: a. $1,456 b. $1,529 c. $1,606 d. $1,686

1 –$50

2 $100

19. Based on the corporate valuation model, Hunsader’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. The company has 10 million shares of stock outstanding. What is the market value added on equity capital? a. $40 b. $50 c. $60 d. $70 20. Which of the following is an internal management reason for the use of the corporate valuation model instead of the dividend growth model? a. The firm has not paid any dividends since its inception. b. The firm has many lines of business with many different assets. c. The firm has many nonoperating assets. d. The firm has a high debt-to-equity ratio.

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Chap 22_4ce 21. A company 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: 1 2 3 Free cash flow: –$15 $10 $40 a. $331 b. $348 c. $367 d. $386 22. Which of the following best describes what rate of return should be used when finding the present value of a series of cash flows? a. Free cash flows should be discounted at the firm’s average cost of debt capital to find the value of its operations. b. Free cash flows should be discounted at the firm’s weighted average cost of capital to find the value of its operations. c. Free cash flows should be discounted at the firm’s cost of equity capital (preferred and common) to find the value of its operations. d. Free cash flows should be discounted at the firm’s cost of preferred equity capital and pre-tax cost of debt capital to find the value of its operations.

23. Simonyan Inc. 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 24. Suppose Toronto Corp.’s free cash flow in the previous year was $250,000, and FCF is expected to grow at a constant rate of 5%. If the company’s weighted average cost of capital is 15%, what is the value of its operations? a. $2,625,000 b. $2,500,000 c. $2,900,000 d. $2,000,000

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Chap 22_4ce 25. Which of the following statements best describes the relationship between price per share obtained using the dividend growth model versus price per share obtained using the corporate valuation model? a. The dividend growth model should produce price per share that is lower than that produced by the corporate valuation model. b. The dividend growth model should produce price per share that is greater than that produced by the corporate valuation model. c. The two methods should produce estimated share prices that are equivalent. d. There should be no relationship between the price per share obtained using the two methods as they each use different information.

26. Zhdanov 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 c. $175 d. $184 27. Which of the following is regarded as being a barrier to hostile takeovers? a. share repurchases b. shareholder rights provisions c. debt covenants d. cumulative voting 28. Which of the following best describes the condition under which an agency relationship arises? a. when a principal contracts employees to work overtime b. when a principal negotiates a new wage contract with a union c. when a principal delegates decision-making authority to another party on behalf of the firm d. when shareholders vote to decline a dividend payment 29. Akyol Corporation is undergoing a restructuring, and its free cash flows are expected to be unstable during the next few years. 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. $757 b. $797 c. $839 d. $883

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Chap 22_4ce 30. Based on the corporate valuation model, the value of a company’s operations is $900 million. 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 31. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. 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

1 –$20

2 $42

3 $45

32. Suppose Leonard, Nixon, & Shull Corporation’s projected free cash flow for next year 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 33. Suppose BC Corp.’s free cash flow in the previous year was $50,000, and FCF is expected to grow at a constant rate of 3%. If the company’s weighted average cost of capital is 15%, what is the value of its operations? a. $416,667 b. $500,000 c. $900,000 d. $429,167

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Chap 22_4ce 34. Based on the corporate valuation model, Hunsader’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. The company 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 35. Manitoba Skate Co.’s free cash flow in the previous year was $1,250,000, and FCF is expected to grow at a constant rate of 2%. If the company’s weighted average cost of capital is 17%, what is the value of its operations? a. $8,000,000 b. $8,333,333 c. $8,500,000 d. $12,000,000 36. Which of the following can be used to mitigate agency costs? a. improved corporate governance b. higher cost of debt c. increased shareholder power d. higher board compensation 37. Which of the following items is considered a nonpecuniary benefit for the CEO of a publicly traded company? a. annual bonuses b. employee stock options c. memberships to professional organizations d. corporate jets 38. Based on the corporate valuation model, the value of a company’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 $800 million in total common equity. If the company 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

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Chap 22_4ce Answer Key 1. False 2. False 3. True 4. False 5. False 6. False 7. False 8. True 9. False 10. False 11. True 12. False 13. d 14. a 15. c 16. c 17. d 18. a 19. c 20. b 21. d 22. b 23. a 24. a 25. c 26. b

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Chap 22_4ce 27. b 28. c 29. d 30. c 31. b 32. d 33. d 34. d 35. c 36. a 37. d 38. b

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Chap 23_4ce Indicate whether the statement is true or false.

