Fundamentals of Corporate Finance, 2nd Edition Test Bank.pdf (22)

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 62. Calculating operating leverage. SunBucks Tea Supplies had EBITDA of $3,000 and EBIT of $2,750, with fixed cash expenses of $600 last year. What was SunBucks degree of accounting operating leverage?

A) 1.20 B) 1.25 C) 1.28 D) 1.31 Ans: D Feedback: EBITDA = $3,000 and EBIT = $2,750 ==> D&A = $250 FC+D&A FC+D&A 1+ =1+ EBIT Degree of accounting operating leverage = EBITDA−D&A Degree of accounting operating leverage = $600+$250 FC+D&A 1+ =1+ =1.309091.31 $2,750 EBIT Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 63. Calculating operating leverage. TurkeyJerkey Dried Meats, Inc., had a degree of accounting operating leverage equal to 1.714 during the most recent period. If the firm's EBITDA was $4,000 and depreciation and amortization was equal to $500, then what was TurkeyJerkey's fixed cash expenses during the same period?

A) $1,49 B) 9 C) $1,99 D) 9 Ans: B$5,49 9 Feedback: $5,99 FC+D&A 1+ =1.714 9 Degree of accounting operating leverage = EBITDA−D&A Degree of accounting operating leverage = FC+$500 FC+D&A 1+ =1+ =1.714 FC =$1,999 $4,000−$500 EBITDA−D&A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 64. Calculating operating leverage. Swan's Bicycle Boats had a degree of accounting operating leverage equal to 1.50 during the most recent period. If the firm's EBITDA was $5,000 and its fixed costs were equal to $1,750, then what was Swan's depreciation and amortization expense during the same period?

A) $500 B) $1,00 C) 0 D) $1,50 Ans: A0 $2,83 Feedback: 3 FC+D&A 1+ =1.5 Degree of accounting operating leverage = EBITDA−D&A Degree of accounting operating leverage = $1,750+D&A FC+D&A 1+ =1+ =1.5 D&A=$500 $5,000−D&A EBITDA−D&A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 65. Break-even analysis. IronVerks Ribshack has total fixed costs of $8,500 per month. It sells rib plates for $15 each, and the variable cost of providing each plate is $10. What is the pretax operating cash flow break-even point for IronVerks?

A) 567 plates 1,700 B) plates 8,500 C) plates None of D) the above Ans: B Feedback: $8,500 FC = =1,700 EBITDABreak−Even= Price−UnitVC $15−$10

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 66. Break-even analysis. Markovian Caviar Sales has discovered that the extent of the demand for its caviar harvest is 20,000 tins per year. If the fixed costs for the new product are $2,300,000 and the variable harvest cost per tin is $35, then what price can Markovian charge per tin if the firm needs to break even on a pretax operating cash flow basis?

A) $135.00 B) $150.00 C) $185.00 None of D) the above Ans: B Feedback: $2,300,000 FC = =20,000Price=$150 EBITDABreak−Even= Price−UnitVC Price−$35 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 67. Break-even analysis. Monochrome Sun Glasses has found that its pretax operating cash flow basis break-even number of glasses sold is 770,000 pairs. If each pair is sold for $25 and the variable cost per unit is $15, then what is the amount of Monochrome's fixed costs?

A) $77,000 B) $1,155,000 C) $7,700,000 D) $11,550,00 Ans: C0 Feedback: FC FC = =770,000 FC =$7,700,000 EBITDABreak−Even= Price−UnitVC $25−$15

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 68. Break-even analysis. TimeKeepers is about to introduce a new LED clock and has determined that it will charge $30 per clock. The firm must decide whether or not to purchase a high-capacity clock-making machine. If the high-capacity machine is selected, then the fixed costs for the firm will be $5,000 per year, with variable costs of $5 per clock. Otherwise the fixed costs will be $1,000, with variable costs of $15 per clock. Above what level of expected sales should TimeKeepers choose the high fixed cost alternative to maximize pretax operating cash flow?

A) 400 units B) 500 units C) 4,000 D) units Ans: A5,000 units Feedback: $5,000−$1,000 FC Alt1 −FC Alt2 = CO EBITDA = =400units Alt1 −Unit Contribalt2 $25−$15 Unit Contrib Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 69. Break-even analysis. Binders-For-School, Inc., is in the process of determining whether to purchase a high-capacity machine to make textbooks for the upcoming school year. The high-capacity machine will generate fixed costs of $10,000 per year versus the $2,000 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $30. The firm will charge $60 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 800 books. What is the contribution margin under the low-capacity machine scenario?

A) $10 B) $20 C) $30 D) $40 Ans: B Feedback: CO EBITDA =

$10, 000− $2,000 FC Alt 1 − FC Alt 2 = = 800units Unit ContribAlt 1 − Unit Contribalt 2 ($60− $30)− Unit Contribalt 2

Unit Contribalt 2 = $20

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 70. Break-even analysis. Binders-For-School, Inc., is in the process of determining whether to purchase a high-capacity machine to make textbooks for the upcoming school year. The high-capacity machine will generate fixed costs of $10,000 per year versus the $2,000 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $30. The firm will charge $60 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 800 books. What is the variable cost per unit under the low-capacity machine scenario?

A) $20 B) $40 C) $60 D) $80 Ans: B Feedback: −$2,000 $10, 000 FC Alt 1 − FC Alt2 = = 800units  CO EBITDA = − Unit ContribAlt 1 Unit Contribalt 2 ($60− $30)−Unit Contribalt 2 Unit Contribalt 2 = $20 VC= $60− $20= $40

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 71. Break-even analysis. A cement contractor has determined that he will maximize pretax operating cash flow buying a large cement truck if he is able to sell more than 500 yards of cement per month. The price of a yard of cement is $60, and the variable costs for a large truck are $20 per yard. The variable costs for a small truck are $40 per yard, and the fixed costs for the small truck are $10,000. What are the fixed costs associated with the large truck?

A) $0 B) $10,00 C) 0 D) $20,00 Ans: C0 $30,00 Feedback: 0 FC Alt 1 − FC Alt2 FC Alt1 − $10, 000 = = 500yards  CO EBITDA = Unit ContribAlt 1 − Unit Contribalt 2 ($60− $20)−($60− $40) FC Alt1 = $20, 000

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 72. Break-even analysis. Max's Brakes is introducing a new revolutionary brake-pad for vehicles that will never wear out. Max's will sell the pads for $100 a pair, and they will cost $80 in variable costs to produce. If cash fixed expenses are $1,500 per year and the depreciation and amortization expenses are $600 per year, then what is the Accounting Operating Profit Break-Even point for Max's?

A) 8 pairs B) 21 pairs C) 75 pairs D) 105 Ans: Dpairs Feedback: $1,500+$600 FC+D&A = =105 pairs EBIT Break−Even = $100−$80 Price−UnitVC Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 73. Break-even analysis. Yoo Computers is introducing a new game system that promises to never become outdated. Yoo will sell the systems for $200, and it will accrue $130 in variable costs to produce. If cash fixed expenses are $35 million per year and the depreciation and amortization expenses are $7 million per year, then what is the Accounting Operating Profit Break-Even point for Yoo? A) 210,000 B) units C) 323,077 D) units Ans: D500,000 units Feedback: $35,000,000+$7,000,000 600,000 FC+D&A = =600,000systems = EBIT Break−Even units $200−$130 Price−UnitVC

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 74. Break-even analysis. ClockWatchers is about to introduce a new employee monitoring tool and has determined that it will charge $100 per unit. The firm must decide whether or not to purchase a high-capacity manufacturing machine. If the high-capacity machine is selected, then the cash fixed costs will be $5,000 per year, with variable costs of $50 per unit and depreciation and amortization expenses of $2,000. Otherwise the fixed costs will be $2,000, with variable costs of $75 per unit and depreciation and amortization expenses of $500. If EBIT Break-even is how the firm evaluates its projects, then above what level of expected sales should ClockWatchers choose the high fixed cost alternative?

A) 60 units B) 90 units C) 120 units D) 180 units Ans: D Feedback: (FC+D&A) − FC+D A ( Alt1 ($5,000+ $2,000)−($2,000+$500) = COEBIT = =180tools & )Alt2 $50 −$25 (Unit ContribAlt1 −Unit ContribAlt2)

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium

75. Break-even analysis. Bright Light Auto Lamps has found that it is indifferent between purchasin high-capacity vacuum sealing machine or a lower capacity machine as long as sales are 200 un month. The price of each sealed beam light is $50. The high-capacity machine has cash expen $10,000 per month, while the alternative has cash expenses of $5,000 per month and depreci and amortization expenses of $2,000 per month. Under high capacity, the variable costs per u $10; and they are $40 for the other alternative. If the firm bases its decisions on the Accountin Operating Profit Break-even, then what are the depreciation expenses under the high-capacity alternative?

A) $3,000 B) $4,000 C) $9,000 D) none of the above Ans: A Feedback:

($10,000+D & A Alt1 )−($5,000 +$2,000) + (FC D&A) Alt 1 − ( FC + D & )A Alt 2 = 200 units =  $40 − $10 (Unit ContribAlt 1 − Unit Contrib Alt 2 ) D&A Alt 1=$3,000

CO EBIT =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 76. Break-even analysis. Poisson Calculators has found that it is indifferent between purchasing a high-capacity vacuum component assembly machine or a lower capacity machine as long as sa are 1,900 units per month. The price of each calculator is $70. The high-capacity machine has expenses of $100,000 per month and depreciation and amortization expenses of $30,000 per while the alternative has cash expenses of $30,000 per month and depreciation and amortizat expenses of $5,000 per month. Under the low-capacity alternative, variable costs per unit are the firm bases its decisions on the Accounting Operating Profit Break-even, then what is the va cost per unit under the high-capacity alternative?

A) $10 B) $47 C) $60 D) $70 Ans: A Feedback:

(FC+D&A) Alt1 − (FC + D & A)Alt2 ($100,000 +$30,000) −($30,000 +$5,000) Alt1 −Unit ContribAlt2) CO EBIT = =1,900units=  Unit ContribAlt1 −$10 (Unit Contrib

Unit ContribAlt1=$60UnitVC=$10

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 77. Capital rationing. Mick's Pub's is considering expanding the number of restaurants it owns. If it decides on the expansion, it will invest $2,300,000, and the NPV of the project is $900,000. What is the profitability index of the project?

A) 0.39 B) 1.00 C) 1.39 D) 2.39 Ans: C Feedback: NPV +Initial Investment $900,000+$2,300,000 PI = = =1.3913 $2,300,000 Initial Investment

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 78. Capital rationing. You are considering a project that has an initial cost of $1,200,000.

If you take the project, it will produce net cash flows of $300,000 per year for the next six years. If the appropriate discount rate for the project is 10 percent, what is the profitability index of the project?

A) 0.09 B) 1.09 C) 2.09 D) 2.18 Ans: B Feedback: NPV + InitialInvestment = ($300, 000 x PVIFA 10%, 6) − $1, 200, 000 PI = ;NPV = Initial Investment =  x 4.35526) − $1, 200, 000 $106, 578.21 ($300, 000

PI =

$106, 578.21 + $1, 200, 000 = 1.0888 1.09 $1, 200, 000

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 79. Capital rationing. TuleTime Comics is considering a new show that will generate annual cash flows of $100,000 into the infinite future. If the initial outlay for such a production is $1,500,000 and the appropriate discount rate is 6 percent for the cash flows, then what is the profitability index for the project?

A) 0.11 B) 0.90 C) 1.11 D) 1.90 Ans: C Feedback: NPV + InitialInvestment = ; NPV = ($100,000/0.06)− $1, 500, 000 PI = Initial Investment − = $166, 666.67  500, 000 $1,666,666.67$1,

PI =

$166, 666.67 + $1, 500, 000 = 1.111111  1.11 $1, 500, 000

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 80. Capital rationing. The profitability index for a project is 1.18. If the project will produce cash inflows of $60,000 for the next 12 years, what is the initial outlay for the project if the appropriate discount rate is 5 percent? (Round to the nearest $10.)

A) $450,670 B) $627,520 C) $1,016,950 D) none of the above Ans: A Feedback: NPV + InitialInvestment ; NPV = ($60, 000x PVIFA 5%,12) − Initial Outlay = PI = Initial Investment = $531,795.10 ($60, 000x 8.86325164) − Initial Outlay − Initial Outlay 

PI =

− Initial Outlay + Initial Outlay $531,795.10 $531,795.10 = = 1.18 Initial Outlay Initial Outlay

Initial Outlay = $450, 673.81 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 81. Which of the following statements is most correct?

A) Variable costs are expenses that do not change if sales revenues rise.

B) A firm can reduce project risk by increasing the sensitivity of EBITDA to C) revenue changes.

A project that has a higher proportion of fixed costs will have cash flows that are more sensitive to changes in revenues than an otherwise identical project with a lower proportion of fixed costs.

D) An investment in new manufacturing equipment that will automate a production process would be an example of a variable cost.

Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 82. Which of the following statements is false?

A) The purchase of equipment to replace labor in a manufacturing process will B) increase a firms operating leverage.

C) The higher the proportion of fixed costs to variable costs in a project, the greater D) the sensitivity of EBIT to revenue changes.

Depreciation and amortization are considered fixed costs.

The lower the proportion of fixed costs to variable costs in a project, the more pre-tax operating cash flows will vary as revenue varies.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 83. The higher a project’s operating leverage, _________________.

A) The lower the sensitivity of EBIT to changes in revenue.

B) The greater the sensitivity of EBITDA to changes in revenue.

C) The lower the sensitivity of net profit to changes in variable costs.

D) The greater the sensitivity of net profit to changes in variable costs.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 84. Calculation of operating leverage. Mega Line, Inc. had the following financial results for the fiscal year ending September 30, 2010. Sales $1,550,250; depreciation and amortization $80,785; fixed costs $125,000; net profit $237,500; operating income $620,100. What was the firm's degree of pre-tax cash flow operating leverage during fiscal 2010?

A) 1.18 B) 1.64 C) 1.27 D) 1.45 Ans: A Feedback:

FC FixedCosts = 1 + DegreeOf Pr e − taxOperatingLeverage= 1 + Pr e − taxOperatingCashFlows EBITDA $125,000 FC = 1 + = 1.178346 1.18 DegreeOf Pr e − taxOperatingLeverage= 1 + $620,100+80,785 EBITDA

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 85. Which is the term used to define how many units must be sold for pre-tax operating cash flow to be equal to zero?

A) Pre-tax accounting operating profit break-even point.

B) Pre-tax operating financial leverage break-even point.

C) Pre-tax accounting sensitivity break-even point.

D) Pre-tax operating cash flow break-even point.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 86. Which of the following differentiates accounting operating profit break-even point from pre-tax operating cash flow break-even point?

A) Accounting operating profit break-even point includes interest expense B) in the numerator, whereas pre-tax operating cash flow does not. Pre-tax C) operating cash flow break-even point includes income taxes in the D) denominator, whereas accounting operating profit break-even point does not. Accounting operating profit break-even point includes depreciation & amortization in the numerator, whereas pre-tax operating cash flow does not. Pre-tax operating cash flow break-even point includes interest expense in the numerator, whereas accounting Ans: Coperating profit break-even point does not.

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 87. Break-even point units: Ski & Surf manufactures snow boards. The firm has fixed costs of $1,090,275. The snow boards sell for $335 each and have a variable cost of $165 each. What is the pretax operating cash flow break-even point for Ski & Surf? (Round off to the nearest unit) A) 9,00 B) 0 C) 6,41 D) 3 Ans: B8,51 1 Feedback: 5,87 6 $1,090,2 $1,090,275 FC = = = 6,413.38 EBITDABreak − even = 170 Pr i ce − Uni tVC 75 $335−16 5 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 88. What decision criteria should managers use in selecting projects when there is not enough capital to invest in all available positive NPV projects?

A) The profitability index.

B) The internal rate of return.

C) The discounted payback.

D) The modified internal rate of return.

Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 89. What might cause a firm to face capital rationing?

A) If a firm has more than one project with a positive NPV. B) If a firm rejects some capital investments that are expected to generate positive C) NPV’s.

D) If investors require returns for their capital that are too high.

If a firm has several projects that are expected to generate negative IRR’s.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 90. Capital Rationing: Myers Limited is considering the purchase of automated equipment that is expected to generate an NPV of $632,500. The cost of the equipment is $2,375,500. What is the profitability index of the project? (Round off to the nearest 0.01) A) B) C) D) 1.54 1.12 1.44 1.27 Ans: D Feedback: PI=

NPV +InitialInvestment InitialInvestment

=

$632,500+$2,375,250 =1.266288 ≈1.27 $2,375,250

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Format: Essay Learning Objective: LO 2 91. Briefly explain the difference between the degree of pretax cash flow operating leverage and the degree of accounting operating leverage. Also explain why someone might be interested in one or the other.

Ans: The formulas for the two are as follows: 1+ FC Degree of pretax cash flow operating leverage = EBITDA and FC+D&A 1+ Degree of accounting operating leverage = EBITDA−D&A. As the chapter mentions, the degree of pretax cash flow operating leverage considers EBITDA, while the degree of accounting operating leverage considers EBIT. Since the difference between EBITDA and EBIT is depreciation and amortization, it is apparent that the accounting method considers a measure of pretax income that has depreciation and amortization removed from the starting point. However, since pretax cash flow does not include noncash items, such as depreciation and amortization, it does not consider those items. If, however, a firm is replacing depreciated assets, then the accounting method might actually serve as a good measure of pretax cash flow.

Format: Essay Learning Objective: LO 5 92. When a firm is in a capital rationing situation, it may be helpful for the firm to use the profitability index to prioritize which projects to take. Briefly describe how the profitability index may fail the firm in that situation.

Ans: The profitability index is helpful because it is a ratio of the benefits of a project to the costs of taking that project. In a situation in which the firm is considering projects for a single year, then the PI works well with a little effort to see which combination of projects will provide the greatest cumulative NPV for the firm.

However, in a multiple-period capital rationing situation in which the cash flows from one or more of the current year's projects are used to finance next year's projects, the PI is limited in recommending the best choice of projects.

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Format: Essay Learning Objective: LO 4 93. Briefly discuss why a firm may not be able to raise financing for as many positive-NPV projects as it can come up with.

Ans: In an ideal world where managers and investors can agree that the projects that the firm wants to invest in are positive-NPV projects, there will be adequate capital for the projects. However, when there is less than perfect information shared between the two parties, then investors may become skeptical about those projects. One reason for less than perfect information sharing is competitive related information that cannot be made public at the time the project is being discussed.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Unique risk is the only risk that investors require compensation for bearing.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 2. Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice because analysts do not have the stock returns from individual projects that are necessary to use in a regression analysis for estimating a project's beta.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 3. Using the firm's overall cost of capital to evaluate a project's cash flows is problematic in that the firm is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 4. If a firm finances the purchase of an asset with cash, then it has zero financial cost to the firm.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. The finance balance sheet is based on market values, just like the accounting balance sheet.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 6. If the market value of a firm's assets are greater than the book value of a firm's assets then the book value of the firm's liabilities and equity must be less than the market value of the firm's liabilities and equity.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 7. The beta of the firm is equal to the weighted-average sum of the betas of the individual projects that the firm is currently operating.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 8. Due to the magic of diversification, the risk associated with the assets of the firm must be less than the risk associated with the financing, or debt and equity, that the firm is utilizing for its assets.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 9. A firm is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. That means that the before-tax cost of capital for the firm must be between 10 and 12 percent.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 10. If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 11. Estimates of security returns will be reliable in all types of markets, including those deemed less efficient than others.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 12. Long-term debt typically describes debt that will mature in two years or more.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 13. Long-term debt is generally viewed as a permanent financing source for the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 14. With respect to the cost of capital, we are generally interested in the cost of a source of financing on a particular date.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 15. If a firm is interested in the current cost of its debt obligations, then it can simply look at the contractual rate of interest due lenders on those obligations.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 16. Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the firm is still 10 percent.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 17. The yield to maturity for a semiannual coupon paying bond will accurately reflect the actual current annual cost of the debt.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 18. The yield to maturity for an annual coupon paying bond will accurately reflect the actual current annual pretax cost of the debt.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 19. The current cost of bank debt can be determined by asking the firm's banker.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 20. The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 21. If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be less than the before-tax cost of debt.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 22. The cost of equity for the firm must take the cost of preferred stock (if any has been issued) that the firm has outstanding into account.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 23. The correct Treasury rate to use in calculating the cost of equity (when using the CAPM) for a firm is a short-term rate.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 24. When trying to estimate the cost of equity for a firm using the CAPM, it is possible to find the beta of a comparable, publicly traded firm whose primary business is closely related to the firm at hand.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 25. The market risk premium for the future is always perfectly known, and it is 6.51 percent.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 26. If a firm is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the firm can be determined by also using the current price of the firm's common shares.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 27. The current cost of preferred equity can be found by taking the ratio of the dividend to the current price of preferred shares.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 28. The CAPM can only be used to determine the cost of common equity.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 29. The proportions of debt and equity used to determine the weighted average cost of capital for the firm is based on the market value of debt and equity outstanding.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 30. The correctly calculated weighted-average cost of capital for the firm can be used to discount the cash flows for any new project that the firm may undertake in the future.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 31. The estimated cost of capital financial managers use for efficiency projects tends to be higher than the cost of capital used to evaluate new projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 32. When using a single rate, such as the WACC, to discount cash flows for all projects of a particular company, the discount rate could lead to accepting projects that will actually have a negative NPV. A) True B) False Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 33. Firms have no way to directly estimate the discount rate that reflects the risk of A) a publicly traded security.