1. 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 2. In an operating merger, the target’s expected cash flows are taken as the incremental post-merger cash flows. a. True b. False 3. 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 4. Most target shareholders would rather receive new shares in the newly merged firm than cash. a. True b. False 5. 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 6. By examining stock prices around merger announcement dates, event studies provide inconclusive results that mergers benefit only targets, not acquirers. a. True b. False 7. Coca-Cola’s acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger. a. True b. False 8. The key difference between liquidation and the outright sale of a division to another firm is that assets are sold off piecemeal in the former while the entire division is sold as a unit in the latter. a. True b. False 9. 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

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Chap 23_4ce 10. The key issue in a merger of equals is the determination of the number of shares owned by the target shareholders relative to the number of shares owned by the acquiring firm’s shareholders. a. True b. False 11. A taxable merger offer is one where the acquiring company offers to purchase the target company with cash.

However, the same deal is not taxable if the merger is paid by exchanging stock. Such nontaxable bids are more prevalent by far. a. True b. False 12. The distribution of synergistic gains between the shareholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger. a. True b. False 13. Interest expense must be explicitly included in a merger incremental cash flow analysis. a. True b. False 14. A tender offer is made when an acquiring company sends a merger notification to the management of the target company. a. True b. False 15. Most empirical research shows that mergers have generally increased the wealth of acquiring firms’ shareholders. a. True b. False 16. Under acquisition accounting, the net income of the merged entity will be simply calculated as the sum of the net income of the acquiring and target companies. a. True b. False 17. 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 18. A merger will be financially justified only if a target firm’s value is greater to the acquiring firm than its market value as a separate entity. a. True b. False

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Chap 23_4ce 19. Leveraged buyouts (LBOs) occur when a firm’s managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying out the public shareholders using large amounts of borrowed money. a. True b. False 20. Some mergers are undertaken to reduce taxes paid by the combined firm. a. True b. False 21. Since a manager’s central goal is to maximize the firm’s common share price, any merger offer that provides shareholders with significant gains over the current share price will be approved by the current management team. a. True b. False 22. Since managers’ central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm’s shareholders. a. True b. False 23. In the 1980s, mergers were sought mainly for reasons of economies of scale or scope, and the preferred method used was stock acquisition. a. True b. False 24. 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 25. Three procedures used to defend against hostile takeovers are 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. These strategies are known as “poison pills.” a. True b. False 26. If the constant growth model is used to calculate the value of a target company, the terminal value is an insignificant cash flow analysis. a. True b. False 27. Currently, mergers in Canada must be accounted for using the acquisition method. a. True b. False

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Chap 23_4ce 28. A spin-off is a type of divestiture in which the assets of a division are sold to another firm. a. True b. False 29. Under acquisition accounting, the acquired assets must be written up or written down if the purchase price does not equal net asset value. a. True b. False 30. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine. a. True b. False 31. 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 32. 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 33. A shareholder rights plan allowing existing shareholders to buy or sell shares at very attractive prices provides the acquirer an inexpensive way for takeovers. a. True b. False 34. In a carve-out, a majority interest in a corporate subsidiary is sold to new shareholders, so the parent gains new equity financing yet retains control. a. True b. False 35. 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 36. In Canada, merger regulations are mainly written to ensure that mergers are accounted for at fair value. a. True b. False

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Chap 23_4ce 37. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers. a. True b. False 38. Foreign firms are interested in buying Canadian companies to gain entrance to Canada. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive. a. True b. False 39. Using the acquisition accounting method to report mergers, goodwill is not amortized; rather, it is subject to an annual impairment test. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

40. Fine Tunes Limited is considering a merger with Songbird Company. Songbird’s free cash flow for next year is estimated to be $2 million. Songbird has a debt of $50 million, of which $10 million will come due at the beginning of next year. At that time, the company plans to issue new debt of $15 million. Songbird’s before-tax cost of debt is 10%, and its marginal tax rate is 40%. Calculate Songbird’s free cash flow to equity for next year. a. $1.3 million b. $2.0 million c. $3.7 million d. $4.5 million 41. Which of the following statements best describes the general nature of recent merger activities in Canada? a. financial, hostile, and completed by cash payments b. financial, friendly, and completed by exchanges of shares c. strategic, friendly, and completed by exchanges of shares d. strategic, hostile, and completed by cash payments 42. Alberta Corp., with a book value of $40 million and a market value of $45 million, has merged with Ontario Corp., with a book value of $26 million and a market value of $28 million, at a price of $30 million. Under the acquisition method, what will be the total assets on the book of the new merged firm? a. $70 million b. $66 million c. $88 million d. $89 million

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Chap 23_4ce 43. Which statement best describes mergers? a. The high Canadian dollar relative to foreign currencies makes Canadian companies comparatively inexpensive to foreign buyers, spurring many mergers. b. The expansion of the junk bond market makes debt more freely available for large acquisitions and LBOs, resulting in an increased level of merger activity. c. Increased nationalization of business and a desire to scale down and focus on producing in one’s home country may virtually halt international mergers. d. A high Canadian dollar results in a high cost of commodities, which results in mergers being more expensive in Canada.

44. Which statement best describes mergers? a. 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. b. If the acquiring firm buys the target’s shares, it assumes responsibility for all pre- and post-merger legal contingencies against the target firm. c. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition. d. Acquiring firms send a signal that their stock is overvalued if they choose to use cash and bonds to pay for the acquisition.

45. Canada Ltd. is considering acquiring Quebec Corp. by offering one share of its common stock for 1.01 shares of Quebec Corp. Currently, the market price of Quebec Corp. is $98. What is the cash bidding price proposed for this deal (rounded up)? a. $99 b. $97 c. $90 d. $103 46. The value of synergy can be estimated by which of the following equations? a. VAB – VA – VB b. VAB – VB – taxes c. VA – VB – costs d. VA + VB – revenues 47. To conduct an empirical study into the effects of mergers on stock returns outside of changes in the general stock market, which of the following measures of returns is used? a. required returns b. abnormal returns c. net returns d. risk-adjusted returns

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Chap 23_4ce 48. Which of the following is a factor in determining the bid price in a takeover attempt? a. uniqueness of the target firm’s assets b. board composition of the target firm c. marketing prowess of the acquiring firm d. risk attitudes of the target firm’s shareholders 49. What is one of the actions that can help managers defend against a hostile takeover? a. establishing an employee stock option program b. granting lucrative golden parachutes to senior managers c. establishing a provision in the company’s bylaws to decrease the percentage of shareholders that must approve an acquisition from 60% to 50% d. changing the voting procedures for the board election from a noncumulative to a cumulative one 50. Which of the following basic merger valuation approaches explicitly considers synergistic value from a merger? a. discounted cash flow b. market multiple c. future value d. M&M market value 51. Saskatchewan Corp., with a book value of $10 million and a market value of $12 million, has merged with Alberta Corp., with a book value of $10 million and a market value of $11 million, at a price of $11 million. Under the acquisition method, what will be the total assets on the book of the new merged firm? a. $26 million b. $20 million c. $21 million d. $39 million 52. DAB Corp. has unfortunately accumulated net operating losses of $70 million and is likely to go bankrupt. CLC Corp. has earnings of $200 million and is in the 36% marginal tax bracket. CLC is considering buying DAB and liquidating the company and retaining a few of the assets. What is the minimum value of DAB to CLC? a. $25.2 million b. $70.0 million c. $72.0 million d. There is insufficient information provided.

53. MCorp, with a book value of $20 million and a market value of $30 million, has merged with NCorp, with a book value of $6 million and a market value of $8 million, at a price of $9 million. Under the acquisition method, what will be the total assets on the book of the new merged firm? a. $26 million b. $29 million c. $38 million d. $39 million

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Chap 23_4ce 54. Blazer Inc. is thinking of acquiring Laker Company. Blazer expects Laker’s NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Laker is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Laker will need $10 million of net new investment in operating capital. Laker’s marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at a constant rate of 4%. Blazer has determined that Laker’s cost of equity is 17.5%, and Laker currently has no debt outstanding.