B) its debt securities.

C) the incremental cash flows from a particular project.

D) none of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 34. A firm's overall cost of capital is A) equal to its cost debt.

B) a weighted average of the costs of capital for the collection of individual projects C) that the firm is working on.

D) best measured by the cost of capital of the riskiest projects that the firm is working on. none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 35. The finance balance sheet is A) the same as the accounting balance sheet, but it is based on market values.

B) the same as the accounting balance sheet, but it does not have to balance.

C) based on cash rather than accrual accounting.

D) net income.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 36. The value of the cash flows that the assets of the firm are expected to generate must equal A) B) the value of the cash flows claimed by the equity investors.

C) D) the value of the cash flows claimed by the debt investors. the value of the cash flows claimed by both the equity and debt investors. the revenue produced by the firm.

Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 37. The beta for a firm can be estimated by A) adding up the betas of the individual projects of the firm.

B) taking the weighted average of the beta for the individual projects of the firm.

C) taking the simple average of the beta for the individual projects of the firm.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 38. The firm can be viewed as A) a portfolio of individual projects, each with their own risks, cost of capital, and B) returns.

C) a collection of equity shares comprising it.

D) a collection of debt instruments financing it. none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 39. In order for a firm to estimate its cost of debt capital by observing the price of its debt instruments, A) the firm must depend on markets being reasonably efficient.

B) the debt must be privately held.

C) the beta of the debt must be greater than the beta of the firm's equity.

D) None of the above.

Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 40. If markets are not reasonably efficient, then A) the estimates of expected returns are not needed.

B) the need for a discount rate to analyze project cash flows is not needed.

C) estimates of expected returns that were based on security prices will not be D) reliable. none of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 41. When estimating the cost of debt capital for the firm, we are primarily interested in A) the cost of short-term debt.

B) the cost of long-term debt.

C) the coupon rate of the debt.

D) none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 42. Long-term debt typically describes A) debt with a maturity greater than one year.

B) only coupon debt.

C) publicly traded debt.

D) none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 43. Which of the following need to be excluded from the calculation of the firm's amount of permanent debt?

A) Long-term debt B) Revolving lines of credit C) Mortgage debt D) None of the above Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 44. When analyzing a firm's cost of debt, we are typically interested in A) the cost of the debt on the date that the analysis is being completed.

B) the coupon rate on the firm's bonds.

C) the risk-free rate plus half a percent.

D) none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 45. If a firm has bonds outstanding and the firm would like to calculate the current cost of debt for the bonds, then the firm would A) use the coupon rate of the bonds to estimate the cost.

B) use the current yield to maturity of the bonds to estimate the cost.

C) use the current coupon yield of the bonds to estimate the cost.

D) none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 46. A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is A) $60.

B) $30.

C) $30 plus or minus the prorate portion of the discount or premium that the bond D) was purchased for. none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 47. Bond issuance costs include A) investment banking B) fees. legal fees.

C) accountant fees. all of D) the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 48. Income taxes have the effect of A) increasing the cost of debt.

B) decreasing the cost of debt.

C) decreasing the cost of capital for the firm.

D) both b and c are correct.

Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 49. The appropriate risk-free rate to use when calculating the cost of equity for a firm is A) a long-term Treasury rate.

B) a short-term Treasury rate.

C) a 50/50 mix of short-term and long-term Treasury rates.

D) none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 50. The average risk-premium for the market from 1926 to 2009 was A) 8.00%. 7.50%. 6.01%.

B) 6.51% + the Treasury C) rate.

D) Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 51. The recommended model to estimate the cost of common equity for a firm is A) a one-stage constant growth model.

B) a multistage growth model.

C) the CAPM. D) none of the above.

Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 52. In order to use the WACC to evaluate a future project's flows, which of the following must hold?

A) The project will be financed with the same proportion of debt and equity as the B) firm.

C) The systematic risk of the project is the same as the overall systematic risk of the D) firm.

The project must be viable. a and b above.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 53. Overall cost of capital: If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?

A) 8.0% B) 10.0 C) % D) 12.0 Ans: D% 16.0 Feedback: E(Ri) =%Rrf + i [E(Rm) – Rrf] = 0.04 + 2.0 [0.06] = 0.04 + 0.12 = 0.16 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 54. Overall cost of capital: What is the beta of a firm whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent?

A) 0.79 1.30 1.57 B) none of the C) above D) Ans: B Feedback: E(Ri) = Rrf + i [E(Rm) – Rrf] ==> 0.213 = 0.07 + i [0.18 – 0.07] ==> i= 1.30

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 55. Overall cost of capital: Stryder, Inc., has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm?

A) $30.0 B) million C) $45.0 D) million Ans: D$75.0 million Feedback: MV of$75.3 assets = MV of liabilities + MV of equity million = (1.01 x $30,000,000) + (3,000,000 x 15) = $75,300,000 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 56. How firms estimate their cost of capital: The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm?

A) 0.96 1.24 1.28 B) None of the C) above D) Ans: B Feedback: 2

 n Asset portfolio =  xii = 0.4(0.4) + 0.6(1.8) = 1.24 i=1

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 57. How firms estimate their cost of capital: You are analyzing the cost of capital for a firm that is financed with 65 percent equity and 35 percent debt. The cost of debt capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is the overall cost of capital for the firm?

A) 12.2 B) % C) 14.0 D) % Ans: C15.8 % Feedback: kFirm20.0 = xDebt kDebt + xEquity kEquity = (0.35 x 0.08) + (0.65 x 0.2) = 0.158 % Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 58. How firms estimate their cost of capital: You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the firm?

A) 13.0 B) % C) 14.0 D) % Ans: C15.0 % Feedback: xDebt16.0 = 200/500 = 0.4, xEquity = 300/500 = 0.6 kFirm% = xDebt kDebt + xEquity kEquity = (0.4 x 0.09) + (0.6 x 0.19) = 0.15

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 59. How firms estimate their cost of capital: The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the firm?

A) 19.75 B) % C) 24.00 D) % Ans: B32.50 % Feedback: xDebt58.00 = 25/100 = 0.25, xEquity = 75/100 = 0.75 kFirm% = xDebt kDebt + xEquity kEquity .1975 ==> = (0.25 x 0.07) + (0.75 x kEquity) ==> kEquity = 0.2400 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 60. How firms estimate their cost of capital: The WACC for a firm is 13.00 percent. You know that the firm's cost of debt capital is 10 percent and the cost of equity capital is 20%. \ What proportion of the firm is financed with debt?

A) 30% B) 33% C) 50% D) 70% Ans: D Feedback: xDebt = Y, xEquity = (1 – Y) kFirm = xDebt kDebt + xEquity kEquity ==> 0.13= (Y x 0.1) + ((1 – Y) x 0.20) ==> Y = 0.7

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 61. The cost of debt: Bellamee, Inc., has semiannual bonds outstanding with five years to maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds?

A) 4.5% B) 7.0% C) 9.0% D) 9.2% Ans: C Feedback: Using the formula for pricing bonds, we have $920.87 = $35 x PVIFA(YTM / 2,10) + $1, 000 x PVIF (YTM / 2,10) and after solving for YTM / 2= 4.5%,we find that YTM = 9.0%. − annual coupons forthebond.

Note that we assume semi

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 62. The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price?

A) 3.5% B) 7.00 C) % D) 7.12 Ans: C% 8.00 Feedback: Using% the formula for pricing bonds, we have $1,080.29= $40x PVIFA YTM / 2, 24)+ $1,000x PVIF YTM / 2, 24) ( (

and after solving for YTM / 2= 3.5%,we find that YTM = 7.0%. − annual coupons for the bond .

Note that we assume semi 0.07 0.0712= 7.12% Now, we adjust for EAR :(1+ 2 )2− 1 =

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 63. The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35%? Assume that your calculation is made as on Wall Street.

A) 6.250% B) 8.125% C) 12.500 D) % Ans: B12.890 % Feedback: Using the formula for pricing bonds, we have $746.16= $42.50x PVIFA YTM / 2, 26)+ $1,000x PVIF YTM / 2, 26) ( (

and after solving for YTM / 2= 6.25%,we find that YTM = 12.50%. − annual coupons forthebond.

Note that we assume semi Now, we adjust taxes:12.50% x(1−0.35)= 8.125%

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 64. The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30 percent? Complete the calculation as is done on Wall Street.

A) 7.050% B) 8.225% C) 11.750 D) % Ans: A12.095 % Feedback: Using the formula for pricing bonds, we have $754.08= $36.25x PVIFA YTM / 2,18)+ $1,000x PVIF YTM / 2,18) ( (

and after solving for YTM / 2= 5.875%,we find that YTM = 11.75%. − annual coupons forthebond.

Note that we assume semi Now, we adjust taxes:11.75% x(1 − 0.3)= 8.225% Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 65. The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent?

A) 7.92% B) 13.20 C) % D) 15.57 Ans: B% 23.60 Feedback: %  i)=Rrf +i E(Rm)−Rrf .  Theequation fortheCAPM is: E(R

If  i = 1.3,Rrf = 0.08,and E(R m) = 0.12,then we have − 0.12= 0.132  = 13.20% E(R i ) = 0.08+1.30.08

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 66. The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 30 percent?

A) 11.20 B) % C) 10.60 D) % Ans: D15.14 % Feedback: 16.00 fortheCAPM is: E(R  i)=Rrf +i E(Rm)−Rrf .  Theequation %

If  i = 1.4,Rrf = 0.09,and E(R m) − Rrf = 0.05,then we have = 0.16= 16.00% E(R i ) = 0.09+1.40.05 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 67. The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35 percent?

A) 1.0 B) 1.28 C) 1.60 D) 4.10 Ans: C Feedback:  i)=Rrf +i E(Rm)−Rrf .  Theequation fortheCAPM is: E(R

If E(R i ) = 0.228,Rrf = 0.10,and E(R m) = 0.18,then we have − 0.10 = = =i = 1.60 0.228= 0.10+  i  0.18

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 68. The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50?

A) 12.00% B) 14.65% C) 15.00% D) 15.36% Ans: C Feedback: expected growth in dividends Since the price of common shares is given as well as the : and the next expected dividend, we can use the following $2.10 D1 +0.03=0.15=15% kc s =0 + g = $17.50 P Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 69. The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00?

A) 5.77% B) 6.00% C) 9.77% D) 10.00% Ans: D Feedback: expected growth in dividends Since the price of common shares is given as well as the : and the last paid dividend, we can use the following D0(1+g) $1.501.04 D + g = + 0.04= 0.10 = 10% kc s =01 + g = P0 $26.00 P

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 70. The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its common shares is currently $25.71?

A) 7.27% B) 8.00% C) 18.00% D) The problem is not solvable with the information that is given.

Ans: B Feedback: expected growth in dividends Since the price of common shares is given as well as the : and the last paid dividend, we can use the following $1.871.1 D0(1+ g ) D1 +g = + 0 =0.08 = 8% kc s =0 + g = P0 $25.71 P Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 71. The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent thereafter. What is the implied cost of common equity capital for Dedus?

A) 7.00% B) 8.00% C) 9.00% D) 10.00% Ans: C Feedback: cos t of We can use the common stock pricing equation to solve for the : common equity capital 2 $1.00(1.1 $1.00(1.1) $1.00(1.1) ) (1.05) + + )2 ; Trial and error gives us kcs = 0.09 2 2

$28.76=

) ( 1+kcs (1+kcs) (1+kcs) (kcs −0.05

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 72. The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility?

A) 9% B) 10% C) 11% D) 12% Ans: D Feedback: We can use the common stock pricing equation to solve for the cost of common equity capital:

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 73. The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share.

The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter.

What is the implied cost of common equity capital for Oasis?

A) 13% B) 14% C) 15% D) 16% Ans: B Feedback: the t of We can use the common stock pricing equation to solve for cos : common equity capital 2 $1.75(1.10 ( ); ) 1.05 $1.75 $1.75(1.10) $1.75(1.10) + + + $21.12= 3 2 ) ( +kcs1)3 (kcs − 0.05 ) kcs ) ) c s(1+ ( 1k+ c(s1k+

2

Trial and error gives us kcs = 0.14

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 74. The cost of preferred equity: Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity?

A) 7% B) 8% C) 9% D) 10% Ans: C Feedback: We start with the pricing equation for preferred shares and rearrange to solve for thecost of preferred equity:

D $3.50 = 0.09 k ps = P = $38.89 0 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 75. The cost of equity: Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity?

A) 6.50 B) % C) 7.00 D) % Ans: B7.50 % Feedback: 8.00 with the pricing equation for preferred shares and rearrange to solve for We start % thecost of preferred equity:

D $1.86 = 0.07 k ps = P = $26.57 0

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 76. The cost of equity: Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's cost of preferred equity?

A) 11.50 B) % C) 11.75 D) % Ans: C12.00 % Feedback: 12.25 with the pricing equation for preferred shares and rearrange to solve for We start % thecost of preferred equity:

D $2.34 = 0.12 k ps = P = $19.50 0 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 77. Using the WACC in practice: Swirlpool, Inc., has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. If the firm is financed with 60 percent common shares and 40 percent debt, then what is the after-tax weighted average cost of capital for Swirlpool if it is subject to a 40 percent marginal tax rate?

A) 10.37 B) % C) 12.00 D) % Ans: C12.72 % Feedback: 14.00 : for WACC is The formula %

 + xpskcs = 0.4  0.08 (1−0.4) + 0.6  0.18= 0.1272 WACC = x DebtkDebtpretax(1−t)

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 78. Using the WACC in practice: Maloney's, Inc., has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. If the firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt, then what is the after-tax weighted average cost of capital for Maloney's if it is subject to a 40 percent marginal tax rate?

A) 8.96% B) 11.16 C) % D) 11.64 Ans: C% 12.60 Feedback: %that the proportion of debt and equity is Noting

= 0.4,xcs = $3, 000, 000 /($3, 000,+000 = $2, 000, 000) $2, 000, 000)0.6 xDebt = $2, 000, 000 /($3, 000,+000 The formula forWACCis:  + 0.6  0.17= 0.1164 WACC = xDebtkDebt pretax(1−t) + xpskcs = 0.4  0.06 (1−0.4)

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 79. Using the WACC in practice: Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. If the firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt, then what is the after-tax weighted average cost of capital for Ronnie's if it is subject to a 35 percent marginal tax rate?

A) 6.05% B) 9.6% C) 8.75% D) 13.65% Ans: B Feedback: Noting that the proportion of debt and equity is:

The formula for WACC is:

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Format: Multiple Choice Learning Objective: LO 4 Level of D ifficulty: Hard 80. Using the WACC in practice: Poly's Parrot Shops has found that its cost of common equity capital is 17 percent. It has 7-year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Poly's if it is subject to a 35 percent marginal tax rate?

A) 10.20 B) % C) 11.76 D) % Ans: D11.88 % Feedback: 13.32 Noting that the proportion of debt and equity is %

000) = 0.4, xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6 xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, The price of the bonds can be used to find the YTM : $767.63= $35 PVIFA YTM (

+ $1,000PVIF (YTM  /2,14) /2,14)

YTM / 2 = 6% YTM =12%=kDebt pretax The formula forWACC is:  + 0.6  0.17= 0.1332 WACC = xDebtkDebt pretax(1−t) + xpskcs = 0.4  0.12 (1−0.35)

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 81. Using the WACC in practice: Marley's Pipe Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Marley's if it is subject to a 35 percent marginal tax rate?

A) 10.20 B) % C) 11.76 D) % Ans: D11.88 % Feedback: 13.32 Noting that the proportion of debt and equity is %

000) = 0.4, xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6 xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, The return on common shares can be found with the CAPM : The equation for the CAPM is : E(R i ) = Rrf +  i E(R m) − Rrf   = 0.17 E(R i)=0.08+1.50.14−0.08

The formula forWACC is:  = 0.4  0.12 (1−0.35) + 0.6  0.17= 0.1332 WACC = xDebtkDebt pretax(1−t) + xpsk cs

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard 82. Using the WACC in practice: Droz's Hiking Gear, Inc., has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. It has 7-year semiannual maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent.. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Droz's if it is subject to a 35 percent marginal tax rate? Calculate the cost of debt as it would be done on Wall Street.

A) 10.20 B) % C) 11.76 D) % Ans: D11.88 % Feedback: 13.32 Noting that the proportion of debt and equity is %

000) = 0.4, xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6 xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, The return on common shares can be found with the CAPM : The equation for the CAPM is : E (R i ) = Rrf +  i E(R m) − Rrf   = 0.17 E(R i)=0.08+1.50.14−0.08

The price of the bonds can be used to find the YTM : $767.63=$35PVIFA( YTM /2,14) + $1,000PVIF (YTM  /2,14) YTM/2=6%YTM

=12%=kDebt pretax

The formula forWACC is :  + 0.6  0.17= 0.1332 WACC = xDebtkDebt pretax(1−t) + xpskcs = 0.4  0.12 (1−0.35)

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 83. Which type of project do financial managers typically use the highest cost of capital when evaluating?

A) Extension projects B) New product projects C) Efficiency projects D) Market expansion projects Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 84. After-tax cost of debt financing A recent leveraged buyout was financed with $50M. This amount comprised of partner’s equity capital of $12M, $20M unsecured debt borrowed at 7% from one bank and the remainder from another bank at 8.5%.

What is the overall after-tax cost of the debt financing if you expect the firm’s tax rate to be 33%?

A) 2.55% B) 3.34% C) 5.17% D) 7.71% Ans: C Feedback: 20M @ 7% and 50M – 12M – 20M = 18M @ 8.5% Weighted average pretax cost of debt = 7(20/38) + 8.5(18/38) = 7.71% After-tax cost of debt = 7.71% (1-.33) = 5.17% Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 85. If a company's weighted average cost of capital is less than the required return on equity, then the firm: A) Is financed with more than 50% debt.

B) Is perceived to be safe C) Has debt in its capital structure D) Must have preferred stock in its capital structure Ans: C

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Format: Essay Learning Objective: LO 2 86. Briefly explain why the book value of debt might not reflect the current cost of debt for the firm, with respect to a single issuance of debt?

Ans: The book value of debt (or bonds) will be reflective of the market and firm risks at the time the bonds were issued. If market or firm conditions have changed materially since that time, then the market price of the bonds will reflect the current cost of debt equity for the firm rather than the book value of that debt.

Format: Essay Learning Objective: LO 3 87. Explain the conditions under which the constant-growth dividend formula for the cost of common stock can be used to find the cost of common equity capital for the firm.

Ans: The first condition that must hold is that the growth rate in dividends must be constant for the foreseeable future of the firm. This condition does not generally hold for growing or contracting firms. The second condition is that the growth rate in dividends must be less than the cost of equity capital for the firm.

Format: Essay Learning Objective: LO 4 88. Discuss the two major conditions for when the firm may use its current weighted average cost of capital to evaluate a new project's cash flows.

Ans: The first condition is that the proportions of capital (debt, common shares, preferred shares) that the firm is relying on to finance the firm must also be utilized to finance the new project. Any material deviation from that mix will alter the individual cost of each type of financing. The second condition is that the level of systematic risk inherent in the overall portfolio of projects the firm is currently taking on must be the same as the level of systematic risk for the new project.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. The appropriate mix of current assets is not a working capital management decision.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. Net working capital is important because it is a measure of liquidity and represents the net short-term investment the firm keeps in the business.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. Working capital management involves making decisions regarding the use and sources of current assets.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. Working capital efficiency refers to the length of time it takes for a firm to convert the raw material to a finished product.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. Liquidity is the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 6. The operating cycle begins when the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 7. The cash conversion cycle is the length of time between the cash outflow for materials and the cash inflow from sales.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 8. Days' payables outstanding (DPO), which tells how long a firm takes to pay off its suppliers for the cost of inventory, is used to measure the operating cycle.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 9. Days' payables outstanding (DPO) tells how long a firm takes to pay off its suppliers for the cost of inventory.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 10. An efficient firm with good working capital management should have a high average collection period compared to its industry.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 11. The flexible strategy calls for management to invest large amounts in cash, marketable securities, and inventory.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 12. The flexible strategy is perceived be a high-risk and low-return course of action for management to follow.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 13. The restrictive strategy is a high-risk, high-return alternative to the flexible strategy.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy 14. The conflict between carrying costs versus shortage costs is called the working capital trade-off.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 15. If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 16. If carrying costs are less than shortage costs, then the firm will maximize value by adopting a more restrictive strategy.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 17. Trade credit, which is short-term financing, comes with an explicit interest charge.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium 18. An offer of 3/10, net 40 means that the selling firm offers a 10 percent discount if the buyer pays the full amount of the purchase in cash within 3 days of the invoice date.

Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 19. Trade credit is a cheap loan from the supplier.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 20. The aging schedule shows the breakdown of the firm's accounts receivable by their date of sale.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy 21. A firm that employs just-in-time management has to increase its investment in working capital.

A) True B) False Ans: B Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 22. Float is the time taken by a credit customer to pay the firm.

A) True B) False Ans: B Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 23. A lockbox system allows geographically dispersed customers to send their payments to a post office box close to them.

A) True B) False Ans: A Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy 24. Under the maturity matching strategy, a firm funds all seasonal demands with short-term borrowing.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy 25. Short term funding strategy calls for all working capital and a portion of fixed assets to be funded with short-term debt.

A) True B) False Ans: A Format: True/False Learning Objective: LO 7 Level of Difficulty: Medium 26. An informal line of credit is short term debt promissory notes issued by large financial firms.

A) True B) False Ans: B Format: True/False Learning Objective: LO 7 Level of Difficulty: Medium 27. A factor is an individual or financial institution that buys accounts receivable without recourse.

A) True B) False Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 28. Which one of the following statements is NOT true?

A) Gross working capital is the funds invested in a company's current liabilities.

B) Net working capital (NWC) refers to the difference between current assets and C) current liabilities.

D) Working capital efficiency refers to the length of time between when a working capital asset is acquired and when it is converted into cash.

Working capital management involves making decisions regarding the use and sources of current assets.

Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 29. Which one of the following statements is NOT true?

A) The higher the cash balance, the better the ability of the firm to meet its B) short-term financial obligations.

C) The lower the cash balance, the better the ability of the firm to meet its short-term D) financial obligations.

The level of the cash balance has no bearing on the firm's ability to meet its short-term financial obligations.

None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 30. The cash conversion cycle A) shows how long the firm keeps its inventory before selling it.

B) begins when the firm invests cash to purchase the raw materials that would be C) used to produce the goods that the firm manufactures.

D) begins when the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. estimates how long it takes on average for the firm to collect its outstanding accounts receivable balance.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 31. Which one of the following statements is NOT true?

A) The cash conversion cycle begins when the firm invests cash to purchase B) the raw materials that would be used to produce the goods that the firm C) manufactures. The cash conversion cycle begins when the firm uses its cash D) to purchase raw materials and ends when the firm collects cash payments on its credit sales. To measure the cash conversion cycle, we need another measure called the days' payables outstanding. The cash conversion cycle ends not with the finished goods being sold to customers and the cash collected on the sales; but when you take into account the time taken by the firm to pay for its purchases.

Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 32. The operating cycle A) begins when the firm receives the raw materials it purchased that would be used B) to produce the goods that the firm manufactures.

C) begins when the firm uses its cash to purchase raw materials and ends when the D) firm collects cash payments on its credit sales.

To measure operating cycle we need another measure called the days' payables outstanding. ends not with the finished goods being sold to customers and the cash collected on the sales; but when you take into account the time taken by the firm to pay for its purchases.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 33. Which ONE of the following statements is true when managing working capital accounts?

A) Maintain minimal raw material inventories without causing manufacturing B) delays.

C) Use as little labor as possible to manufacture the product while producing a D) quality product.

Delay paying accounts payable as long as possible without suffering any penalties.

All of the above are true.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 34. Which ONE of the following statements is true?

Cash conversion cycle = DSO + DSI+DPO A) Cash conversion cycle = DSO + B) DSI−DPO Cash conversion cycle = DSO C) −DPOof the above.

D) None Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 35. Which one of the following statementsNOT is true?

Cash conversion cycle = DSO + DSI−DPO A) Operating cycle = DSO + DSI B) C) a and b D) None of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 36. The flexible current asset investment strategy A) has a high percent of current assets to sales.

B) calls for management to invest large amounts in cash, marketable securities, and C) inventory.

D) leads to high levels of accounts receivable.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 37. Which one of the following is NOT true about the flexible current asset investment strategy?

A) The strategy promotes a liberal trade credit policy for customers.

B) The flexible strategy calls for management to invest large amounts in cash, C) marketable securities, and inventory.

D) The flexible strategy is perceived be a high-risk and high-return course of action for management to follow.

The strategy's downside is the high inventory carrying cost.

Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 38. A restrictive current asset investment strategy calls for A) current assets kept to a minimum.

B) the firm barely investing in cash and inventory.

C) tight terms of sale intended to curb credit sales and accounts receivable.

D) All of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 39. The restrictive strategy is a high-risk, high-return alternative to the flexible strategy because of A) financial shortage costs.

B) production shortage costs.

C) human resources shortages costs.

D) None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 40. Which ONE of the following statements is true?

A) Financial shortage costs arise mainly from illiquidity—shortage of cash or a lack B) of marketable securities to sell for cash.

C) Operating shortage costs result from lost production and sales.

D) Operating shortage costs can be substantial, especially if the product markets are competitive.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 41. Operating shortage costs that result from lost production and sales are caused by A) not holding enough raw materials in inventory.

B) running out of finished goods.

C) restrictive sale policies.

D) All of the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 42. Which ONE of the following statements about working capital tradeoff is true?

A) Financial managers need to balance shortage costs against carrying costs to find B) an optimal strategy.

C) If carrying costs are larger than shortage costs, then the firm will maximize value D) by adopting a more restrictive strategy.

If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 43. Which one of the following statements about working capital trade-off is NOT true?

A) Financial managers need to balance shortage costs against carrying costs to find B) an optimal strategy.

C) If carrying costs are smaller than shortage costs, then the firm will maximize D) value by adopting a more restrictive strategy.

If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy.

Management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs.

Ans: B Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 44. The aging schedule A) shows the breakdown of the firm's accounts receivable by their date of sale.

B) identifies and then tracks delinquent accounts and to see that they are paid.

C) are an important financial tool for analyzing the quality of a company's D) receivables.

All of the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 45. Which ONE of the following statements is true?

A) The economic order quantity (EOQ) mathematically determines the minimum B) total inventory cost.

C) The EOQ takes into account reorder costs and inventory carrying costs.

D) The optimal order size is determined by the EOQ model.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 46. Which one of the following statements is NOT true?

A) The economic order quantity (EOQ) mathematically determines the minimum B) total inventory cost.

C) The EOQ ignores reorder costs and inventory carrying costs.

D) The optimal order size is determined by the EOQ model.

All of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 47. Which one of the following statements about just-in-time inventory management policy is NOT true?

A) It calls for the exact day-by-day, or even hour-by-hour raw material needs to be B) delivered by the suppliers.

C) If the supplier fails to make the needed deliveries, then production shuts down.

D) A big disadvantage in this system is that there are high raw inventory costs.

It eliminates obsolescence or loss to theft.

Ans: C

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 48. Which one of the following statements about collection time is NOT true?

A) Collection time, or float, is the time between when a customer makes a payment B) and when the cash becomes available to the firm.

C) Collection time can be broken down into three components.

D) Delivery time or mailing time is not part of the float.

Processing delay is part of the collection time.

Ans: C Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 49. Which ONE of the following statements about matching maturity strategy is true?

A) All working capital is funded with short-term borrowing.

B) As the level of sales varies seasonally, short-term borrowing fluctuates between C) some minimum and maximum level.

D) All fixed assets are funded with long-term financing.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 50. Which ONE of the following statements about short term funding strategy is true?

A) All working capital and a portion of fixed assets are funded with short-term debt.

B) This strategy lowers the cost under some interest rate scenarios.

C) It forces the firm to continually refinance the funding of the long-term assets in a D) changing interest rate environment.

All of the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 51. Which one of the following statements is NOT true?

A) Firms using matching maturity strategy fund all working capital needs with B) long-term borrowing.

C) Long-term financing strategy relies on long-term debt to finance both capital D) assets and working capital.

All working capital and a portion of fixed assets are funded with short-term debt when firms use the aggressive funding strategy.

Firms using a matching maturity strategy fund all working capital needs with short-term borrowing.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 52. Which one of the following statements is NOT true?

A) Accounts payable (trade credit), bank loans, and commercial paper are common B) sources of short-term financing.

C) An informal line of credit is a verbal agreement between the firm and the bank, D) allowing the firm to borrow up to an agreed-upon upper limit.

An informal line of credit is also known as “revolving credit.”

A formal line of credit is also known as “revolving credit.”

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 53. Operating cycle: Trend Foods distributes its products to more than 100 restaurants and delis. The company's collection period is 32 days, and it keeps its inventory for 10 days.

What is Trend's operating cycle?

A) 22 days 32 days B) 42 days None of C) the above.

D) Ans: C Feedback: DSI = 10 days DSO = 32 days + Operating cycle= DSO DSI = 32+10 = 42days

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 54. Operating cycle: Stamp, Inc., has an operating cycle of 81 days and takes 47 days to collect on its receivables. What is its level of inventory if the firm's cost of goods sold is $312,455? Round to the nearest dollar.

A) $9,190 B) $14,68 C) 5 D) $29,10 Ans: C5 $69,33 Feedback: 9 Operating cycle = 81 days DSO = 47 days Cost of goods sold = $19,630 Operating cycle = DSO + DSI DSI = OC – DSO = 81 – 47 = 34 days Inventory Inventory Inventory DSI=34 days= COGS 365 = = $312,455 365 $856.04 Inventory=34856.04=$29, 105.40 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 55. Operating cycle: Le Baron Company, a men's designer firm, has an operating cycle of 123 days. The firm's days' sales in inventory is 73 days. How much does the firm have in receivables if it has credit sales of $433,450? Round to the nearest dollar.

A) $59,37 B) 7 C) $71,25 D) 2 Ans: A$47,50 1 Feedback: $64,23 Operating cycle = 123 days 3 DSI = 73 days Operating cycle = DSO + DSI DSO = OC – DSI = 123 – 73 = 50 days Credit sales = $433,450 Accounts receivables Accounts receivables DSO= = $433,450365 = 50 days Credit sales365 Accounts receivables = 50$1,187.53=$59,376.71

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 56. Operating cycle: All Stars, Inc., has inventory of $44,233 and cost of goods sold of $512,902. The company has an operating cycle of 74 days. What is the firm's days' sales outstanding (DSO)?

A) 43 B) days C) 32 D) days Ans: A49 days Feedback: 26 cycle = 74 days Operating days Cost of goods sold = 212,902 Inventory = $44,233 $44,233 Inventory = = 31.5 days DSI = COGS 365 $512,902 365 Operating cycle = DSO + DSI DSO = OC – DSI = 74 – 31.5 = 42.5 days Use the following to answer questions 57-58: You are provided the following working capital information for the Ridge Company: Ridge Company Account $ Inventory $12,890 Accounts 12,800 12,670 receivable $124,589 Accounts payable 99,630 Net sales Cost of goods sold

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Reference: Ref 14-1 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 57. Operating cycle: What is the operating cycle for Ridge Company?

A) 47 B) days C) 85 D) days Ans: B36 days Feedback: 51 receivables = $12,800 Accounts dayspayables = $12,670 Accounts Net sales = $124,589 Inventory = $12,890 Cost of goods sold = $99,630

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Reference: Ref 14-1 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 58. Cash conversion cycle: What is the cash conversion cycle for Ridge Company?

A) 83.5 days B) 38.3 days C) 129.9 D) days 46.4 Ans: Bdays Feedback: Accounts receivables = $12,800 Accounts payables = $12,670 Net sales = $124,589 Inventory = $12,890 Cost of goods sold = $99,630

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 59. Cash conversion cycle: Wolfgang Electricals estimates that it takes the company 31 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 54 days and days sales' outstanding of 34 days. What is its cash conversion cycle?

A) 119 B) days 34 C) days 57 D) days 46 Ans: Cdays Feedback: Feedback for Question 57: DPO = 31 DSI = 54 DSO = 34 Cash conversion cycle = DSO + DSI – DPO =34 + 54 – 31 = 57 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 60. Cash conversion cycle: Renald Corp. estimates that it takes the company 27 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 43 days and days sales' outstanding of 45 days. What is its cash conversion cycle?

A) 61 days B) 115 days C) 57 days D) 46 days Ans: A Feedback: DPO = 27 days DSI = 43 days DSO = 45 days Renald's cash conversion cycle = Cash conversion cycle=DSO+DSI−DPO =45+43−27 =61 days

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 61. Cash conversion cycle: Your boss asks you to compute the company's cash conversion cycle. Looking at the financial statements, you see that the average inventory for the year was $126,300, accounts receivable were $97,900, and accounts payable were at $115,100. You also see that the company had sales of $324,000 and that cost of goods sold was $282,000. What is your firm's cash conversion cycle? Round to the nearest day.

A) 119 B) days 34 C) days 57 D) days Ans: D125 days Feedback: Accounts receivables = $97,900 Accounts payables = $115,100 Net sales = $324,000 Inventory = $126,300 Cost of goods sold = $282,000 Accounts receivables $97, 900 =110.3 days DSO = Credit sales365 = $324,000 365 $126, 300 Inventory =163.5 days DSI = COGS 365 = $282,000 365 Accounts payables $115, 100 =149 days = DPO = COGS 365 $282,000 365 = DSO DSI + − DPO Cash conversion cycle = 110.3+163.5−149 = 124.8 days

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 62. Cash conversion cycle: West Handicrafts, Inc., has net sales of $423,000 with 30 percent of it being credit sales. Its cost of goods sold is $324,000. The firm's cash conversion cycle is 47.9 days. The firm's operating cycle is 86.3 days. What is the firm's accounts payable? Round to the nearest dollar A) $34,087 B) $126,90 C) 0 D) $71,203 Ans: A$56,322 Feedback: Net sales = $423,000 Credit sales = (0.3 x $423,000) = $126,900 Cash conversion cycle = 47.9 days Operating cycle = 86.3 days Cost of goods sold = $324,000 = (DSO + DSI ) − DPO Cash conversion cycle 47.9 = 86.3 − DPO DPO = 38.4 days

DPO =

Accounts payables Accounts payables = $324,000 365 = 38.4 days COGS 365

Accounts payables= 38.4 $887.67= $34, 086.53 The firm has accounts payables $34,087 of .

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 63. Effective interest rate: Serengeti Travels has borrowed $50,000 at a stated APR of 8.5 percent. The loan calls for a compensating balance of 8 percent. What is the effective interest rate for this company?

A) 9.24% B) 8.50% C) 8.00% D) 16.50 Ans: A% Feedback: Amount to be borrowed = $50,000 Stated annual interest rate = 8.5% Compensating balance = 8% Amount deposited as compensating balance = $50,000 x 0.08 = $4,000 Effective borrowing amount = $50,000 – $4,000 = $46,000 Interest expense = $50,000 x 0.085 = $4,250 $4,250 Interest expense Effective interest rate = = Effective borrowing amount $46,000=9.24%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 64. Effective interest rate: Sun Prairie Traders borrowed $63,000 at an APR of 10 percent. The loan called for a compensating balance of 10 percent. What is the effective interest rate on the loan?

A) 10.00 B) % C) 11.11 D) % Ans: B8.00% 12.50 Feedback: % to be borrowed = $63,000 Amount Stated annual interest rate = 10% Compensating balance = 10% Amount deposited as compensating balance = $63,000 x 0.10 = $6,300 Effective borrowing amount = $63,000 – $6,300 = $56,700 Interest expense = $63,000 x 0.10 = $6,300 $6,300 Interest expense Effective interest rate = = Effective borrowing amount $56,700=11.11%

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 65. Effective interest rate: Good Homes Furnishings is borrowing $225,000. The loan requires a 10 percent compensating balance, and the effective interest rate on the loan is 8.25 percent. What is the stated APR on this loan? Round to one decimal place.

A) 10.00 B) % C) 11.11 D) % Ans: C7.4% 8.25% Feedback: Amount to be borrowed = $225,000 Stated annual interest rate = ?

Compensating balance = 10% Effective interest rate = 8.25% Compensating balance = (0.10 x $225,000) = $22,500 Effective borrowed amount = $225,000 – $22,500 = $202,500 Interest expense Effective interest rate =Effective borrowing amount Interest expense 8.25% = $202, 500

 $202,500= $16,706.25 I nterest expense=0.0825 Stated interest rate = $16,706.25 / $225,000 = 7.425%

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 66. Effective interest rate: Maggie's Bistro is borrowing $375,000. The loan requires an 8 percent compensating balance, and the effective interest rate on the loan is 10.326 percent. What is the stated APR on this loan? Round to one decimal place.

A) 10.0 B) % C) 9.5% D) 7.4% Ans: B8.5% Feedback: Amount to be borrowed = $375,000 Stated annual interest rate = ?

Compensating balance = 8% Effective interest rate = 10.326% Compensating balance = (0.08 x $375,000) = $30,000 Effective borrowed amount = $375,000 – $30,000 = $345,000 Interest expense Effective interest rate =Effective borrowing amount Interest expense 10.326% = $345, 000

 $345,000= $35,625 I nterest expense=0.10326 Stated interest rate = $35,625 / $375,000 9.5% =

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 67. Formal line of credit: Gibbs, Inc., has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit?

A) 8.00 B) % C) 7.25 D) % Ans: C6.58 % Feedback: Line of8.25 credit limit = $1,000,000 % = 6.25% Loan rate Annual fee on unused balance = 0.5% Amount borrowed = $600,000 Unused balance = $400,000 Annual fee = $400,000 x 0.005 = $2,000 Interest expense = $600,000 x 0.0625 = $37,500 Interest expense+ Annual fee Effective interest rate= Borrowed amount ($37,500 + $2,000) = = 6.58% $600,000

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 68. Formal line of credit: Trend, Inc., has just set up a formal line of credit of $5 million with First National Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 7.5 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $2,300,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round to one decimal place.

A) 8.5% B) 7.25 C) % D) 9.0% Ans: D8.1% Feedback: Line of credit limit = $5,000,000 Loan rate = 7.5% Annual fee on unused balance = 0.5% Amount borrowed = $2,300,000 Unused balance = $2,700,000 Annual fee = $2,700,000 x 0.005 = $13,500 Interest expense = $2,300,000 x 0.075 = $172,500 Interest expense+ Annual fee Effective interest rate= Borrowed amount ($172,500 + $13,500) = = 8.09% $2,300,000

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 69. Formal line of credit: Storm Electronics has set up a formal line of credit of $2 million with First Kentucky Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 60 basis points on the unused balance. The firm borrowed $1,500,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round to two decimal places.

A) 7.50 B) % C) 6.45 D) % Ans: B6.25 % Feedback: Line of7.15 credit limit = $3,000,000 % = 6.25% Loan rate Annual fee on unused balance = 0.6% Amount borrowed = $1,500,000 Unused balance = $500,000 Annual fee = $500,000 x 0.006 = $3,000 Interest expense = $1,500,000 x 0.0625 = $93,750 Interest expense+ Annual fee Effective interest rate= Borrowed amount ($93,750 + $3,000) = $1,500,000 = 6.45%

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 70. Lockbox: Porter Corp. has just signed up for a lockbox. Management expects the lockbox to reduce the mail float by 2.3 days. The firm's remittances average $41,250 a day, with the average check being $165. The bank charges $0.39 per processed check.

Assume that there are 270 business days in a year and their opportunity cost of funds is 5 percent. What will the firm's savings be from using the lockbox?

A) $4,743.75 B) $975.50 C) $2,632.50 D) $94,875.00 Ans: A Feedback: Average daily sales = $41,250 No. of business days = 270 Average check amount = $165 No. of checks processed per day = $41,250 / $165 = 250 Collection time saved = 2.3 days Per check processing fee = $0.39 The cost of a lockbox = 250 checks × $0.39 per check × 270 days = $26,325 Savings from mail float = 2.3 days × $41,250 = $94,875 Savings from lockbox = ($94,875 – $26,325) = $68,550 x .05 = $4,743.75 Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 71. Lockbox: Rocky Corp. has daily sales of $18,100. The financial manager determined that a lockbox would reduce the collection time by 2.2 days. Assuming the company can earn 6 percent interest per year, what are the savings from the lockbox? Round to the nearest dollar.