Assuming that all cash flows occur at the end of the year, Blazer must pay $45 million to acquire Laker. What is the NPV of the proposed acquisition? Note that you must first calculate the value to Blazer of Laker’s equity. a. $ 45.0 million b. $ 68.2 million c. $ 94.1 million d. $139.1 million 55. Under the acquisition method of accounting for a merger, what must be recorded if the purchase price paid is greater than the fair value of the target’s identifiable net assets? a. acquisition differential b. goodwill c. gain on purchase d. loss on purchase 56. Which of the following are synergistic benefits of a merger? a. operating economies of scale b. financial economies c. improved managerial efficiency d. all of the above 57. PEI Ltd. is considering acquiring Sask Corp. by offering one share of its common stock for .56 shares of Sask Corp. Currently, the market price of Sask Corp. is $38. What is the cash bidding price proposed for this deal (rounded up)? a. $89 b. $97 c. $90 d. $68 58. Kelly Tubes is considering a merger with Reilly Tires. Reilly’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 Kelly acquires Reilly, 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%. What will be Reilly’s required rate of return on equity after it is acquired? a. 7.4% b. 8.9% c. 9.3% d. 9.7%

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Chap 23_4ce 59. What required rate of return should be used in evaluating a merger based on the free cash flow to equity (FCFE) approach? a. weighted average cost of capital (WACC) of the target firm b. weighted average cost of capital (WACC) of the acquiring firm c. cost of equity of the target firm d. cost of equity of the acquiring firm 60. Which statement best describes leveraged buyouts (LBOs)? a. LBOs occur when a firm issues equity and uses the proceeds to take a firm public. b. In a typical LBO, bondholders do well but shareholders see their value decline. c. Firms are forbidden by law to sell any assets during the first five years following a leveraged buyout. d. The objective is to take the firm public again or to sell to others in a few years after boosting the firm’s value through efficient management.

61. Which statement best describes mergers? a. 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. b. 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. c. 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. d. 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 are generally not a valid motive for a publicly held firm.

62. Hostile mergers typically occur as a result of which of the following? a. shareholders’ needs to maximize personal wealth b. unions’ actions to maximize shareholders’ wealth c. government policies to maximize shareholders’ wealth d. managers’ actions to maximize shareholders’ wealth 63. Which of the following statements best describes a divestiture? a. sale of a company’s shares to get ready for a future takeover attempt b. purchase of an undervalued company with the plan of selling off its assets piecemeal to obtain their fair value c. sale of some of a company’s operating assets d. sale of all of a company’s operating assets 64. Which of the following is a valid reason for a company to seek external growth through mergers? a. to avoid paying dividends b. to purchase assets above their replacement cost c. to take advantage of the tax savings on cash payment for shares d. to maintain availability of raw materials Copyright Cengage Learning. Powered by Cognero.

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Chap 23_4ce 65. Which of the following statements best defines arbitrage? a. purchase of an asset and holding it to obtain a long-term return b. sale of an asset that was borrowed from another company for a fee c. search for a highly inflated market in which to sell an asset d. purchase of an asset in one market and then selling it in another market for a higher price Dustvac Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac’s pre-merger beta is 1.36. Magiclean’s beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean’s capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

66. Refer to Scenario: Dustvac. What Dustvac’s pre-merger WACC? a. 9.02% b. 9.50% c. 9.83% d. 10.01% 67. Which statement best describes accounting for mergers? a. Goodwill is amortized for shareholder reporting. b. Goodwill is subject to an impairment test for possible decline in value. c. Goodwill is no longer created in a merger. d. Goodwill is subject to an amortization test and a majority vote of the board of directors.

Maritime TV Emporium, a national retailer of flat-panel screens, is investigating an opportunity to purchase Maritime TV and Sound Inc. An acquisition is expected to lower overhead costs, improve distribution efficiencies, and improve ordering volumes from the major manufacturers. If those improvements (synergies) are implemented, TV Emporium financial staff estimate the following incremental net cash flows to be $5 million, $5.6 million, and $6.9 million for the first three years. Cash flows would grow at 3% thereafter. Maritime TV and Sound’s tax rate is 30%. Its cost of equity is 10%.