A) $3,620.5 B) 0 C) $2,389.2 D) 0 Ans: B$39,820 $1,100.4 Feedback: 5 daily sales = $18,100 Average Collection time saved = 2.2 days Savings from mail float = 2.2 days × $18,100 = $39,820 Savings if invested = $39,820 x 0.06 = $2,389.20

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 72. Cost of trade credit: Senter Corp. sells its goods with terms of 2/10 EOM, net 30.

What is the implicit cost of the trade credit?

A) 18.50 B) % C) 30.00 D) % Ans: C44.59 % Feedback: Credit21.89 terms = 2/10 EOM, net 30 365/dayscredit % Effective annual rate   Discount −1 1+  Discounted price   = = (1 + 2/98)365/20 – 1 = (1.0204)18.2500 – 1 = 1.4459 – 1 = 0.4459, or 44.59% Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 73. Cost of trade credit: Kearns, Inc., sells its goods with terms of 3/15 EOM, net 60.

What is the implicit cost of the trade credit?

A) 15% B) 45% C) 34% D) 28% Ans: D Feedback: Credit terms = 3/15 EOM, net 60 365/dayscredit Effective annual  Discount  −1 rate 1+  Discounted price  =  = (1 + 3/97)365/45 – 1 = (1.0309)8.1111 – 1 = 1.2800– 1 = 0.28, or 28%

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 74. Factoring: Pride, Inc., sells $150,000 of its accounts receivable to factors at 2.875 percent discount. The firm's average collection period is 75 days. What is the simple annual interest cost of the factors loan?

A) 35.5 B) % C) 32.9 D) % Ans: A27.8 % Feedback: 31.1receivables sold = $150,000 Accounts Factor%discount = 2.875% Average collection period = 75 days Dollar cost of factoring per month = $150,000 x 0.02875 = $4,312.50 Simple monthly interest cost of factoring = 2.875/97.125 = 0.0296 Simple interest cost of factoring = 0.0296 x 12 = 35.5% Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 75. Factoring: A firm sells $125,000 of its accounts receivable to factors at 3 percent discount. The firm's average collection period is one month. What is the dollar cost of the factoring service?

A) $3,00 B) 0 C) $4,50 D) 0 Ans: C$3,75 0 Feedback: $4,25 Accounts receivables sold = $125,000 Factor0discount = 3% Average collection period = 30 days Dollar cost of factoring per month = $125,000 x 0.03 = $3,750 Use the following to answer questions 76-77: Economic order quantity: Jensen Autos, one of the largest car dealers in Eau Claire, sells about 700 vehicles a year. The cost of placing an order with their supplier is $1,100, and the inventory carrying costs are $120 for each car. Most of their sales are in late fall of each year.

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Reference: Ref 14-2 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 76. What is the number of cars per order?

A) 80 cars B) 101cars C) 58 cars D) 113 cars Ans: D Feedback: Annual sales = 700 units Cost of placing an order = $1,100 Inventory carrying cost = $120  per period 2 Reorder costsSales EOQ= Carrying cos ts

2  $1,100  700 = 113.3 $120 Economic order quantity = 113 cars =

Reference: Ref 14-2 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 77. How many orders will the dealer need to place this year?

A) 4 B) orders C) 5 D) orders Ans: C6 orders Feedback: 7 of orders = 700 / 113  6 Number orders

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Basic 78. Which of the following is the equation for net working capital?

A) Total assets – total liabilities B) Current assets – current liabilities C) Current assets/current liabilities D) Total assets/total liabilities Ans: B Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Basic 79. Which of the following is a short-term financing instrument?

A) Accounts payable B) Bank loans with a maturity of less than 1 year C) Commercial paper D) All of the above Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 80. Ticktock Clocks sells 10,000 alarm clocks each year. If the total cost of placing an order is $65 and it costs $85 per year to carry the alarm clock in inventory, use the EOQ formula to calculate the optimal order size.

A) 124 clocks B) 161 clocks C) 15,294 clocks D) 26,154 clocks Ans: A Feedback: EOQ= =

2Reorder costsSales per period Carrying costs 2$6510,000 = 123.7 $85

Economic order quantity = 124 clocks

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Format: Essay Learning Objective: LO 1 81. What are some strategies that financial managers can follow in managing their working capital accounts?

Ans: When managing working capital accounts, financial managers want to do the following: · Delay paying accounts payable as long as possible without suffering any penalt · Maintain minimal raw material inventories without causing manufacturing dela · Use as little labor as possible to manufacture the product while producing a qua · product. · Maintain minimal finished goods inventories without losing sales. · Offer customers the most attractive credit terms possible on trade credit to max sales while minimizing the risk of nonpayment.

Collect cash payments on accounts receivable as fast as possible to close the lo Format: Essay Learning Objective: LO 3 82. Explain working capital trade-off.

Ans: The optimal current asset investment strategy will depend on the relative magnitudes of carrying costs versus shortage costs. This conflict is often referred to as the working capital trade-off.

Financial managers need to balance shortage costs against carrying costs to find an optimal strategy. If carrying costs are larger than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. On the other hand, if shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. Overall, management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs.

Format: Essay Learning Objective: LO 5 83. How does the just-in-time inventory management work?

Ans: In this system the exact day-by-day, or even hour-by-hour raw material needs are delivered by the suppliers, who deliver the goods “just in time” for them to be used on the production line. A big advantage in this system is that there are essentially no raw inventory costs and no chance of obsolescence or loss to theft.

On the other hand, if the supplier fails to make the needed deliveries, then production shuts down. If the system works for a firm, it cuts down their investment in working capital dramatically.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Most businesses are started when an entrepreneur is given a vision for a new business or product by institutional investors.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. The process by which many entrepreneurs raise “seed” money and obtain other resources necessary to start their businesses is often called bootstrapping.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. The initial “seed” money usually comes from the entrepreneur or other founders.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. The bootstrapping period usually lasts about five years.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 5. Venture capitalists are individuals or firms that help privately held businesses go public.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 6. Angel investors are investors who come to the rescue of firms threatened by takeovers.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 7. A significant number of venture capital firms focus on high-technology investments.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 8. A significant number of venture capital firms focus on mature businesses.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 9. Traditional sources of funding work for new or emerging businesses despite the presence of only intangible assets.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 10. The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 11. A principal way for venture capitalists to exit is to sell part of the firm's equity back to the entrepreneur.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 12. A venture capitalist may exit an investment by selling common stock in an initial public offering.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 13. The amount of equity capital that can be raised in the public equity markets is typically smaller than the amount that can be raised through private sources.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 14. Privately held firms find it easier to attract top management talent and to better motivate current managers.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 15. To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to market.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 16. To complete an IPO, a firm will need the services of angel investors, who are experts in bringing new securities to market.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 17. Underwriting is the risk-bearing part of investment banking.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 18. In the firm-commitment underwriting, which is more typical, the investment banker guarantees the issuer a fixed amount of money from the stock sale.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 19. With a firm-commitment underwriting, the investment banking firm makes no guarantee to sell the securities at a particular price.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 20. At the closing of a best-efforts offering, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 21. Underpricing is defined as offering new securities for sale at a price below their true value.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 22. In a best-efforts offering, the underwriters will suffer a financial loss if the offer price is set too high.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 23. If the offer price is set too high, the issuing firm will lose under a best-efforts agreement.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy 24. A general cash offer is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public.

A) True B) False Ans: A Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 25. Bootstrapping and venture capital financing are part of the public market.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 26. Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals.

A) True B) False Ans: A Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 27. The biggest drawback of private placements involves restrictions on the resale of the securities.

A) True B) False Ans: A Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 28. Transactions in which a public company sells unregistered stock to an investor are called PIPE transactions.

A) True B) False Ans: A Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy 29. The major disadvantage of a PIPE transaction to issuers is that it slows the firm's access to capital.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy 30. Term loans are defined as business loans with maturities greater than one month but less than one year.

A) True B) False Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 31. The initial seed money comes from A) public investors.

B) investment banks.

C) the entrepreneur or other founders.

D) commercial banks.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 32. Bootstrapping is the process by which A) many entrepreneurs raise “seed” money and obtain other resources necessary to B) start their businesses.

C) the entrepreneur often fleshes out his or her ideas and makes them operational.

D) most businesses are started by an entrepreneur. none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 33. Which one of the following statements is NOT true?

A) The process by which many entrepreneurs raise “seed” money and obtain other B) resources necessary to start their businesses is often called bootstrapping.

C) Most businesses are started by an entrepreneur who has a vision for a new D) business or product and a passionate belief in the concept's viability.

The initial “seed” money usually comes from the entrepreneur or other founders.

The seed money is spent on developing an initial public offering.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 34. Which ONE of the following statements is true?

A) The venture capital industry as we know it today emerged in the late 1960s with B) the formation of the first venture capital limited partnerships.

C) Modern venture capital firms tend to specialize in a specific line of business, such D) as hospitality, food manufacturing, or medical devices.

A significant number of venture capital firms focus on high-technology investments.

All of the above are true statements.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 35. Which one of the following statements is NOT true?

A) Approximately $23 billion was invested in venture capital funds in 2010.

B) The venture capital industry as we know it today emerged in the late 1990s.

C) Modern venture capital firms tend to specialize in a specific line of business, such D) as hospitality, food manufacturing, or medical devices.

A significant number of venture capital firms focus on high-technology investments.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 36. Tactics that venture capitalists use to reduce the risk of their investment include A) funding the ventures in stages, requiring entrepreneurs to make no personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize.

B) funding the ventures completely in the beginning, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize.

C) funding the ventures in stages, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize.

D) None of the above.

Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 37. Which one of the following statements is NOT true?

A) Venture capitalists often require an entrepreneur to make a substantial personal B) investment in the business.

C) Syndication occurs when the originating venture capitalist buys off other venture D) capitalists involved in the venture.

Another factor that reduces risk is the venture capitalist's in-depth knowledge of the industry and technology.

The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 38. Provisions that are part of venture capital agreements include A) timing of exit, number of board positions after exit, and what price is acceptable.

B) timing of exit, the method of exit, and what price is acceptable.

C) the method of exit, number of board positions after exit, and what price is D) acceptable.

None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 39. The three principal ways in which venture capital firms exit venture-backed companies are A) selling to a strategic buyer, buying out the founder, and offering stock to the B) public.

C) selling to a strategic buyer, selling to a financial buyer, and buying out the D) founder. selling to a strategic buyer, selling to a financial buyer, and offering stock to the public.

None of the above.

Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 40. Which ONE of the following statements is true?

A) A typical venture capital fund may generate annual returns of 15 to 25 percent on the money that it invests, compared with an average annual return for the S&P 500 of almost 12 percent.

B) A typical venture capital fund may generate annual returns of 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 20 percent.

C) A typical venture capital fund may generate annual returns of 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 25 percent.

D) None of the above Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 41. Advantages of going public include all EXCEPT A) Larger amount of capital can be raised this way than the amount that can be B) raised through private sources.

C) Publicly traded firms find it harder to attract top management talent.

D) Going public can enable an entrepreneur to fund a growing business without giving up control.

Additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost.

Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 42. Which ONE of the following statements is true?

A) After the IPO, there is a less active secondary market for the firm's shares.

B) Only smaller amounts of capital can be raised through an IPO than the amount C) that can be raised through private sources.

D) Publicly traded firms find it easier to attract top management talent.

Going public can enable an entrepreneur to fund a growing business but not without giving up control.

Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 43. Disadvantages of going public include all EXCEPT A) Managers' tendency to focus on long-term profits.

B) The high cost of the IPO itself.

C) The costs of complying with ongoing SEC disclosure requirements.

D) The transparency that results from this compliance can be costly for some firms.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 44. Basic services investment bankers provide when bringing securities to market include A) Origination B) Underwriting C) distribution.

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 45. Which one of the following statements is NOT true?

A) Investment bankers provide three basic services when bringing securities to B) market—origination, underwriting, and distribution.

C) During the origination phase, the investment banker helps the firm determine D) whether it is ready for an IPO. Origination is the risk-bearing part of investment banking.

Origination includes giving the firm financial advice and getting the issue ready to sell.

Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 46. All of the following about a firm-commitment underwriting is true EXCEPT: A) The investment banker guarantees the issuer a fixed amount of money from the B) stock sale.

C) The investment banker actually buys the stock from the firm.

D) The issuer bears the risk that the resale price might be lower than the price the underwriter pays.

The underwriter bears the risk that the resale price might be lower than the price the underwriter pays.

Ans: C Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 47. With a best-efforts underwriting A) the investment banking firm makes no guarantee to sell the securities at a B) particular price.

C) the investment banker does not bear the price risk associated with underwriting D) the issue. compensation is based on the number of shares sold.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 48. Which one of the following statements is NOT true?

A) In a best-efforts offering, the underwriters will suffer a financial loss if the offer B) price is set too high.

C) In a best-efforts agreement, the issuing firm will lose if the offer price is set too high.

If the underpricing is significant, the investment banking firm will suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have.

D) Underpricing is defined as offering new securities for sale at a price below their true value.

Ans: A

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 49. The three basic costs associated with issuing stock in an IPO are A) price premium, out-of-pocket expenses, and underpricing.

B) underwriting spread, out-of-pocket expenses, and underpricing.

C) underwriting spread, price premium, and underpricing.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 50. Data from the marketplace show that the shares sold in an IPO are typically A) priced between 2 and 5 percent below the price at which they close at the end of B) first day of trading.

C) priced between 10 and 15 percent above the price at which they close at the end D) of first day of trading. priced between 10 and 15 percent below the price at which they close at the end of first day of trading. priced between 2 and 5 percent above the price at which they close at the end of first day of trading.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 51. Which one of the following statements is NOT true?

A) In a competitive sale, the firm specifies the type and amount of securities it wants B) to sell.

C) In a negotiated sale, the issuer selects the underwriter at the beginning of the D) origination process.

In a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis.

For equity securities, competitive sales generally provide the lowest-cost method of sale.

Ans: D

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 52. Which one of the following statements is NOT true?

A) Shelf registration gives firms less flexibility in bringing securities to market.

B) During a two-year window, the firm can take the securities “off the shelf” and C) sell them as needed.

D) Shelf registration allows firms to periodically sell small amounts of securities.

A shelf registration statement can cover multiple securities, and there is no penalty if authorized securities are not issued.

Ans: A Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 53. Benefits from shelf registration include all EXCEPT: A) Greater flexibility in bringing securities to market.

B) Shelf registration allows firms to periodically sell small amounts of securities and C) raise capital as needed.

D) A shelf registration statement can cover multiple securities, but there is a penalty if authorized securities are not issued.

Costs associated with selling the securities are reduced because only a single registration statement is required.

Ans: C Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 54. Which one of the following statements is NOT true?

A) For many smaller firms and firms of lower credit standing that have limited access, or no access, to the public markets, the cheapest source of external funding is often the private markets.

B) Bootstrapping and venture capital financing are not part of the private market.

C) Bootstrapping and venture capital financing are part of the private market.

D) Many private companies that are owned by entrepreneurs, families, or family foundations and are sizable companies of high credit quality prefer to sell their securities in the private markets.

Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 55. Which one of the following statements is NOT true?

A) Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals.

B) All corporate debt is sold through the private placement market.

C) About half of all corporate debt is sold through the private placement market.

D) Investment banks and money center banks often assist firms with private placements.

Ans: B Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy 56. Advantages of private placements include: A) Cost of funds may be lower.

B) Private lenders are more willing to negotiate changes to a bond contract.

C) The speed of private placement deals and flexibility in issue size.

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 57. Which one of the following statements is NOT true?

A) Private equity firms pool money from wealthy investors, pension funds, B) insurance companies, and other sources to make investments.

C) Private equity firms invest in more mature companies.

D) Private equity firms invest in new companies.

Private equity investors focus on firms that have stable cash flows because they use a lot of debt to finance their acquisitions.

Ans: C

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 58. Private equity firms improve the performance of firms in which they invest by: A) making sure that the firms have the best possible management teams.

B) closely monitoring each firm's performance and providing advice and counsel to C) the firm's management team.

D) facilitating mergers and acquisitions that help improve the competitive positions of the companies in which they invest.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 59. Which one of the following statements is NOT true?

PIPEA)transactions are registered with the SEC. PIPEB)transactions are not registered with the SEC. In a C) PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement.

D) The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets.

Ans: A Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium 60. Which ONE of the following statements is true?

A) Under federal securities law, they can be resold to investors in the public markets B) immediately even if they are not registered.

C) As part of the PIPE contract, the company often agrees to register the restricted D) securities with the SEC, usually within 90 days of the PIPE closing.

As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC after 90 days of the PIPE closing.

PIPE transactions involving a healthy firm can also be executed without the use of an investment bank but result in a cost increase of 7 to 8 percent of the proceeds.

Ans: B

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Use the following to answer questions 61-63: IPO pricing: Stump, Inc., a technology firm in Prairie View, Texas, issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day.

Reference: Ref 15-1 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 61. What is the underpricing spread?

A) $51 million $15 B) million $66 C) million None of D) the above.

Ans: B Feedback: Underwriter's gross spread ($22 – $17) =$5 per share.

Number of shares outstanding = ($66 million/$22 per share) = 3 million.

Underwriting cost = ($5 per share x 3.0 million shares) = $15.0 million Reference: Ref 15-1 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 62. What is the underpricing on this issue?

A) $9,900,000 B) $24,900,000 C) $15,000,000 D) None of the Ans: Aabove.

Feedback: Stock price at end of first day = $22(1.15) = $25.30 First-day underpricing = ($25.30 - $22) = $3.30 per share.

Total underpricing = ($3.30 per share x 3,000,000 shares of stock) = $9,900,000

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Reference: Ref 15-1 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 63. What is the firm's total cost of issuing the securities?

A) $24.9 million B) $15.35 million C) $25.25 million D) None of the Ans: Cabove Feedback: Total cost to the firm of selling the IPO = $15,000,000 + $350,000 + $9,900,000 = $25,250,000 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 64. IPO pricing: Pau, Inc., issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underpricing cost of issuing the securities to the firm?

A) $13.6 B) million C) $20.6 D) million Ans: C$6.96 million Feedback: Stock$7.57 price at end of first day = $19.30 × (1.18) = $22.78 million First-day underpricing = ($22.78 – $19.30) = $3.48 per share.

Total underpricing = ($3.48 per share x 2,000,000 shares of stock) = $6,960,000

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 65. IPO pricing: Pau, Inc., issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underwriting cost?

A) $13.6 million B) $20.6 million C) $6.96 million D) None of the Ans: Aabove.

Feedback: Underwriter's gross spread ($19.30 – $12.50) =$6.80 per share.

Number of shares outstanding = ($38.6 million/$19.30 per share) = 2 million.

Underwriting cost = ($6.80 per share x 2.0 million shares) = $13.6 million Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 66. IPO pricing: Pau, Inc., issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the total cost of issuing the securities to the firm?

A) $13.6 million B) $20.83 million C) $20.6 million D) None of the above Ans: B Feedback: Stock price at end of first day = $19.30(1.18) = $22.78 First-day underpricing = ($22.78 – $19.30) = $3.48 per share.

Total underpricing = ($3.48 per share x 2,000,000 shares of stock) = $6,960,000 Underwriter's gross spread ($19.30 - $12.50) =$6.80 per share.

Number of shares outstanding = ($38.6 million/$19.30 per share) = 2 million.

Underwriting cost = ($6.80 per share x 2.0 million shares) = $13.6 million Total cost to the firm of selling the = $13,960,000 + $270,000 + $6,960,000 IPO = $20,830,000

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 67. IPO underpricing: When Geo Corp. went public in September 2008, the offer price was $19.00 per share and the closing price at the end of the first day was $24.70. The firm issued 4 million shares. What was the loss to the company due to underpricing?

A) $13.6 million B) $20.83 C) million $20.6 D) million $22.8 Ans: Dmillion Feedback: Change in price on first day = $24.70 – $19.00 = $5.70 Number of shares outstanding = 4.0 million Loss due to underpricing = $5.70 × 4,000,000 = $22.8 million Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 68. IPO: Bethesda Biosys issues an IPO sold on a best-efforts basis. The company's investment bank demands a spread of 18 percent of the offer price, which is set at $25 per share. Four million shares are issued. However, the bank was overly optimistic and eventually is able to sell the stock for only $23 per share. What are the proceeds for the issuer?

A) $74 million $92 B) million $100 C) million None of D) the above Ans: A Feedback: Gross proceeds from offer = $25.00 x 4,000,000 = $100,000,000 Underwriting spread = $100,000,000 x 0.18 = $18,000,000 Proceeds to issuer = ($23 x $4,000,000) – $18,000,000 = $74 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 69. IPO: Fortune Hotels issues an IPO sold on a best-efforts basis. The company's investment bank demands a spread of 20 percent. Five million shares are issued.

However, the bank was overly optimistic and could not sell at the offer price of $31. If the net proceeds to the issuer were $110 million, what was the per share price at which the shares were sold?

A) $27.50 $22 $31 B) None of the C) above D) Ans: A Feedback: Number of shares issued = 5 million Net Proceeds to issuer = $110 million Underwriting spread = 20% Gross proceeds from offer = $110,000,000 / 0.80 = $137.5 million Selling price per share = $137.5 million / 5 million = $27.50 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 70. IPO: Fortune Hotels issues an IPO sold on a best-efforts basis. The company's investment bank demands a spread of 20 percent. Five million shares are issued.

However, the bank was overly optimistic and could not sell at the offer price of $31. If the net proceeds to the issuer is $110 million, how much did the investment bank receive?

A) $22.0 million B) $27.5 million C) $31.0 million D) None of the Ans: Babove Feedback: Number of shares issued = 5 million Net proceeds to issuer = $110 million Underwriting spread = 20% Gross proceeds from offer = $110,000,000 / 0.80 = $137.5 million Proceeds to underwriter = $137.5 million × 0.20 = $27.5 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 71. IPO: Dienz Pharma issues an IPO sold on a best-efforts basis. The company's investment bank demands a spread of 16 percent of the selling price. The offer price is set at $32 per share. Three million shares are issued. However, the bank was able to see the shares at $26.25 per share. What are the proceeds for the issuer?

A) $96.00 million B) $78.75 million C) $66.15 million D) None of the Ans: Cabove Feedback: Number of shares issued = 3 million Gross proceeds from issue = ($26.25 × 3,000,000) = $78,750,000 Underwriting spread = $78,750,000 x 0.16 = $12,600,000 Proceeds to issuer = $78,750,000 – $12,600,000 = $66.15 million Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 72. General cash offering: Star Corporation, an auto fuel cell maker, is planning a new plant and needs to raise $30 million to finance it. The company plans to raise the money through a general cash offering priced at $23.50 a share. Star's underwriters charge a 6 percent spread. How many shares does the company have to sell to achieve its goal?

A) 1,358,081 B) shares C) 1,276,596 D) shares Ans: A1,200,000 shares None of Feedback: the above Underwriter's spread = 6 % Price per share the firm gets = 23.50*(1 – 0.06) = $22.09 Therefore, to raise $30 million, the company needs to issue: $30,000,000 / $22.09 = 1,358,081 new shares

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 73. Bank lending: Jasper, Inc., is looking for a five-year term loan of $3 million. Its bank is willing to make the loan. The firm will have to pay a premium of 1.5 percent for default risk and another 0.75 percent for maturity risk. The current prime rate is 7.5 percent. What is the loan rate on this bank loan?

A) 9% 8.25% B) 9.75% None of C) the above D) Ans: C Feedback: Prime rate = PR = 7.5% Maturity risk premium = MAT = 0.75% Default risk premium = DRP = 1.5% Cost of loan = k = PR + DRP + MAT = 7.5% + 1.5% = 0.75% = 9.75% Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 74. Bank lending: Suppose two firms want to borrow money from a bank for a period of 10 years. Firm A has excellent credit and can borrow at the prime rate, whereas Firm B's credit standing is prime + 2. The current prime rate is 5.75 percent, the 30-year Treasury bond yield is 4.35 percent, the three-month Treasury bill yield is 3.54 percent, and the 10-year Treasury note yield is 4.24 percent. What are the appropriate loan rates for each customer?

A) 6.45%, 7.75% B) 6.45%, 8.45% C) 5.75%, 8.45% D) None of the above Ans: B Feedback: Prime rate =PR = 5.75%; Maturity risk premium = MAT = k10-year – kT-bill = 4.24% - 3.54% = 0.70% Borrowing rate for firm A = k = Prime rate + MAT = 5.75% + 0.70% = 6.45% = k = Prime rate + 2% + MAT Borrowing rate for firm B = 5.75% + 2% + 0.70% = 8.45%

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 75. Bank lending: Marigold Corp. wants to borrow money from Howard Bank for a period of five years. The firm's credit standing calls for a premium of 1.5 percent over the prime rate. The current prime rate is 6.5 percent, the 30-year Treasury bond yield is 5.375 percent, the three-month Treasury bill yield is 3.525 percent, and the 5-year Treasury note yield is 4.25 percent. What is the appropriate loan rate for this customer?

A) 8.725% 7.225% B) 6.500% None of C) the above D) Ans: A Feedback: Prime rate =PR = 6.5%; Default risk premium = DRP = 1.5% Maturity risk premium = MAT = k5-year – kT-bill = 4.25% - 3.25% = 0.725% Borrowing rate for firm A = k = PR +DRP+ MAT = 6.5% + + 1.5% + 0.725% = 8.725% Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 76. The most likely reason that underpricing of new issues occurs more frequently than overpricing is the: A) Underwriters’ desire to reduce the risk of a firm commitment.

B) Demand for a new issue is typically too high.

C) Underwriters earn low rates of return D) Issuing firms demand that equity be underpriced.

Ans:A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 77. A firm is making an initial public offering. The investment bankers agree to a firm underwriting commitment of 500,000 shares priced to the public at $50 a share. The underwriter’s spread is 12%. In addition, the underwriter charges $600,000 in legal fees.

On the first day of trading, the firm’s stock closed at $61. What were the total costs of the issue? a. $3,000,000 b. $3,600,000 c. $8,500,000 d. $9,100,000 Ans:D

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Feedback: Stock price at end of first day = $61.00 First-day underpricing = ($61.00 – $50.00) = $11.00 per share.

Total underpricing = ($11.00 per share x 500,000 shares of stock) = $5,500,000 Underwriter's gross spread ($50.00 x .12) =$6.00 per share.

Underwriting cost = ($6.00 per share x 500,000 shares) = $3 million Total cost to the firm of selling the = $3,000,000 + $600,000 + $5,500,000 IPO = $9,100,000 Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium 78. Castle Co. needs to borrow $10 million for process improvement upgrades. Management decides to sell 20-year bonds. They determine that the 3-month Treasury bill rate is 2.75 percent, the firm's credit rating is A, and the yield on 20-year Treasury bonds is 1.80 percent higher than that for 3-month Treasury bills. Bonds with an A rating are selling for 50 basis points above the 20-year Treasury bond rate. What is the borrowing cost to do this transaction? a. 4.55% b. 5.05% c. 7.75% d. 9.55% Ans:B Feedback: kl = 2.75 + 1.80 + 0.50 = 5.05% Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 79. Why is the total cost of bringing a general cash offer to the market lower than issuing an IPO? a. They do not include a large underpricing b. Underwriting spreads are smaller c. There is less risk involved with a general cash offer than an IPO d. all of the above Ans:D

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Format: Essay Learning Objective: LO 1 80. Why do traditional sources of funding not work for new or emerging businesses?

Ans: New firms cannot resort to traditional sources of funding for three main reasons.

First, starting a new business is a risky proposition. The fact is that most new businesses fail, and it is difficult to identify which firms will be successful. Most suppliers of capital, such as banks, pension funds, and insurance companies, are averse to undertaking high-risk investments, and much of their risk-averse behavior is mandated in regulations that restrict their conduct. Second, most new firms do not have real or tangible assets against which they can borrow. Most commercial loans are made to firms that have tangible assets, such as machines, equipment, and physical inventory. Lenders understand the operations of these “traditional” firms and their inherent risks; thus, they are comfortable making loans to them. The third reason is the information gap that exists between the entrepreneur and potential investors. An entrepreneur knows more about his or her company's prospects than a lender does. When dealing with highly specialized technologies or companies emerging in new business areas, most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs. As a result, they are reluctant to invest in these firms.

For these reasons, many investors—such as pension funds, insurance companies, endowment funds, and university foundations—find it difficult to participate directly in the venture capital market. Instead, they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments, and selling (exiting) them at the appropriate time.

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Format: Essay Learning Objective: LO 3 81. What are the advantages and disadvantages of going public?

Ans: Going public has a number of potential advantages. · The amount of equity capital that can be raised in the public equity markets is · typically larger than the amount that can be raised through private sources. · Once an IPO has been completed, additional equity capital can usually be raised · through follow-on seasoned public offerings at a low cost. · Going public can enable an entrepreneur to fund a growing business without gi up control.

After the IPO, there is an active secondary market in which stockholders can bu and sell its shares.

Publicly traded firms find it easier to attract top management talent and to bette motivate current managers if a firm's stock is publicly traded.

There are also several disadvantages to going public. · One disadvantage of going public is the high cost of the IPO itself. · The costs of complying with ongoing SEC disclosure requirements also represe · disadvantage of going public. · The transparency that results from this compliance can be costly for some firms Finally, some investors argue that the SEC's requirement of quarterly earnings forecasts and quarterly financial statements encourages managers to focus on short-term profits rather than long-term wealth maximization.

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Format: Essay Learning Objective: LO 6 82. What are PIPE transactions and how do they help firms raise capital?

Ans: Private investment in public equity (PIPE) transactions are transactions in which a public company sells unregistered stock to an investor. In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement.

The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets to compensate the buyer for limits on the liquidity associated with these securities and, often, for being able to provide capital quickly. Because the securities sold in a PIPE transaction are not registered with the SEC, they are “restricted securities.” As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. If the registration is delayed past a deadline date, the issuer might be required to pay the investor liquidity damages, usually 1 or 1.5 percent per month, as compensation for the loss of liquidity.

The major advantage of a PIPE transaction to issuers is that it gives them faster access to capital and a lower funding cost than a registered public offering. PIPE transactions involving a healthy firm can also be executed without the use of an investment bank, resulting in a cost saving of 7 to 8 percent of the proceeds. A PIPE transaction can be the only way for a small financially distressed company to raise equity capital.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Increasing a firm's outstanding equity will increase firm leverage.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. Minimizing the cost of a firm's financing activities also maximizes the total value of the firm.

A) B) True False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. When calculating free cash flow, it is important to include interest and principal payments.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. The enterprise value of a firm is the value of equity minus the value of debt.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 6. A financial restructuring can change the value of a firm's real assets, such as plant and equipment.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 7. M&M Proposition 2 states that the required rate of return on a firm's stock is related to the debt-to-equity ratio.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 8. M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 9. If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium 10. Under the M&M assumptions with taxes, the value of the firm with debt is the value of the firm without debt plus the present value of the interest tax shield.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 11. With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 12. Issuing debt is less expensive than issuing stock.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 14. Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 15. When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 16. Direct bankruptcy costs are considered small when compared to indirect costs.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 17. Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 18. Unlike direct bankruptcy costs, indirect costs are not considered transactions costs.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 19. Indirect bankruptcy costs will often increase when a firm is in financial stress and may even push the company into bankruptcy.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 20. More debt in the capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 21. Dividends reduce the value of lender claims, and this is why bondholders often limit the firm's ability to distribute cash to equity holders.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 22. Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 23. When a firm is in financial distress, stockholders would like to overinvest in positive NPV projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium 24. Without debt in the capital structure, there are no asset substitution or underinvestment problems.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 25. The trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 26. Under the pecking order theory, debt is factually the cheapest source of funds due to the interest tax shield.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium 27. Firms have a difficult time selling equity when in financial distress.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 28. Industries with large amounts of tangible assets often use little debt.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 29. More profitable firms have less debt, which supports the trade-off theory.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 30. Managers often focus on cash flows, but reported accounting earnings are a better indicator of the firm's economic health.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO for Appendix Level of Difficulty: Medium 31. An operating lease is treated like a purchase for accounting purposes.

A) True B) False Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 32. A firm's capital structure is the mix of financial securities used to finance its activities and can include all of the following except A) stock.

B) bonds.

C) equity options.

D) preferred stock.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 33. The optimal capital structure of a firm A) minimizes the cost of financing a firm's projects.

B) minimizes interest payments to creditors.

C) maximizes firm value.

D) both a and c.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 34. M&M Proposition 1 assumes all of the following except that A) there are no taxes.

B) there are no costs to acquiring information.

C) there are no transactions costs.

D) the real investment policy of the firm is affected by its capital structure decisions.

Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 35. A firm's enterprise value is given by A) the value of equity plus the value of debt.

B) the value of equity minus the value of debt.

C) the value of equity minus the value of debt plus the value of future projects.

D) none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 36. A financial restructuring A) will not change the value of a firm's real assets under M&M B) Proposition 1. includes financial transactions that change the capital C) structure of the firm. means that a firm has issued equity to retire D) debt. both a and b.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 37. The weighted average cost of capital (WACC) includes A) the required return on equity and required return on underlying firm assets.

B) the cost of any debt and the cost of equity.

C) the cost of any debt and required return on underlying firm assets.

D) none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 38. M&M Proposition 2 states that the cost of a firm's common stock is related to A) the debt-to-equity ratio.

B) the required rate of return on the firm's underlying assets.

C) the return of the market index.

D) a and b.

Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 39. According to M&M Proposition 2, the cost of a firm's equity A) increases with the debt-to-equity ratio.

B) decreases with the debt-to-equity ratio.

C) increases and then falls with the debt-to-equity ratio.

D) decreases and then increases with the debt-to-equity ratio.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 40. Financial risk A) refers to the effect that a firm's financing decisions has on the riskiness to cash B) flows that investors will receive.

C) increases a firm's business risk.

D) decreases a firm's business risk. is related to how debt affects the business decisions of a firm.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 41. Which of the following is a reason financial policy might matter?

A) Firms must pay corporate income taxes.

B) Capital structure choices can affect investment decisions, such as R&D and C) PP&E. D) Issuing equity is expensive.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 42. The interest tax shield A) does not affect the WACC. B) makes it less costly to distribute cash to the security holder through interest C) payments than through dividends.

D) is given by D × (1 – t). b and c.

Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 43. In order to calculate the present value of debt tax savings, the _______ is used as the discount rate.

A) WACC B) risk-free rate C) required rate of return on debt D) none of the above Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 44. Academic studies have estimated that the tax benefit of debt realized by firms is approximately A) 10% of firm value.

B) a 10% reduction in WACC. C) a 10% reduction in the cost of debt D) 10% of debt value.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 45.

The use of debt financing A) may cause a manager to take on riskier projects in order to make interest B) payments.

C) is more expensive than issuing equity due to the use of covenants.

D) allows managers to make discretionary interest payments. limits the ability of managers to waste stockholder money.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 46. Which of these statements about direct bankruptcy costs is not true?

A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and B) consultants.

C) Direct bankruptcy costs are less than indirect costs.

D) Suppliers requiring cash on delivery is part of a firm's direct bankruptcy costs.

Negotiating with lenders may help a firm reduce direct bankruptcy costs.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 47. Which of these is not an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be B) honored.

C) Employees begin to leave the firm.

D) New accountants are brought in to help with the bankruptcy process.

A bankruptcy judge orders new projects to be halted.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 48. The use of debt financing A) reduces agency costs between the stockholders and management by increasing B) the amount of risk the managers take.

C) increases agency costs between the stockholders and management by limiting the D) amount of risk the managers take. increases agency costs since managers prefer to keep more retained earnings rather than pay a dividend. b and c.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 49. The asset substitution problem occurs when A) managers substitute riskier assets for less risky ones to the detriment of B) bondholders.

C) managers substitute less risky assets for riskier ones to the detriment of D) bondholders. managers substitute riskier assets for less risky ones to the detriment of equity holders. managers substitute less risky assets for riskier ones to the detriment of equity holders.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 50. The underinvestment problem occurs in a financially distressed firm when A) the value of investing in a positive-NPV project is likely to go to debt holders B) instead of equity holders.

C) the value of investing in a positive-NPV project is likely to go to equity holders D) instead of debt holders. management invests in negative-NPV projects to reduce their own risk. issuing equity becomes difficult due to increased risk.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium 51. Which of the following supports the trade-off theory of capital structure?

A) Firms use cash on hand first, since issuing equity and debt is expensive.

B) A firm's capital structure is the result of past equity and debt issuance decisions.

C) Firms have a target capital structure.

D) a and b.

Ans: C Use the following to answer questions 52-58: Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock.

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Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 52. M&M Proposition 1: How much is Dynamo worth today?

A) $1,765 $1,500 B) $2,143 None of C) the above.

D) Ans: B Feedback: CF $150 V Firm = i = 0.1 =$1,500 Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 53. M&M Proposition 1: How much are your cash flows today?

A) $12.38 B) $15 C) $4.50 D) $150 Ans: A Feedback: Cash flows to = Cash flows – Interest payments shareholders = $150 – ($1,500) × (0.25) × (0.07) = $123.75 Therefore, your 10% share = $123.75 × 0.1 = $12.375

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Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 54. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity and use the debt proceeds to pay a special dividend to shareholders, how much debt should they issue?

A) $32 B) 1 C) $37 D) 5 Ans: D$60 0 Feedback: $22 = 0.25 × $1,500 = $375 Debt today 5 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 55. M&M Proposition 1: How much does Dynamo currently pay in interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant?

A) $42 and $26.25 B) $26.25 and $42 C) $160 and D) $37.50 $37.50 Ans: Band $60 Feedback: Debt today = 0.25 × $1500 = $375 Interest payment on debt before restructuring = $375 × 0.07 = $26.25 Total debt after restructuring =0 .4 × $1,500 = $600 Interest payment on debt after restructuring = 0.07 × $600 = $42

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Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 56. M&M Proposition 1: How much of the special dividend do you receive, and how much do you receive in regular dividends per annum after the restructuring?

A) $15 and $60 $60 B) and $15 $10.80 C) and $22.50 D) $22.50 and $10.80 Ans: D Feedback: Portion of special dividend received = 0.10 × $225 = $22.50 Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80 Note: $42 = Interest payment on debt after restructuring Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 57. M&M Proposition 1: According to M&M Proposition 1, what transaction do you need to take in order to undo the restructuring?

A) Sell $22.50 of stock. Sell B) $10.80 worth of stock.

C) Buy $22.50 worth of D) debt. Buy $10.80 worth Ans: Cof debt.

Feedback: M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy that much of the new debt issuance.

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Reference: Ref 16-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 58. M&M Proposition 1: What are the interest payments that you receive after you undo the restructuring, and what are your total cash flows?

A) $1.58 and $12.38 B) $23.55 and $75 C) $1.125 and $12.38 D) None of the above.

Ans: A Feedback: Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 = $1.58 in interest payments. Since you will receive $10.80 in dividends after the restructuring, your total cash flows are $1.58 + $10.80 = $12.38, the same as before the restructuring!

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 59. M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40% debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the risk-free rate is 3%, what is the appropriate WACC? A) 8.4% B) 9.6% C) 10.4 D) % Ans: C9.2% Feedback: WACC = xDebt kDebt + xEquity kEquity = (0.40 ×.08) + (0.60 × 0.12) = 0.104

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 60. M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC? A) 9% 10% 11% B) None of the C) above.

D) Ans: C Feedback: Using the debt-to-equity ratio, you can solve for the percentage of the capital structure that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1 and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2/3) × 0.13 = 0.11.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 61. M&M Proposition 2: Swirlpool, Inc., has a WACC of 11%, a cost of debt of 8%, and a cost of equity of 12%. What must the debt-to-equity ratio be?

A) 1/2 1/4 1/6 None B) of the above.

C) D) Ans: D Feedback: WACC= xDebt kDebt + xEquity kEquity = xDebt × 0.08 + xEquity × 0.12 = 11% Also, D + E = 1 by definition. Therefore, substituting gives you: xDebt × 0.8 + (1 – xDebt) × 0.12 = 0.11.

Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E is 1/3.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 62. M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70% equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal corporate income tax rate is 35%. What is the appropriate WACC? A) 8.17 B) % C) 6.35 D) % Ans: A8.80 % Feedback: 7.44 WACC with = xDebt kDebt pretax (1 – t) + xEquity kEquity taxes % = 0.30 ×.06×(1 – 0.35) + 0.70 × 0.10 = 0.0817 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 63. M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the appropriate WACC? A) 6% B) 8% C) 9% D) 10% Ans: D Feedback: WACC= xDebt kDebt + xEquity kEquity = (300/1200) × 0.07 + (900/1200) × 0.11 = 0.10

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 64. M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the firm is financed with equity?

A) 50% 60% 70% B) None of the C) above D) Ans: B Feedback: WACC = 0.085 = (1 – xEquity)kDebt (1 – t) + xEquity kEquity = (1 – xEquity) × 0.05 × (1 – 0.35) + xEquity × 0.12 Solving for xEquity gives you 0.60 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 65. M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?