68. Refer to Scenario: Maritime. What is the horizon value of Maritime’s operation as of Year 3? a. $101.53 million b. $98.57 million c. $86.66 million d. $71.07 million

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Chap 23_4ce 69. What is one of the defensive tactics firms use to fight off undesired mergers? a. developing poison pills b. getting black knights to bid for the firm c. purchasing shares in the acquiring firm d. issuing new shares at low prices in the market 70. Brau Auto, a national auto parts chain, is considering purchasing a smaller chain, South Granville Parts (SGP).

Brau’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 $1 $3 $3 $7 Unlevered horizon value 75 Tax shield 1 1 2 3 Horizon value of tax shield 32 Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% 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 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Brau? a. $53.40 million b. $61.96 million c. $64.64 million d. $76.96 million Dustvac Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac’s pre-merger beta is 1.36. Magiclean’s beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean’s capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

71. Refer to Scenario: Dustvac. What discount rate should you use to discount Dustvac’s free cash flows and interest tax savings? a. 10.01% b. 10.06% c. 11.34% d. 11.44%

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Chap 23_4ce 72. Firm X is considering acquiring Firm Y by offering one share of its common stock for 0.8728 shares of Firm Y. Currently, the market price of Firm X is $48. What is the cash bidding price proposed for this deal? a. $35 b. $42 c. $55 d. $63 Dustvac Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac’s pre-merger beta is 1.36. Magiclean’s beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean’s capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

73. Refer to Scenario: Dustvac. What is the value of Dustvac’s equity to Magiclean? (Round your answer to the closest thousand dollars.) a. $16.019 million b. $17.080 million c. $18.916 million d. $22.080 million Maritime TV Emporium, a national retailer of flat-panel screens, is investigating an opportunity to purchase Maritime TV and Sound Inc. An acquisition is expected to lower overhead costs, improve distribution efficiencies, and improve ordering volumes from the major manufacturers. If those improvements (synergies) are implemented, TV Emporium financial staff estimate the following incremental net cash flows to be $5 million, $5.6 million, and $6.9 million for the first three years. Cash flows would grow at 3% thereafter. Maritime TV and Sound’s tax rate is 30%. Its cost of equity is 10%.

74. Refer to Scenario: Maritime. What is the highest price TV Emporium pays for Maritime? a. $67.75 million b. $76.28 million c. $81.10 million d. $90.64 million 75. Which statement best describes mergers? a. The acquiring firm’s required rate of return in most horizontal mergers will not be affected, because the two firms will have similar betas. b. Financial theory says that the choice of how to pay for a merger is irrelevant because although it may affect the firm’s capital structure, it will not affect its overall required rate of return. c. The basic rationale for any consolidation is financial synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis. d. The primary rationale for most operating mergers is synergy.

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Chap 23_4ce 76. Dunbar Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware.

Dunbar’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 Eastern is 16%. Eastern has 4 million shares outstanding and no debt. Eastern’s current price is $16.25. What is the maximum price per share that Dunbar should offer? a. $16.25 b. $16.97 c. $17.42 d. $18.13 77. Fine Tunes Limited is considering a merger with Songbird Company. Fine Tunes has 10 million shares outstanding at a market price of $30 per share. Songbird has 5 million shares at a market price of $3 per share. Fine Tunes estimates that the post-merger value of Songbird is $20 million. Fine Tunes will offer Songbird’s shareholders a package worth $3.60 per share. What is the exchange ratio in this merger? a. 0.12 b. 0.23 c. 0.34 d. 0.45 78. Which of the following is the appropriate discount rate to be used when calculating the NPV of a target company using the corporate valuation model? a. the cost of equity of the acquiring firm b. the cost of debt of the target company c. the cost of equity of the target company d. the WACC of the target company 79. Which statement best describes mergers? a. The purchase of Red Lobster Restaurants initiated by Remax Realty is an example of a conglomerate merger. b. A merger can be blocked either by a firm’s customers or its suppliers, but not the government. c. The existence of golden parachutes is one reason that the management of a target company tries to encourage a takeover. d. In a hostile takeover, the target company’s management makes a tender offer asking its shareholders to sell their shares to the acquiring company.