A) 12.15% 13.15% B) 14.15% None of C) the above D) Ans: B Feedback: kcs = kAssets + (D/E)(kAssets – kDebt) = 0.12 + (1/5)(0.12 – 0.0625) = 0.1315

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 66. M&M Proposition 2: Using the information for Bellamee from Question 64, what is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on their debt to 7%?

A) 14% B) 14.25 C) % D) 14.50 Ans: %A15% Feedback: kcs = kAssets + (D/E)(kAssets – kDebt) = 0.12 + (2/5)(0.12 – .07) = 0.14 Use the following to answer questions 67-69: Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%.

Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure.

Reference: Ref 16-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 67. M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are variable with the added debt?

A) 27.9% and 72.1% B) 72.1% and 27.9% C) 25.23 and 74.77% D) 74.77% and 25.23% Ans: C Feedback: With the debt, fixed cost percentage is (SG&A + Interest payments)/(SG&A + Interest payments + CGS) = ($100 + ($700)(0.05)) / ($100 + ($700)(0.05) + $400) = 25.23%.

Therefore, variable costs are $400 / ($100 + ($200)(0.05) + $400) or 74.77%.

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Reference: Ref 16-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 68. M&M Proposition 2: What is the net income of Banana without and with the debt?

A) $500 and B) $484.2 $484.2 C) and $500 $500 D) and $465 $490 Ans: Cand $500 Feedback: Without debt, net income is $1000 – $400 – $100 = $500 With debt, net income is $1000 – $400 – $100 – $35 = $165 Reference: Ref 16-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 69. M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in net income with and without the debt? Assume that the total variable productions costs remain the same.

A) 64.5% and 60% B) 60% and 64.5% C) 59.2% and D) 40.8% 40.8% Ans: Band 59.2% Feedback: Without debt, the new net income is $700 – $400 – $100 = $200 Therefore, the percent change is ($500 – $200) / $500 = 60% With debt, the new net income is $700 – $400 – $100 – $35 = $165 Therefore, the percent change is ($465 – $165) / $465 = 64.5%

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 70. M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E is changed to 1/3?

A) 11.35% and 13.25% B) 11.35% and 8.25% C) 13.25% and 11.35% D) None of the above.

Ans: D Feedback: kcs = kAssets + (D/E)(kAssets – kDebt) 12% = kAssets + (1/6)( kAssets – 7.5%) Then, kAssets= 11.4%.

Note that if D/E changes, kAssets does not change.

The new cost of equity is then given by kcs = 11.4% + (1/3)(11.4% – 7.5%) = 12.7% Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 71. The benefits of debt: Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be 6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?

A) $238 $272 $259 B) None of the C) above.

D) Ans: A Feedback: After-tax earnings = (Earnings – Interest payments)×(1 – t) = ($500 – $160) × (1 –.3) = $238

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 72. The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the firm's annual tax liability?

A) $13,500 $22,500 B) $32,500 None of C) the above.

D) Ans: B Feedback: Tax = D × kDebt × t shield = $1,000,000 × 0.09 × 0.25 = $22,500 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 73. The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?

A) $11,025 B) $20,475 C) $350,00 D) 0 Ans: C$227,50 0 Feedback: VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000 Use the following to answer questions 74-75: Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket.

The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders.

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Reference: Ref 16-3 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 74. The cost of equity: What is its value without debt in the capital structure?

A) $350 B) $650 C) $2,91 D) 7 Ans: D$5,41 7 Feedback: VFirm = [ CF × (1-t)] /i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417 Reference: Ref 16-3 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 75. The cost of equity: What is Millennium's value after the debt issuance?

A) $5,417 $5,942 B) $6,392 None of C) the above.

D) Ans: B Feedback: PV of tax shield = $1,500 × 0.35 = $525 VFirm = VNo leverage+ PV of the tax shield = $5,417 + $525 = $5,942 Use the following to answer questions 76-79: Suppose that UBM Corp has $100mm invested in 8% risk-free bonds that mature in one-year.

The firm also has $80mm in debt outstanding that will also mature in a year. UBM shareholders are considering selling the $100mm in debt and investing in a project that has a 60% chance of returning $200mm and a 40% chance of returning $2mm.

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Reference: Ref 16-4 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 76. Agency costs: What will the equity value of UBM be in one-year without shareholders taking on the project?

A) $100m B) m C) $80mm D) $20mm Ans: C$8mm Feedback: Value of risk-free debt owner – Value of bonds maturing = $20mm Reference: Ref 16-4 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 77. Agency costs: What is the expected value of the bonds to the lenders if the stockholders sell the debt?

A) $100mm B) $88.8mm C) $48.8 mm D) None of the above.

Ans: C Feedback: E[VBonds] = (0.60 × $80 mm) × + (0.40 × $2mm) = $48.8 mm Reference: Ref 16-4 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 78. Agency costs: What is the expected value of the equity if the stockholders sell the debt ? A)$175mm B) C)$97.5mm D) $51mm None of the above.

Ans: D Feedback: E[VEquity] = ((0.60 × $200mm) – $80mm) + (0.40 × $0mm) = $40mm

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Reference: Ref 16-4 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 79. Agency costs: Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?

A) 1/3 B) 1/4 C) 1/5 D) 1/6 Ans: D Feedback: E[VEquity] = (PSuccess × 200mm – $80mm) + ((1 – PSuccess) × $0) = $20mm (PSuccess × 200mm – $80mm) = $20mm Therefore, PSuccess must be 1/6.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 80. Agency costs: Suppose that JMK, Inc., has debt with a face value of $100mm and assets worth $70mm. Firm management has just identified a project that will require an initial outlay of $10mm and will return a NPV of $16mm, risk-free. The firm currently has no cash. What would be the net return to shareholders if they took on this project?

A) $– B) 10mm C) $0mm D) $26mm Ans: A$70mm Feedback: If they take on the project, the firm will receive its $10mm back, along with the $16mm. This gives them assets worth $96mm, which is still less than the value of outstanding debt. Therefore, the shareholders would be out the $10mm of equity that they had to sell in order to take on the project.

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 81. The pecking order theory: A firm wishes to undertake a project that costs $150mm. It currently has $10mm in cash on hand and believes that it can raise $75mm in debt and $100mm in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt?

A) 0% B) 26.67% C) 50% D) None of the above Ans: C Feedback: According to the pecking order theory, the firm will first use its available cash, which is $10mm. Next, the firm will turn to debt. Since the amount of debt it can raise plus the amount of cash on hand is less than the project cost, their entire line of credit will be used. Therefore, $75mm/$150mm = 50%.

Format: Multiple Choice Learning Objective: LO for Appendix Level of Difficulty: Medium 82. Which of the following should a company consider when deciding to buy or lease an asset?

A) Taxes

B) Information or transaction costs C) If the choice would affect the real investment policy of the firm D) All of the above Ans: D Format: Multiple Choice Learning Objective: LO for Appendix Level of Difficulty: Medium 83. Which of the following arises because the lessee can have the incentive to use the asset more than the lessor would prefer?

A) Operating lease conflict B) Capital lease conflict C) Intensity of use conflict D) Maintenance conflict Ans:C

Format: Multiple Choice Learning Objective: LO for Appendix Level of Difficulty: Medium 84. Which of the following will limit the asset abuse problem for the lessor?

A) Track the total services obtained from the asset and charge the lessee based on usage B) Bundle the lease contract with a service contract C) Provide the lessee with the right to buy the asset when the lease expires Page 28

Ans:D

D) All of the above

Format: Multiple Choice Learning Objective: LO for Appendix Level of Difficulty: Hard 85. LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative, the company will only need the laser for 5 years. Assume LMNOs marginal tax rate is 30 percent.

Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed with a five year balloon loan at 9%. The laser will be depreciated on straight line and have no salvage value. Maintenance on the laser is expected to be $1,200 per year.

Lease alternative: The company that manufactures the laser offers a 5 year leasing option with annual lease payments of $12,500.With this option the lessor will be responsible for maintenance of the laser and will take it back after 5 years. The lease will be classified as an operating lease.

Which is the best option for LMNO Manufacturing?

A) Purchase, the company will be $4,416 better off.

Ans:B

B) Lease, the company will be $4,416 better off.

C) Purchase, the company is $10,496 better off D) Lease, the company is $10,496 better off

Feedback: Purchase: After tax annul interest expense = 50,000 x .09(1-.3) = <3,150> Annual depreciation = 50,000/5 = 10,000, so annual tax savings = 10,000 x .3= 3,000 After tax annual maintenance cost = 1,200 x (1-.3) = <840> So after tax cash flow years 1-4 = <3,150> + 3,000 + <840> = <990> After tax cash flow year 5 = <50,000> loan repayment + <990> = <50,990> NPV of total after tax cash flows at the after-tax cost of debt .09(1 - .3) = .063 = <$40,975.08> Lease: After tax annual lease payment = 12,500 x (1 - .3) = <8,750> NPV of <8,750> for 5 years at 6.3% = <$36,559.31> So, the total cost of Leasing is 40,975.08 – 36,559.31 = 4,415.77 less.

Format: Essay Learning Objective: LO 1 86. One of the conditions that the M&M Propositions required was for there to be no taxes. Briefly discuss whether the introduction of taxes decreases or increases the value of the firm. Ans: The relaxation of the no-tax assumptions actually increases the value of the firm by an amount equal to the present value of the tax shield on the firm's debt obligations. If we consider the debt to be infinitely outstanding, then we can approximate the present value of the tax shield by multiplying the amount of the debt by the tax rate.

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Format: Essay Learning Objective: LO 2 87. Briefly explain how an increase in the amount of debt that a firm has outstanding may actually decrease the agency costs caused by the conflict between managers and stockholders.

Ans: The manager-stockholder agency conflict is caused by a misalignment of interests between the two parties. When a firm has excess cash available for managers to waste—which is bad for stockholders—then an increase in debt, and consequently the level of interest service required of that debt, will make less cash available for the manager to waste. This has the effect of reducing manager-stockholder agency cost.

Format: Essay Learning Objective: LO 3 88. The pecking order theory of capital structure suggests that managers will choose to utilize retained earnings before issuing additional debt when financing new projects.

Does that imply anything about the flotation costs of issuing new securities?

Ans: The answer to the question is no. It implies that managers perceive there to be a higher cost of issuing new debt versus stockholder's equity. It is a perception because even after considering flotation costs, new debt is still much cheaper than retained earnings, which belongs to stockholders.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Starting a business is less risky than buying and growing a business that someone else has already established.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. The founder of a company has to make many critical decisions but not any related to strategies to sell the firm's products.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. Businesses do not fail because of management's inability to estimate correctly how much money it will take to get their businesses up and running.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. A business has a better chance to succeed if one doesn't overanalyze opportunities to the point where you are just convincing yourself not to proceed.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. A business has a better chance to succeed if one takes calculated risks.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 6. An LLC leads to unlimited liability for the people who make the business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 7. Limited partnerships are no more costly to form than sole proprietorships.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 8. Limited partnerships are more costly to form than sole proprietorships because the partners must hire an attorney to draw up and maintain the partnership agreement.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 9. The downside of being able to raise equity capital from other people is that the entrepreneur must inevitably share control with other investors.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 10. An S-corporation allows the stockholders to avoid double taxation but places limits on the ownership of the firm's stock.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 11. An S-corporation can have no more than 50 stockholders.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 12. Corporations, which are “legal persons” under state law, automatically have a finite life.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 13. The two tools that are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require are cash flow break-even analysis and the cash budget.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 14. The cash flow break-even analysis helps identify how much money will be needed to launch a new product or business.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 15. The cash budget summarizes the cash flows into and out of a firm over a period of time.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 16. The business plan presents the results from a strategic planning process that focuses on how the business will be developed over time.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 17. A business plan includes a detailed discussion of the marketing and sales activities that will enable the business to achieve the sales and margin levels reflected in the financial forecasts.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 18. An important thing to remember in valuing a business is that the value of a business changes over time.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 19. A financial investor is one who is interested in the financial performance of the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 20. A strategic investor is interested in buying the firm and not just its financial performance.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 21. Cost approaches include replacement cost and multiples analysis.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 22. The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities but is generally less applicable for operating businesses.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 23. In the transaction approach, analysts use the information on what someone has paid for a comparable company in a merger or an acquisition to estimate a value for the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 24. In the free cash flow to equity (FCFE) approach, an analyst values the free cash flows that the assets of the firm are expected to produce in the future.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 25. The free cash flow from the firm (FCFF) approach uses only the portion of the cash flows that are available for distribution to stockholders.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 26. In contrast to the FCFE approach, which values cash flows that are available for distribution to stockholders, the DDM approach values the stream of cash flows that stockholders expect to receive through dividend payments.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 27. In contrast to the financial statements of publicly help firms, private company financials often include personal expenses of the owner and excess compensation expenses.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 28. Differences in marketability can result in premiums of 30 percent or more for shares of private companies.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 29. An important issue that must be considered when valuing a business is whether a controlling ownership interest or a minority interest is being valued.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 30. In valuing a business, analysts must also consider whether it is appropriate to adjust the estimated value of the business for the likelihood that these “key people” may not remain with the firm as long as expected.

A) True B) False Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 31. The founder of a company must start from scratch and make several critical decisions including A) choosing the product(s) to sell.

B) choosing the best strategy for selling them.

C) raising the money necessary to develop the product(s).

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 32. Starting a business is _________ risky than buying and growing a business that someone else has already established.

A) more B) less C) equally D) none of the above Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 33. According to the text, businesses fail for a number of different reasons but not due to A) poorly thought-out strategy.

B) a very competitive market.

C) poor management skills to properly execute a good strategy.

D) underestimating how much money it will take to get their businesses up and running.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 34. A business's chances of success improve if you do all EXCEPT A) not jump into a business without careful thought.

B) not overanalyze opportunities to the point where you are just convincing yourself C) not to proceed.

D) Take no risks. not think that failure will ruin your chances of ultimately achieving business success.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 35. All of the following are organizational forms EXCEPT A) sole proprietorships, partnerships, and Z-corporations.

B) sole proprietorships, S-corporations, and limited liability companies.

C) C- Corporations, S-corporations, and LLCs. D) C- Corporations, S-corporations, and partnerships.

Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 36. A limited liability company (LLC) is A) a hybrid of a limited partnership and a corporation.

B) more costly to form than sole proprietorships C) less constrained than general partnerships because they can raise money from D) limited partners.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 37. Which one of the following statements is true?

A) Limited partnerships are no more costly to form than sole proprietorships.

B) Like a corporation, an LLC provides limited liability for the people who make the business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership.

C) The lives of partnerships and LLCs are not flexible.

D) Limited partners and LLCs are more constrained than general partnerships because they can raise money only from limited partners or “members.”

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 38. Which one of the following statements is NOT true?

A) An Scorporation can have no more than100 stockholders.

B) All profits of an Scorporation pass directly to the stockholders as they would pass C) to the partners in a partnership.

D) An Scorporation is a variation of the Ccorporation form that is used by public corporations.

Only some Ccorporations can become an Scorporation with approval from the IRS. Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 39. Which one of the following statements is true?

A) An Scorporation can have more than100 stockholders.

B) All profits of an Scorporation pass directly to the stockholders as they would pass C) to the partners in a partnership.

D) An Scorporation is a variation of the LLC. Only foreign investors can own the shares of an S-corporation.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 40. Which one of the following statements is NOT true?

A) A sole proprietorship is the least expensive type of business to start.

B) The life of a sole proprietorship is unlimited C) Sole proprietorships must rely on equity contributions from the proprietor and D) debt or lease financing.

All profits of the sole proprietorship pass directly to the owner and are taxed at the owner's marginal tax rate.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 41. Which one of the following statements is NOT true?

A) Two tools are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require—cash flow break-even analysis and the cash budget.

B) The cash flow break-even point calculation focuses on the importance of C) maximizing a product's per unit contribution.

D) The cash flow break-even point does not tell one how much money will be needed to launch a new product or business.

The cash flow break-even point estimates how long it will take for a product to reach the break-even point.

Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 42. Which one of the following statements is true?

A) The cash budget is also a very useful planning tool for entrepreneurs B) The cash budget summarizes the cash flows into and out of a firm over a period C) of time.

Preparing a cash budget helps an entrepreneur better understand where money is coming from, where it is going, and how much external financing is likely to be needed and when.

D) All of the above are true.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 43. Which one of the following statements about business plans is true?

A) A business plan is like a road map for a business.

B) A business plan presents the results from a strategic planning process that focuses C) on how the business will be developed over time.

A well-prepared business plan makes it easier for an entrepreneur to communicate to potential investors precisely what returns an investor might expect to receive.

D) All of the above are true Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 44. A business plan is a tool that A) can help raise capital B) can help an entrepreneur set the goals and objectives for the company, C) serve as a benchmark for evaluating and controlling the company's performance D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 45. The key elements in a business plan includebut all A) an executive B) summary a company C) overview a dividend D) policy a market analysis Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 46. Which one of the following elements is included in a business plan?

A) A detailed description or the product(s) and services the company will sell B) A detailed discussion of the marketing and sales activities that will enable the C) business to achieve the sales and margin levels reflected in the financial forecasts.

D) A detailed discussion of capital requirements and uses.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium NOT 47. Which one of the following statements about business valuation is true?

A) The value of a business changes over time.

B) There is a single value for any business.

C) There is no such thing as the value for a business.

D) Actions by competitors also affect the value of a business.

Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 48. The value of a business changes over time because A) changes in general economic conditions, industry conditions, and decisions that are made by the managers all affect the value of the cash flows that a business is expected to generate in the future.

B) actions by competitors also affect the value of a business.

C) the investment, operating, and financing decisions made by managers also affect D) the value of a business.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium Note: Wording changed to match text 49. Which one of the following statements is NOT true?

A) A strategic investor is one who has an interest in acquiring the business.

B) The investment value of the firm to a strategic investor will take into C) consideration the benefits that can accrue from the acquisition.

D) The market value of a business is likely to carry a higher value than the investment value.

A financial investor, on the other hand, is only interested in the financial performance of the firm and not in acquiring the business.

Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 50. Which one of the following statements is NOT true?

A) Replacement cost and adjusted book value are cost-based valuation approaches.

B) The replacement cost approach involves restating the value of the individual C) assets in a business to reflect their fair market values.

D) The replacement cost of a business is the cost of duplicating the assets of the business in their present form as of the valuation date.

The replacement cost valuation approach is generally used to value individual assets within a business when they are being insured.

Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 51. The adjusted book value approach involves A) restating the value of the individual assets in a business to reflect their fair market B) values.

C) valuing all tangible and intangible assets.

D) valuing holding companies whose main assets are publicly traded or other investment securities but are generally less applicable for operating businesses.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 52. When using the multiples analysis approach to valuing a business, one must be aware A) of the presence of a marketability discount that can be sizable.

B) that identifying one or more comparable firms is not an easy task.

C) of differences in the capital structures of the firms being compared.

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 53. The transaction approach is difficult to use because A) transactions data are not typically as reliable as the data available for multiples B) analysis, especially when they are associated with a private firm.

C) transactions involving the purchase or sale of an entire business in an industry D) tend to occur relatively infrequently and hence the data is not very timely. the terms of the transactions can be difficult to assess.

All of the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 54. Which one of the following statements about the free cash flow from the firm (FCFF) approach is NOT true?

A) The present value of these cash flows exceeds the total value of the firm, or its B) enterprise value.

We do not include the cash necessary to pay short-term liabilities that do not have interest charges associated with them, such as accounts payable and accrued expenses.

C) The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses, are subtracted in the calculation of FCFF. D) the total value of the firm, VF, is computed as the present value of the FCFF, discounted by the firm's WACC. Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 55. The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses, A) are subtracted in the calculation of free cash flow from the firm (FCFF).

B) are added in the calculation of FCFF. C) are not a factor in the calculation of FCFF D) none of the above Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 56. In the free cash flow from the firm (FCFF) approach, the total value of the firm, VF, is computed as the present value of the FCFF, A) discounted by the firm's cost of equity B) discounted by the firm's WACC C) discounted by the firm's cost of debt D) None of the above.

Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 57. The free cash flow to equity (FCFE) approach uses only the portion of the cash flows that are available A) for distribution to bondholders.

B) for distribution to bondholders and stockholders.

C) for distribution to stockholders.

D) None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 58. The three specific cash flows associated with lenders that are included free in the cash flow to equity (FCFE) approach are A) the interest expense on existing debt, the repayment of debt principal, and the B) proceeds from new debt issues.

C) the interest expense on existing term debt, the repayment of debt principal, and D) the proceeds from new equity issues. the interest expense on existing debt, the repayment of debt principal, and the payment of dividends.