80. Which of the following correctly describes the difference between a hostile and a friendly takeover? a. The transfers of cash and stocks go through the company in a friendly takeover, whereas the transfers go through an independent financial institution in a hostile takeover. b. In a hostile takeover, only majority shareholders are approached by the acquiring firm’s management, whereas in a friendly takeover, all shareholders are approached simultaneously. c. The difference between a hostile and a friendly takeover is that the target’s board would resist the merger in the former but recommend agreement in the latter. d. The target’s management has more bargaining power in a hostile takeover than in a friendly takeover.

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Chap 23_4ce 81. Which of the following best defines a joint venture? a. 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. b. 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 expansive in scope. c. A joint venture is one in which two, or sometimes more, independent companies agree to merge into a single firm, usually wider in scope. d. A joint venture is one in which two, or sometimes more, independent companies agree to merge into a single firm, usually limited in scope.

82. Which of the following best describes a merger with true synergies? a. In a merger with true synergies, the pre-merger value exceeds the sum of the separate companies’ premerger values and the dollar cost of the firms’ capital. b. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies’ premerger values. c. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies’ premerger values plus a risk-adjusted cash flow relative to the risk of the combined firm. d. In a merger with true synergies, the post-merger value is less than the sum of the separate companies’ pre-merger values.

83. Fine Tuna Inc. is considering a merger with Seabird Company. Seabird’s net income for next year is estimated to be $7 million, and it anticipates $10 million net investment in operating capital. Seabird has a debt of $50 million, of which $10 million will come due at the beginning of next year. At that time, the company plans to issue new debt of $15 million. Seabird’s before-tax cost of debt is 10%, and its marginal tax rate is 40%. Calculate Seabird’s free cash flow to equity for next year. a. $1.3 million b. $2.0 million c. $3.7 million d. $4.5 million 84. In which of the following forms of merger will the target firm usually cease to exist as a separate entity? a. when the acquiring firm tenders for the target’s shares directly from its shareholders b. when the acquiring firm offers to buy the target’s assets c. when the acquiring firm makes a takeover offer through the target’s board of directors d. when the target firm’s management actively seeks out a buyer for its assets 85. Two firms merge and synergies are evident. Which statement best confirms this result? a. The reduction in risk in the combined firm benefits the bondholders at the expense of the shareholders. b. The value of the debt in the combined firm will likely be greater than the value of the debt in the two separate firms. c. The size of the gain to the bondholders depends on the specific reductions in bankruptcy probabilities after the merger. d. The share price of the acquiring or combined company increases substantially.

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Chap 23_4ce 86. Ontario Ltd. is considering acquiring BC Corp. by offering one share of its common stock for 0.95 shares of BC Corp. Currently, the market price of BC Corp. is $108. What is the cash bidding price proposed for this deal (rounded up)? a. $114 b. $95 c. $103 d. $163 87. Firms A and B, both all-equity financed, are merging. Prior to the merge, Firm A, having 100 shares outstanding, is worth $15,000, while Firm B has 50 shares outstanding worth $10,000. The combined firm will be worth $30,000. Firm A pays $11,500 in cash for Firm B. What is the net benefit of the merger to Firm A? a. $3,500 b. $5,000 c. $11,500 d. $18,500 88. Which of the following is a good reason for a divestiture? a. a firm has excess cash b. the good performance of a business unit c. a change in a firm’s strategic thinking d. a reduction in tax burden 89. Kelly Tubes is considering a merger with Reilly Tires. Reilly’s market-determined value is $3.75 million, and Kelly’s market value as a stand-alone company is $4.50 million. Both firms are all equity-financed. Kelly acquires Reilly for $4.25 million because it believes the combined firm value will increase to $9.25 million. What will be the synergy from this merger? a. $0.50 million b. $1.00 million c. $4.75 million d. $5.00 million 90. Which statement best describes a merger concept? a. A conglomerate merger is one where a firm combines with another firm in the same industry. b. Regulations in Canada prohibit acquiring firms from using common shares to purchase another firm. c. Defensive tactics are designed to make a company less vulnerable to a takeover. d. The corporate valuation method and the equity residual method, even properly applied, produce different results.