None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 59. In contrast to the FCFE approach, the dividend discount model (DDM) approach values A) cash flows that are available for distribution to stockholders.

B) the stream of cash flows that stockholders expect to receive through dividend C) payments.

D) cash flows that remain after payments to all lenders.

None of the above.

Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 60. Important issues that one must consider in valuing private firms include A) whether key people remain in the firm, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued.

B) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued.

C) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, whether key people remain in the firm, and whether a controlling ownership interest or a minority interest is being valued.

D) None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: hard 61. Break-even analysis: Trident, Inc., makes designer gold bracelets. Their annual costs include shop rent of $12,500, salaries for two jewelers of $118,000, design software costs of $10,000, and other overhead costs of $13,000. An average bracelet is priced at $5,500. It costs $2,000 in raw material, $1,250 in labor, and $250 in other expenses.

What is the minimum number of bracelets that need to be sold to earn a profit?

A) 28 B) 44 C) 77 D) 17 Ans: C Feedback: Fixed costs = $12,500 + $118,000 + $10,000 + $13,000 = $153,500.

Unit variable costs = $2,000 + $1,250 + $250 = $3,500 Unit selling price = $$5,500 Therefore, Fixed costs Break-even point= Price−Unit Variable cost $153, 500 = 76.75 bracelets = $5, 500 − $3, 500 The firm needs to sell at least 77 bracelets annually before it can make a profit.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 62. Break-even analysis: Jackson Electronics makes circuit boards and markets them to electronic goods manufacturers. The firm has nonsalary fixed costs of $212,000 and salary costs of $134,250. Each circuit board is sold at a price of $111.50 and involves variable costs of $81.73 per unit. What is the break-even point for Jackson?

A) 3,105 B) 11,63 C) 1 D) 4,237 Ans: B3,714 Feedback: Fixed costs = $212,000 + $134,250 = $346,250 Unit variable costs = $81.73 Unit selling price = $111.50 Therefore,

Fixed costs Price−Unit Variable cost $346, 250 = 11,630.8 circuit boards = $111.50 − $81.73 The firm needs to sell at least 11,631 circuit boards annually before it can make a profit.

Break-even point=

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 63. Break-even analysis: Sherwin Furniture makes period pieces. The firm has total fixed costs of $632,750. The average piece is sold at a price of $2,125 and involves variable costs of $1,675 per unit. What is the break-even point for this firm?

A) 1,40 B) 6 C) 298 D) 167 Ans: A378 Feedback: Fixed costs = $632,750 Unit variable costs = $1,675 Unit selling price = $2,125 Therefore, Fixed costs Break-even point= Price−Unit Variable cost $632, 750 = 1,406.1 pieces = $2,125 − $1, 675 The firm needs to sell at least 1,406 pieces of furniture annually before it can make a profit.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 64. Break-even analysis: Triad Electrical Supply Company needs to sell 3,500 circuit breakers to break even. Its unit variable cost is $341.50, and its unit selling price is $713.50. What is the fixed cost of this company?

A) $2,497,25 B) 0 C) $1,302,00 D) 0 Ans: B$1,195,25 0 Feedback: $3,692,50 Break-even point = 3, 500 units 0 Unit variable costs= $341.50 Unit selling price = $713.50 Fixed costs Break-even point= Price−Unit Variable cost Fixed costs 3,500 = $713.50 − $341.50 = $1, 302, 000 Fixed costs= 3,500  $372 The firm has fixed costs of $1,302,000.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 65. Break-even analysis: Johnstone Corp. wants to break even at 20,000 units on its only product. Its unit variable cost is $63.75, and its fixed cost is $742,000. What should be the company's unit selling price?

A) $37.10 B) $26.65 C) $100.8 D) 5 Ans: C$63.75 Feedback: Break-even point = 20,000 units Unit variable costs = $63.75 Fixed costs = $742,000 Fixed costs Break-even point= Price−Unit Variable cost $742,000 20, 000= Price − $63, 75

 $742, 000   + $63.75 = $100.85  20,000   The firm has to sell its product at $100.85.

Unit selling price=

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 66. Adjusted BV: Sterling, Inc., has cash of $10,000, receivables of $31,250, and inventory of $27,445. In addition, the firm has fixed assets of $125,000. Management has also told you that you can reasonably expect to collect 91 percent of the receivables, that the inventory could be sold to realize 85 percent of its book value, and that the sale of the property, plant, and equipment would yield $96,100. What is the liquidation value of this company? Round to the nearest dollar.

A) $157,86 B) 6 C) $193,69 D) 5 Ans: A$147,86 6 Feedback: $183,69 value is The liquidation Cash 5 $ 10,000 ×100% =$ 10,000.00 Accounts receivable $ 31,250 × 91% =$ 28,437.50 =$ 23,328.25 Inventory $ 27,445 × 85% $ 96,100.00 Net PP&E $125,000 $193,695 $157,865.75 Total assets Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 67. Adjusted BV: Troy Corp. has cash of $24,250, receivables of $81,700, and inventory of $117,875. In addition, the firm has property, plant, and equipment of $152,000.

Management has also told you that you can reasonably expect to collect 85 percent of the receivables, that the inventory could be sold to realize 80 percent of its book value, and that the sale of the property, plant, and equipment would yield $113,250. What is the liquidation value of this company? Round to the nearest dollar.

A) $375,82 B) 5 C) $293,69 D) 5 Ans: D$351,57 5 Feedback: $301,24 value is The liquidation Cash 5 $ 24,250 ×100% = $ 24,250 Accounts $ 81,700 ×85% = $ 69,445 Receivable $117,875 ×80% = $ 94,300 Inventory $152,000 $113,250 Net PP&E $375,825 Total assets $301,245

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 68. Multiples analysis: Turner Corp. has debt of $230 million and generated a net income of $121 million in the last fiscal year. In attempting to determine the total value of the firm, an investor identified a similar firm in Jacobs, Inc., an all-equity firm. This firm had 150 million shares outstanding, a share price of $14.25, and net income of $182 million. What is the total value of Turner Corp.? Round to the nearest million dollars.

A) $1,421 B) million C) $1,651 D) million Ans: B$1,191million $1,715 Feedback: million The P/E multiple for Jacobs Inc. is: Total equity ($14.25150,000,000) P/E = = =11.74 Net income $182,000,000 Implied equity value for Turnbull: V E = P/E  Net income= 11.74$121,000,000 = $1,420,540,000 Value of Turnbull's debt = VD = $230 million Therefore, the implied total value of Turnbull is: VF = VE + VD = $1,420.54 + $230.00 = $1,650.54 million Use the following to answer questions 69-70: Turnbull Corp. had an EBIT of $247 million in the last fiscal year. Its depreciation and amortization expenses amounted to $84 million. The firm has 135 million shares outstanding and a share price of $12.80. A competing firm that is very similar to Turnbull has an enterprise value/EBITDA multiple of 5.40.

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Reference: Ref 18-1 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 69. Multiples analysis: What is the enterprise value of Turnbull Corp.? Round to the nearest million dollars.

A) $1,334 B) million C) $453.6 D) million Ans: C$1,787million $1,315 Feedback: million value/EBITDA multiple for Turnbull's competitor = 5.40 The enterprise Turnbull's EBITDA = EBIT + D&A = $247 million +$84 million$84 million = $331 million Turnbull's enterprise value is: V F = Multiple EBITDA = 5.40 $331million = $1,787.4 million Reference: Ref 18-1 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 70. Multiples analysis: What is the value of Turnbull Corp's debt? Round to the nearest million dollars.

A) $121 B) million C) $165 D) million Ans: D$97million $59 million Feedback: No. of shares outstanding = 135 million Share price = $12.80 Value of Turnbull's equity = VE = $12.80 x 135 million = $1,728 million Turnbull's enterprise value = $1,787.4 million Turnbull's debt value = VD = VF - VE = $1,787.4 - $1,727 = $59.4 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 71. Income approaches: Rentech, Inc., a biotech firm, is expected to grow rapidly in the next three years and then have a level growth rate for the foreseeable future. The firm expects free cash flows of $342.5 million, $512.3 million, and $750 million over the next three years, and thereafter its cash flows will grow at a steady rate of 8 percent per annum. The company has no nonoperating assets (NOA). If the appropriate WACC is 11.25 percent, what is the enterprise value of this business? Round to the nearest million.

A) $19,367 B) million C) $18,101 D) million Ans: A$26,190 million Feedback: $24,923 Cost of capital = WACC = 11.25% million The present value of the cash flows in the first three years is: $750.0 $342.5 $512.3 + (1.1125)2+ (1.1125)3 PV(FCFF 3)= (1.1125) = $307.87 + $413.93 + 544.70 = $1,266.50 million Free cash flows in year 4 = $750(1.08) = $810 million $810 =$24,923 million TV= 0.1125−0.08 Terminal value = The present value of the terminal value is: $24,923 TV 3 = (1.1125)3=$18,100.96 millions PV (TV 3)= (1+WACC)3 Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,266.5 + $18,100.96 + $0$19,367.46 = million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 72. Income approaches: Shenandoah Corp. is expected to grow rapidly in the next four years and then have a zero growth rate for the foreseeable future. The firm expects free cash flows of $42.5 million, $64.3 million, $77.1 million and $92 million over the next four years, and thereafter its cash flows will stay constant.

The company has cash to the tune of $23.4 million. If the appropriate WACC is 10 percent, what is the enterprise value of this business? Round to the nearest million.

A) $628 B) million C) $864 D) million Ans: B$841 million Feedback: $818 Cost of capital = WACC = 10.0% million value of the cash flows in the first four years is: The present $42.5 $64.3 $77.1 $92.0 + + + PV (FCFF 4)= (1.10) (1.10)2 (1.10)3 (1.10)4 = $212.54 million Free cash flows in year 5 = $92 million $92 =$920 million TV= 0.10−0.00 Terminal value = The present value of the terminal value is: $920 TV 4 = (1.10)4=$628.37 millions PV (TV 4)= (1+WACC)4 Nonoperating assets = NOA = $23.4 million Total enterprise value is, therefore million VF = PV(FCFT) + PV(TVT) + NOA = $212.54+ $628.37+ $23.4$864.31 =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 73. Income approaches: Maryland Electronics, an electronics manufacturer, is expected to grow rapidly in the next five years and then have a stable growth rate for the foreseeable future. The firm expects free cash flows of $262.5 million next year. These cash flows are expected to grow at a 30 percent rate over the following four years, and thereafter its cash flows will grow at a steady rate of 6 percent per annum. The company has nonoperating assets (NOA) of $31 million in the form of cash.. If the appropriate WACC is 9 percent, what is the enterprise value of this business? Round to the nearest million.

A) $26,490 B) million C) $22,222 D) million Ans: C$19,014 million Feedback: $22,191 Cost of capital = WACC = 9.0% million value of the cash flows in the first five years is: The present 2 3 4 $262.5(1.3) $262.5(1.3) $262.5 $262.5(1.3) $262.5(1.3) + + + (1.09)2 + PV(FCFF 5)= (1.09)3 (1.09)4 (1.09)5 (1.09) = $1,766.44 million Free cash flows in year 6 = $749.73(1.06) = $794.71 million $794.71 =$26,490.33 million TV= 0.09−0.06 Terminal value = The present value of the terminal value is:

The present value of the terminal value is: Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA $19,014.34 Million = $1,766.44 + $17, 216.90 + $31 =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 74. Income approaches: Quicksilver Software Co. is expected to grow rapidly in the next three years and then have no growth for the foreseeable future. The firm expects free cash flows of $9.1 million, $11.4 million, and $17.7 million over the next three years, and thereafter its cash flows will stay constant. The company has no nonoperating assets. If the appropriate WACC is 12 percent and debt of 44.5 million, what is the equity value of this business? Round to the nearest million.

A) $135 B) million C) $105 D) million $45 Ans: Dmillion $90 million Feedback: Cost of capital = WACC = 12.0% The present value of the cash flows in the first three years is: $9.1 $11.4 $17.7 + (1.12)2+ PV(FCFF 3)= (1.12)3 (1.12) = $29.81 million Free cash flows in year 4 = $17.7 million $17.7 =$147.5 million TV= 0.12−0.00 Terminal value = The present value of the terminal value is: $147.5 TV PV (TV3 ) = = (1.12)3=$104.99 millions 3 (1+WACC)3 Nonoperating assets = NOA = $0 Total enterprise value is, therefore million VF = PV(FCFT) + PV(TVT) + NOA = $29.81+ $104.99 + $0 $134.8 = Value of debt = VD = $44.5 million Value of equity = VE = $134.8 - $44.5 = $90.3 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard Note: Correct answer & Feedback 75. Income approaches: You are using the FCFF approach to value a business. The estimated FCFF for next year will be $13.6 million, and it will increase at a rate of 6 percent for each of the following five years. After that point, the FCFF will increase at a rate of 3 percent forever. If the WACC for this firm is 8 percent, what is it worth?

A) $301 B) million 354 C) million D) $241 Ans: Amillion $144 Feedback: million You can value the FCFF for the first five years using the growing annuity formula from Chapter 6 (Equation 6.5).

FCFF for year 1 = $13.6 million Cost of capital = WACC = 8.0%

g4 x (1+gnormal) = $60.67 million = FCFF 1 x (1+) Free cash flows in year 6 =$13.6 x (1.06)4 x (1.03) = $17.68 million $17.68 =$353.70 million TV= Terminal value = 0.08−0.03 The present value of the terminal value is: $353 TV 3 PV (TV5)= = .7 =$240.72 millions (1+WACC)5 (1.08 )5 and the value of the firm is therefore: VF = $60.67 million + $240.72 million = $301.39 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 76. Income approaches: You are valuing the equity of a company using the FCFE approach and have estimated that the FCFE in the next three years will be $6.25, $7.70, and $8.36 million, respectively. Beginning in year 4, you expect the cash flows to increase at a rate of 4 percent per year for the indefinite future. You estimate that the cost of equity is 12 percent. What is the value of equity in this company?

A) $77 million B) $95 million C) $109 D) million $60 Ans: Bmillion Feedback: Cost of equity = kE = 12.0% The present value of the cash flows expected over the next five years is: $6.25 $7.70 $8.36 + (1.12)2+ PV(FCFF 3)= (1.12)3 (1.12) = $17.67 million The terminal value is: FCFE 3  (1+ g ) $8.36 (1.04)=$108.68 million = TV 3 = 0.12 − 0.04 kE − g The present value of the terminal value is: $108.68 TV 3 = = $77.36 millions ( 3)= PVTV 3 (1.12)3 (1+ kE ) Therefore, if there are no nonoperating assets, the value of the equity is VF = $17.67 + $77.36 = $95.03 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 77. Income approaches: You are valuing the equity of Cirona Corp. using the FCFE approach and have estimated that the FCFE in the next three years will grow at a 8 percent rate from last year's FCFE of $2.1 million. Beginning in year 4, you expect the cash flows to increase at a constant rate of 5 percent per year for the indefinite future.

The cost of equity for the firm is10 percent. What is the value of equity in this company?

A) $42 million B) $56 million C) $48 million D) $6 million Ans: C Feedback: FCFE for year 1 = $2.1(1.08) = $2.268 million Cost of equity = kE = 10.0% $2.268 $2.268(1.08) $2.45(1.08) + (1.10)2 + PV(FCFE 3)= (1.10)3 (1.10) = $6.07 million The terminal value is: FCFE 3  (1+ g ) $2.65 (1.05) =$55.55 million = TV 3 = 0.10 − 0.05 kE − g The present value of the terminal value is: $55.55 TV 3 = = $41.74 millions ( 3)= PVTV 3 (1+ kE ) (1.10)3 Therefore, if there are no nonoperating assets, the value of the equity is VF = $6.07 + $41.74 = $47.81 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: hard 78. Valuing private company: You are interested in investing in a private company.

Based on earnings multiples of similar publicly traded firms, you estimate the value of the private company's stock to be $13.44 per share. You plan to acquire a majority of the shares in the company. The expected control premium is 12 percent, while the marketability discount for such a firm is 15 percent. The discount for the key person, one of the founders who may leave the firm upon your control of the firm, is 15 percent. What price should you be willing to pay for these shares?

A) $14.9 B) 2 C) $16.6 D) 5 Ans: D$11.8 0 Feedback: Value$10.8 per share =Share value * [(1 + Control premium)*(1 – Marketability 8 discount) * (1 – Key person discount) = $13.44*(1+12%)*(1-15%)*(1-15%) = $10.88 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: hard 79. Valuing private company: Keshav Sinha is interested in investing in a private company. Based on earnings multiples of similar publicly traded firms, he estimates the value of the private company's stock to be $21.27 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 10 percent.

Keshav estimates the marketability discount for such a firm to be 12 percent. The discount for the key person, one of the founders who may leave the firm upon Keshav's control of the firm, is 20 percent. What price should he be willing to pay for these shares?

A) $16.4 B) 7 C) $31.4 D) 5 Ans: A$15.7 2 Feedback: Value$32.9 per share =Share value * [(1 + Control premium)*(1 – Marketability 4 * (1 – Key person discount) discount) = $21.27*(1+10%)*(1-12%)*(1-20%) = $16.47

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: hard 80. Valuing private company: Shane Bauer wants to invest in Trajectory Tech, a private company. Based on earnings multiples of similar publicly traded firms, Shane estimates the value of the private company's stock to be $18.97 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 12 percent. He estimates the marketability discount for such a firm to be 15 percent. The discount for the key person, one of the founders who may leave the firm upon Shane's control of the firm, is 15 percent. What price should he be willing to pay for these shares?

A) $15.3 B) 5 C) $28.1 D) 0 Ans: A$14.0 5 Feedback: Value$30.7 per share =Share value * [(1 + Control premium)*(1 – Marketability 0 discount) * (1 – Key person discount) = $18.97*(1+12%)*(1-15%)*(1-15%) = $15.35 Format: Essay 81. What difficulties are associated with valuing real assets compared to financial assets?

Ans: The valuation of real assets, however, is less straightforward than the valuation of financial assets for several reasons. First, in many cases, cash flows for financial assets are well documented in a legal contract. If they are not, we are at least able to make some reasonable assumptions about what they are. For real assets, no such information exists. Specialists within the firm, usually from the finance, marketing, and production groups, prepare estimates of future cash flows for the capital project. Second, many financial securities are traded in public markets, and these markets are reasonably efficient. Thus, market data on rates of return are accessible. For real assets, no such markets exist. As a result, we must look at investors' opportunity cost, the rate of return they give up when they invest in real assets rather than financial assets. We must estimate required rates of return on real assets from market data on financial assets, which can be difficult to do.

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Format: Essay 82. Explain how valuations can differ between public and private companies and between young and mature companies as well as the importance of marketability, control, and key person considerations in valuation.

Ans: Valuations differ between public and private companies for a number of reasons.

Two reasons discussed in this section are that the quality of the financial statements and the marketability of the securities being valued can differ considerably. Marketability is important because it affects the price that investors are willing to pay for a security. The less marketable a security is, the lower the price investors will be willing to pay. Young, rapidly growing companies tend to be more difficult to value than mature companies because there is less reliable historical information on young companies and the future of young companies tends to be less certain. Control is an important consideration in business valuation because having control of a business provides an investor with more flexibility with regard to how he or she will manage the business. Investors value this flexibility and will, therefore, pay more for a controlling interest in a company. If the cash flows that a business is expected to generate depend heavily on certain employees, those employees are key people. When valuing a business, an analyst must account for the possibility that the key people will unexpectedly leave the company and the associated impact on the company's cash flows.

Format: Essay 83. What are some things to watch out for when doing multiples analysis?

Ans: While doing a multiples analysis, one needs to be aware of certain issues. · When using multiples of publicly held firms to value one that is not, one · shoul aware of the presence of a marketability discount that can be · sizable. Identifying one or more comparable firms is not an easy task. · When using the multiple of a comparable firm, one needs to be aware of · differ in the capital structures of the firms being compared. You are · estimating a fair market value, not the investment value. It is important to make sure that the numerator and the denominator of the rati are using are consistent with each other. The data used to compute the multiple for the comparable company should inc the stock price as of the valuation date and accounting data from the same peri for which you have accounting data for the company of interest.

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Format: Essay 84. Why does the value of a business change over time?

Ans: The value of a business changes over time because: • changes in general economic conditions, industry conditions, and managers' decisions all affect the value of the cash flows that a business is expected to generate in the future.

Actions by competitors also affect the value of a business.