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Chap 23_4ce 91. Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%. Great Subs’s analysts project that the merger will result in incremental 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 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. 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% 92. Which of the following is a valid, acceptable reason for a closely held firm proposing a merger activity? a. synergistic benefits arising from mergers b. reduction in competition resulting from mergers c. attempts to stabilize earnings by diversifying d. minimizing taxes when disposing of excess cash

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Chap 23_4ce Answer Key 1. False 2. False 3. True 4. False 5. True 6. True 7. True 8. True 9. False 10. False 11. False 12. False 13. True 14. False 15. False 16. False 17. True 18. True 19. True 20. True 21. False 22. False 23. False 24. True 25. True 26. False

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Chap 23_4ce 27. True 28. False 29. True 30. False 31. False 32. True 33. False 34. False 35. True 36. False 37. True 38. True 39. True 40. c 41. c 42. a 43. b 44. b 45. b 46. a 47. b 48. a 49. b 50. a 51. c 52. a 53. b 54. c Copyright Cengage Learning. Powered by Cognero.

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Chap 23_4ce 55. b 56. d 57. d 58. d 59. c 60. d 61. d 62. d 63. c 64. d 65. d 66. c 67. b 68. a 69. a 70. c 71. c 72. c 73. b 74. d 75. d 76. d 77. a 78. d 79. a 80. c 81. a 82. b Copyright Cengage Learning. Powered by Cognero.

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Chap 23_4ce 83. b 84. b 85. d 86. a 87. a 88. c 89. b 90. c 91. b 92. c

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Chap 24_4ce Indicate whether the statement is true or false.

1. The high valuations of Yahoo and Amazon at the beginning of the 21st century were primarily due to the immense real growth options and riskiness inherent in their businesses. a. True b. False 2. The variance on a company’s stock returns is typically lower than the variance on its individual projects due to diversification effects. a. True b. False 3. A real timing option resembles a call option in that the company has the right but not the obligation to defer investment in a project and invest in it at a later date when more information is available and its NPV is positive. a. True b. False 4. Real options affect the size, but not the risk, of a project’s expected cash flows. a. True b. False 5. As the valuation of real options involves judgment on both the model and inputs, its outputs are purely speculative and therefore not useful for business decision making. a. True b. False 6. In a qualitative assessment of a project’s investment timing option, the strike price of the option is the project’s cost. a. True b. False 7. At the present time, very few companies are using real option valuation techniques to evaluate projects as the models do not produce useful estimates. a. True b. False 8. Decision trees can be used to evaluate real option values, as long as the project’s original cost of capital is used throughout the process. a. True b. False 9. Financial engineering is a process by which a new derivative instrument such as options is designed and brought to market. a. True b. False

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Chap 24_4ce 10. Real options are options to buy real assets, such as stocks, rather than interest-bearing assets, such as bonds. a. True b. False 11. Real options are most valuable when the underlying source of risk is very low. a. True b. False Indicate the answer choice that best completes the statement or answers the question.

Oklahoma Oklahoma Instruments (OI) is considering a project called F-200 that has an up-front cost of $250,000. The project’s subsequent cash flows are critically dependent on whether another of its products, F-100, becomes an industry standard. There is a 50% chance that the F-100 will become the industry standard, in which case the F200’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 F-100 will not become the industry standard, in which case the F-200’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%.

12. Refer to Scenario: Oklahoma. Now assume that 1 year from now OI will know if the F-100 has become the industry standard. Also assume that after receiving the cash flows at t = 1, OI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 (on top of the original time 1 inflow of $25,000) 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. $2,075 b. $4,067 c. $8,945 d. $10,745

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Chap 24_4ce 13. Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties and then selling the successful ones to major oil refining companies. TWI 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, TWI 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 oil and then receiving only a $10,000 inflow.

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? (Hint: You must calculate joint probabilities.) a. $336.15 b. $373.50 c. $415.00 d. $461.11

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Chap 24_4ce 14. Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front cost at t = 0 of $1,500.

(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 Health Canada. If Health Canada 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 competing 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 1 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 Health Canada’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 6 years (t = 2 … 7).

Assuming that all cash flows are discounted at 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 15. Which of the following is an example of a real growth option? a. A company has an option to invest in a project today or to wait a year. b. A company has an option to abandon an operation if it turns out to be unprofitable. c. 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. d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.

16. Which one of the following is an example of a flexibility option? a. A company has an option to invest in a project today or to wait a year. b. A company has an option to abandon an operation if it turns out to be unprofitable. c. 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. d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.

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Chap 24_4ce 17. XYZ Co. has a 2-year project with a cost of $2 million and 2 years of $2 million in cash inflows. After the second year of operation, the company can decide to reinvest in the project for another 2 years. This secondgeneration project will still cost $2 million and yield another 2 years of $2 million in cash inflows. Using the decision tree technique to evaluate this real growth option, XYZ’s managers have calculated the present value at Year 0 of the cash inflows from the second-generation project are $2.5 million. Which of the following statements is correct? a. The growth option is considered in the money. b. The growth option is considered out of the money. c. The growth option is considered at the money. d. The growth option is considered between the money.

18. Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front cost at t = 0 of $1,500.

(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 Health Canada. If Health Canada 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 certain 1 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 Health Canada’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 6 years (t = 2 … 7).

Assuming that all cash flows are discounted at 10%, calculate the effect on the proposed project’s risk, by waiting to undertake the project. By how much will delaying reduce the project’s coefficient of variation? a. 2.23 b. 2.46 c. 2.70 d. 2.97

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Chap 24_4ce 19. Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties and then selling the successful ones to major oil refining companies. TWI 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, TWI 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 oil and then receiving only a $10,000 inflow.

Using the information provided above, and assuming that the project is considered to be quite risky, with a 20% cost of capital, calculate the project’s coefficient of variation. (Hint: You must calculate joint probabilities.) a. 5.87 b. 6.52 c. 7.25 d. 8.77 Diplomat.com Diplomat.com is considering a project that has an up-front cost of $3 million and is expected to 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%.

20. Refer to Scenario: Diplomat. 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

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Chap 24_4ce 21. Refer to Scenario: Diplomat.com. If Diplomat.com 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 favourable, 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 unfavourable, in which case the future investment opportunity will have a net present value of –$6 million at t = 5. Diplomat.com 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 22. Which of the following is an example of a real option? a. the option to abandon a project b. a call option to abandon a project c. a put option to sell a common stock d. an employee’s stock option 23. Commodore Corporation is deciding whether to invest in a project today or to postpone the decision until next year. 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 Commodore decides to wait.

Which of the following issues should Commodore consider most seriously when making this investment decision? a. The more uncertainty about the future cash flows, the more logical it is for Commodore 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.

24. Which of the following best describes real options? a. Real options change the size, but not the risk, of projects’ expected cash flows. b. Real options change the risk, but not the size, of projects’ expected cash flows. c. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash flows. d. Very few projects actually have real options.

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Chap 24_4ce 25. Lighthouse Corporation 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 small, because projects’ NPVs are often larger when real options are taken into account. b. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options. c. 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. d. 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.

26. Under what circumstances does a “real option” exist? a. When managers have the opportunity, before a project has been implemented, to make operating changes in response to changed conditions that do not modify the project’s cash flows. b. When managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that do not modify the project’s cash flows. c. 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. d. When managers have the opportunity, after a project has been implemented, to make financing changes in response to changed conditions that modify the project’s cash flows.

Oklahoma Oklahoma Instruments (OI) is considering a project called F-200 that has an up-front cost of $250,000. The project’s subsequent cash flows are critically dependent on whether another of its products, F-100, becomes an industry standard. There is a 50% chance that the F-100 will become the industry standard, in which case the F200’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 F-100 will not become the industry standard, in which case the F-200’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%.

27. Refer to Scenario: Oklahoma. Based on the above information, what is the F-200’s expected net present value? a. –$6,678 b. –$3,251 c. $15,303 d. $20,004 28. Which circumstance will increase the value of a real option? a. shortening the time in which a real option must be exercised b. an increase in the volatility of the underlying source of risk c. a decrease in the risk-free rate d. an increase in the cost of obtaining the real option

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Chap 24_4ce 29. A project has an expected NPV of –$250, based on the traditional DCF analysis. However, the real option valuation shows that the expected NPV is $750. What is the value of the option? a. $250 b. $500 c. $750 d. $1,000

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Chap 24_4ce Answer Key 1. True 2. True 3. True 4. False 5. False 6. True 7. False 8. False 9. False 10. False 11. False 12. d 13. d 14. d 15. d 16. c 17. a 18. a 19. c 20. b 21. c 22. a 23. d 24. c 25. a 26. c

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Chap 24_4ce 27. a 28. b 29. d

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