• The investment, operating, and financing decisions made by managers also • affect the value of a business.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Financial planning deals with establishing sales forecasts for a time horizon set by a firm's management.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. In putting together a financial plan, management addresses three main issues through their strategic plan, investment plan, and financing plan.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. The investment plan addresses the issue of what capital resources the management needs to get to achieve their goals.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. The financing plan deals with how the firm is going to secure the funds needed to pay for the capital resources required.

A) True B) False Ans: A

Page 1

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. The financing plan documents the firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities the firm needs to sustain its competitive position.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 6. The strategic plan identifies everything but mergers, alliances, and divestitures that may happen in the near future.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 7. The strategic plan addresses the issue of what capital resources management needs to achieve their goals.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 8. Capital expenditures can be one-time investments or routine investments that allow the firm to continue its operations.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 9. Once capital investments are made, they are almost always impossible to reverse.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 10. In the financing plan, management states that the firm will seek to raise funds externally even if sufficient internally generated funds are available to fund projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 11. The financial plan focuses on strategic planning and investment planning.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 12. The cash budget identifying the time line for cash inflows and outflows included in divisional business plans is part of the financial plan.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 13. Financial planning models are not considered an integral part of financial planning.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 14. Financial models provide management with the ability to prepare projected financial statements.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 15. Since sales are often correlated to the regional or national economy, macroeconomic forecasts are incorporated into the model.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 16. Financial statements and sales forecasts are considered major inputs in developing financial planning models.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 17. Investment and financing decisions are not considered inputs in financial planning models.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 18. The outputs of the financial planning model are a series of pro forma financial statements and financial ratios based on these statements.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 19. Pro forma financial statements that result from financial planning models are always perfectly balanced.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 20. Projected or pro forma statements can be used to analyze the investment alternatives but not to estimate the amounts of external funding needed.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 21. While sales are often correlated to the regional or national economy, it is not necessary to incorporate macroeconomic forecasts into the model.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 22. The percent of sales method is a complex financial planning model.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 23. In the percent of sales method, all income statement and balance sheet accounts vary directly with sales.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 24. The capital intensity ratio measures the dollar amount of sales per dollar invested in assets.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 25. Fixed assets vary directly with sales when firms are operating at full capacity.

A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 26. Fixed assets vary directly with sales when firms are operating at less than full capacity.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy 27. Firms that are not highly capital intensive are more risky than those that are.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 28. Financial planning helps management establish financial and operating goals for the firm and to communicate those goals throughout the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy 29. When a firm maintains a constant dividend policy, the firm's growth rate has no bearing on the external financing needed.

A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 30. Holding the growth rate constant, the higher the firm's payout ratio, the larger the amount of debt or equity financing needed.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy 31. The sustainable growth rate is the rate of growth that the firm can sustain without selling additional debt.

A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 32. The sustainable growth rate is the rate of growth that the firm can sustain without selling additional equity.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 33. The higher a firm's dividend payout ratio, the higher the firm's internal growth rate.

A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 34. The higher a firm's plowback ratio, the higher the firm's sustainable growth rate.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 35. The lower a firm's ROE, the lower the firm's sustainable growth rate.

A) True B) False Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 36. Which of the following components make up a financial plan A) the strategic plan.

B) the investment plan.

C) the financing plan.

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 37. The financial plan addresses the following issue(s): A) Where is the company headed?

B) What capital resources does the management need to get there?

C) How is the firm going to pay for the resources needed?

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 38. All but one of the following issues are addressed in the financial plan.

What A)is the growth rate for a firm's main competitor?

Where B) is the company headed?

What C)capital resources does the management need to get there?

HowD) is the firm going to pay for the resources needed?

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 39. According to the text, the financial plan covers a period of A) one year.

B) three to five years.

C) ten years.

D) None of the above.

Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 40. The strategic plan identifies A) the lines of business in which a firm will compete.

B) major areas of investment in real assets.

C) capital expenditures, acquisitions. and new lines of business.

D) All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 41. The strategic plan does NOT identify A) major areas of investment in real assets.

B) future mergers, alliances, and divestitures.

C) working capital strategies.

D) the lines of business a firm will compete in.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 42. Which one of the following is true about capital expenditures?

A) It is part of a firm's investment plan.

B) Once a capital investment is made, they are almost always impossible to reverse.

C) Capital expenditures can be one-time investments or routine investments that D) allow the firm to continue its operations.

All of the above are true of capital investments.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 43. Which one of the following is NOT true about the capital budgeting process?

A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders.

B) Senior management reviews the list.

C) The list is revised to comply with the firm's budget constraints.

D) All of the above are true of the capital budgeting process.

Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 44. Which one of the following is NOT true about the capital budgeting process?

A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders.

B) Senior management reviews the list.

C) Once the list is made, no management review can change it.

D) All of the above are true of the capital budgeting process.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 45. The financing plan of a firm will indicate A) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's dividend policy.

B) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's working capital policy.

C) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the firm's dividend policy, and the firm's working capital policy.

D) the firm's dividend policy, the desired capital structure for the firm, and the firm's working capital policy.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 46. Which one of the following is NOT part of a financing plan?

A) The dollar amount of funds that has to be raised externally and the sources of B) funds available to the firm C) The desired capital structure for the firm D) The firm's dividend policy All of the above are part of a financial plan.

Ans: D

Page 11

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 47. The financial plan includes A) the strategic plan, financing plan, and options plan.

B) the strategic plan, investment plan, and financing plan.

C) the financing plan, investment plan, and options plan.

D) none of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 48. The financial plan focuses on A) the inventory accounting method decision and the accounts payables decision.

B) the current assets decision and the current liabilities decision.

C) the investment decision and the financing decision.

D) none of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 49. Financial planning models A) help management make investment decisions.

B) help management make financing decisions.

C) make the process speedy and accurate.

D) all of the above are true.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 50. The sales forecasts used in financial planning A) are developed using a variety of techniques.

B) are generated within the firm.

C) utilize macroeconomic variables as input.

D) All of the above are true.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 51. Which one of the following statements is NOT true?

A) Sales forecasts models are typically very basic and use no complicated analysis.

B) are generated within the firm.

C) utilize macroeconomic variables as input.

D) All of the above are true.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 52. The inputs used in building financial planning models include A) financial statements, sales forecasts, and the firm's investment decisions.

B) pro forma statements, sales forecasts, and macroeconomic variables.

C) pro forma statements, sales forecasts, and financing decisions.

D) none of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 53. Which one of the following is NOT an input in financial planning models?

A) Financial statements B) Pro forma financial statements C) Investment decisions D) Financing decisions Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 54. Which one of the following statements is NOT true about financial planning models?

A) Financial statements serve as the first major input and become the baseline to B) compare the projected financial statements.

C) Macroeconomic forecasts and their impact on the firm's sales are also included.

D) Investment and financing decisions are not considered as inputs.

Changes in the firm's balance sheet and income statement items as a result of the growth in sales are also used in these models.

Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 55. Planning models that are more sophisticated than the percent of sales method have A) all variable costs change directly with sales.

B) working capital accounts like inventory, accounts receivables, and accounts C) payables vary directly with sales.

D) fixed assets that do not always vary directly with sales.

All of the above are true.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 56. One statement that is NOT true about more sophisticated financial planning model is that: A) only fixed costs change directly with sales.

B) working capital accounts like inventory, accounts receivables, and accounts C) payables vary directly with sales.

D) fixed assets do not always vary directly with sales.

All of the above are true Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 57. Which statement is NOT true for a firm that is operating at full capacity?

A) Fixed assets vary directly with sales.

B) Fixed assets can never vary directly with sales.

C) Fixed assets can be incrementally changed.

D) All of the above are true Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 58. Which one of the following statements is NOT true?

A) The ratio of total assets to sales is called the capital intensity ratio.

B) The ratio of sales to total assets is called the capital intensity ratio.

C) The higher the ratio, the more capital a firm needs to generate sales.

D) Firms that are highly capital intensive are more risky than those that are not.

Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 59. In using more sophisticated planning models, which one of the following statements is NOT true?

A) Current liabilities are likely to vary directly with sales.

B) Long-term liabilities and equity accounts change as a direct result of managerial C) decisions.

D) Retained earnings will vary directly as sales changes.

All of the above are true Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 60. In using more sophisticated planning models, which one of the following statements is NOT true?

A) Current liabilities are likely to vary directly with sales.

B) Long-term liabilities and equity accounts change as a direct result of managerial C) decisions.

D) Retained earnings will vary as sales changes but not directly as it is affected by the firm's dividend payout policy.

All of the above are true Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 61. Some weaknesses in financial planning models include: A) Interest expense is not accounted for.

B) All working capital accounts do not necessarily vary directly with sales, C) especially cash and inventory.

D) How fixed assets are adjusted.

All of the above are weaknesses.

Ans: D

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 62. In accounting for changes in fixed assets, which one of the following statements is NOT true?

A) When a firm is not operating at full capacity, sales may be increased without B) adding any new fixed assets.

C) Since it requires time to get new assets operational, they are added in small D) discrete quantities.

Fixed assets are added in large discrete amounts called lumpy assets.

All of the above are true.

Ans: B Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 63. In accounting for changes in fixed assets, which one of the following statements is NOT true?

A) When a firm is not operating at full capacity, sales may be increased without B) adding any new fixed assets.

C) Since it requires time to get new assets operational, they are added as the firm D) nears full capacity.

Fixed assets are added in large discrete amounts called lumpy assets.

All of the above are true.

Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 64. External funding needed (EFN) is A) the additional debt or equity a firm needs to issue so that it can purchase B) additional assets to support an increase in sales.

C) the additional funds raised by a firm to pay off existing short-term debt.

D) the additional funds raised by a firm to pay off existing long-term debt.

None of the above are true.

Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 65. Which one of the following statements is NOT true?

A) The internal growth rate (IGR) is defined as the maximum growth rate that a firm B) can achieve without external financing.

C) The higher the retained earnings generated by a firm, the higher the growth D) possible without using external funding.

Given the same level of retained earnings, a firm that has the higher amount of total assets, the higher the growth possible without using external funding.

All of the above are true.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 66. Firms that achieve higher growth rates without seeking external financing A) have a high plowback ratio. have less equity and/or are able to generate B) high net income leading to a high ROE. are not highly leveraged. All of C) the above are true.

D) Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 67. Firms that achieve higher growth rates without seeking external financing A) have a low plowback ratio.

B) have less equity and/or are able to generate high net income leading to a high C) ROE. D) are highly leveraged.

None of the above.

Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 68. The sustainable growth rate (SGR) A) is a function of the plowback ratio and the ROE. B) the rate of growth that the firm can sustain without selling additional shares of C) equity.

D) helps management determine whether they can avoid issuing new equity.

All of the above are true of the SGR. Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 69. Which one of the following statements about the sustainable growth rate (SGR) is NOT true?

A) B) The SGR is a function of the plowback ratio and the ROE. C) D) The SGR determines the rate of growth that the firm can sustain without selling additional shares of equity.

The SGR helps management determine whether they can avoid issuing new debt.

All of the above are true of the SGR. Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 70. Which one of the following statements about the sustainable growth rate (SGR) is NOT true?

A) B) The higher a firm's ROE, the higher the SGR. C) D) The higher the plowback ratio, the larger the proportion of net income retained in the firm and the greater the firm's SGR. Both a and b are true None of the above.

Ans: C

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 71. Addition to retained earnings: Hilton Corp. has revenues of $1,214,800 and costs of $816,355, and pays a tax rate of 32 percent. If the firm pays out 50 percent of its earnings as dividends every year, what is the amount of retained earnings?

A) $135,471.30 B) $270,942.60 C) $413,032.00 D) None of the above.

Ans: A Feedback: Revenue = $1,214,800 Costs = $816,355; Payout ratio = 50% Tax rate = 32% = - $816,355) (1 - 0.32) ($1,214,800 Net income = $270,942.60 Retained = 270,942.60 (1-0.50) earnings = $135,471.30 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 72. Addition to retained earnings: Tangent, Inc., has revenues of $4,375,233 and costs of $2,467,321, and pays a tax rate of 34 percent. If the firm pays out 60 percent of its earnings as dividends every year, what is the amount of retained earnings?

A) $171,254.18 B) $755,533.15 C) $503,688.77 D) None of the above.

Ans: C Feedback: Revenue = $4,375,233 Costs = $2,467,321; Payout ratio = 60% Tax rate = 34% = - $2,467,321) (1 - 0.34) ($4,375,233 Net income = $1,259,221.92 Retained = 1,259,221.92 (1-0.60) earnings = $503,688.77

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 73. Retention ratio: A firm paid out $163,961.60 as dividends on net income of $298,112.

What is the firm's retention ratio?

A) 55% 45% 50% B) None of the C) above.

D) Ans: B Feedback: Dividends = $163,961.60 Net income = $298,112.

Dividends $163,961.

Dividend payout ratio= = =55% Net income 60 $298,112.

Retention ratio = (1 - Dividend Payout ratio) = (1 – 0.55) = 45% 00 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 74. Payout and retention ratio: Tradewinds Corp. has revenues of $9,651,220, costs of $6,080,412, interest payment of $511,233, and a tax rate of 34 percent. It paid dividends of $1,384,125 to shareholders. Find the firm's dividend payout ratio and retention ratio.

A) 66%, B) 34% C) 25%, D) 75% Ans: C69%, 31% Feedback: 34%, Tradewinds Corp.

66% Revenues Costs Amount EBIT Interest EBT $9,651,220.00 Taxes (34%) Net 6,080,412.00 income $3,570,808.00 511,233.00 $3,059,575.00 1,040,255.50 $2,019,319.50 Dividends paid = $1,384,125 Dividends $1,384,125.00 Dividend payout ratio= = =68.5% Net income $2,019,319.50 Retention ratio = (1 - Dividend Payout ratio) = (1 – 0.69) = 31%

Page 20

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 75. Payout and retention ratio: Drekker, Inc., has revenues of $312,766, costs of $220,222, interest payment of $31,477, and a tax rate of 34 percent. It paid dividends of $34,125 to shareholders. Find the firm's dividend payout ratio and retention ratio.

A) 85%, B) 15% C) 45%, D) 55% Ans: A55%, 45% Feedback: 15%, Amount 85% Revenues $312,766.00 Costs EBIT 220,220.00 Interest $ 92,544.00 EBT Taxes 31,477.00 (34%) Net $ 61,067.00 income 20,762.78 $ 40,304.22 Dividends paid = $34,125 Dividends $34,125.0 Dividend payout ratio= = =84.7% Net income 0 $40,304.2 Retention ratio = (1 - Dividend Payout ratio) = (1 – 0.75) = 15% 2 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 76. Capital intensity ratio: Comacho Traders has total assets of $513,480 and sales of $723,062. What is the firm's capital intensity ratio?

A) 1.41 0.71 1.23 B) None of the C) above.

D) Ans: B Feedback: Total assets = $513,480 Sales = $723,062 Total assets Capital intensity ratio= Net sales

=

$513, 480 = 71.01% $723, 062

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 77. Capital intensity ratio: Michael Holdings, Inc., has total assets of $1,480,072 and sales of $2,236,625. What is the firm's capital intensity ratio?

A) 66.2% 53.7% B) 151.1% None of C) the above.

D) Ans: A Feedback: Total assets = $1,480,072 Sales = $2,236,625 Total assets Capital intensity ratio= Net sales $1, 480, 072 = $2, 236, 625 = 66.17%

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: hard 78. Capital intensity ratio: Dennis Compton, Inc., has total assets of $5,335,901 and a capital intensity of 53.9%. What is the firm's sales?

A) $5,335,901 B) $2,828,028 C) $9,899,631 None D) of the above.

Ans: C Feedback: Total assets = $5,335,901 Capital intensity ratio = 53.9%

Page 22

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 79. Internal growth rate: Swan Supply Company has net income of $1,212,335 on assets of $12,522,788 and retains 70 percent of its income every year. What is the company's internal growth rate?

A) 7.6% B) 6.8% C) 8.6% D) 9.3%.

Ans: B Feedback: Net income = $1,212,335 Total assets = $12,522,788 Plowback ratio = 70% Internal growth rate (IGR)= Plowback ratio  ROE  Equity ratio = Plowback ratio  Net income Equity Equity Total assets Net income = Plowback ratio  Total assets $1,212,335

$12, 522, 788 = 0.70  6.8% =

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 80. Internal growth rate: Mercantile Company has net income of $3,413,500 on assets of $16,109,445 and retains 55 percent of its income every year. What is the company's internal growth rate?

A) 21.2% B) 8.6% C) 11.7% D) 9.4% Ans: C Feedback: Net income = $3,413,500 Total assets = $16,109,445 Plowback ratio = 55% Internal growth rate (IGR)= Plowback ratio  ROE  Equity ratio = Plowback ratio  Net income Equity Equity Total assets Net income = Plowback ratio  Total assets $3, 413, 500 = 0.55  $16,109, 445

= 11.65%

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 81. Internal growth rate: Mandolin Bottlers has net income of $4,272,335 and retains 65 percent of its income every year. If the company's internal growth rate is 8.6 percent, what is the firm's total assets?

A) $32,290,904 B) $238,824 C) $30,388,235 D) None of the above.

Ans: A Feedback: Net income = $4,272,335 Total assets = ?

Plowback ratio = 55% IGR = 8.6% Internal growth rate (IGR)= Plowback ratio  ROE  Equity ratio Net income Equity = Plowback ratio   Equity Total assets Net income = Plowback ratio  Total assets $4, 272, 335 0.086= 0.65  Total assets $4,272,335 =$32,290,904 Total assets= 0.65 0.086

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 82. Internal growth rate: Meredith, Inc., has a return on equity of 21.5 percent, an equity ratio of 55 percent, and a dividend payout ratio of 70 percent. What is the company's internal growth rate?

A) 8.3% B) 3.6% C) 6.4% D) 4.8% Ans: B Feedback: ROE = 21.5% Equity ratio = 55% Dividend payout ratio = 70% Plowback ratio = 30% IGR = Plowback ratioROE  Equity ratio = 0.30  0.215  0.55

= 3.55% Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 83. External financing needed: Sterling Resorts has total assets worth $13,442,975. It is expecting to grow its revenue at a rate of 25 percent next year. For next year they expect a net income of $3,475,321 and will pay out 45 percent as dividends. What is the external financing needed by this firm to meet its growth expectations?

A) $1,796,849.30 B) $1,449,317.20 No external C) funding is needed. None of D) the above Ans: B Feedback: Total assets = $13,442,975 Expected net income = $ 3,475,321 Addition to retained earnings = $3,475,321 x (1-0.45) = $1,911,426.55 EFN = (Initial assetsGrowth rate)-Addition to retianed earnings = ($13, 442, 975  0.25) − $1, 911, 426.55 = $3, 360, 743.75 − $1, 911, 426.55 = $1, 449, 317.20

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 84. External financing needed: Nederland Finance Company has total assets worth $9,751,223. It is expecting to grow its revenue at a rate of 20 percent next year and will have a net income of $2,213,564 next year. The firm pays out 65 percent of its net income as dividends. What is the external financing needed by this firm to meet its growth expectations?

A) $1,175,497.20 B) $511,428.00 C) No external funding is needed.

D) None of the above Ans: A Feedback: Total assets = $9,751,223 Net income = $2,213,564 Addition to retained earnings = $2,213,564 x (1 0.65) = $774,747.40 EFN = (Initial assetsGrowth rate)-Addition to retianed earnings = ($9, 751, 223  0.20) − $774, 747.40 = $1, 950, 244.60 − $774, 747.40 = $1,175, 497.20

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 85. External financing needed: Triumph Company has total assets worth $6,413,228.

Next year it expects a net income of $3,145,778 and will pay out 70 percent as dividends. If the firm wants to limit its external financing to $1 million, what is the growth rate it can support?

A) 32.9 B) % C) 6.4% D) 30.3 Ans: % C Feedback: Total assets = $6,413,228 Net income = 26.5 $3,145,778 EFN = $1,000,000 Addition to retained earnings = % $3,145,778 x (1 - 0.70) = $943,733.40

EFN = (Initial assetsGrowth rate)-Addition to retianed earnings $1,000,000 = ($6,413,228Growth rate)-$943,733.40 = $6,413,228Growth rate $1,000,000 + $943,733.40 $1,943,733.40 Growth rate = = 30.3% $6,413,228

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 86. External financing needed: Jockey Company has total assets worth $4,417,665. At year-end it will have net income of $2,771,342 and pay out 60 percent as dividends. If the firm wants no external financing, what is the growth rate it can support?

A) 32.9 B) % C) 25.1 D) % Ans: B30.3 % Feedback: Total 27.3 assets = $4,417,665 % Net income = $2,771,342 EFN = $0 Addition to retained earnings = $2,771,342 x (1 - 0.60) = $1,108,536.80 EFN = (Initial assetsGrowth rate)-Addition to retianed earnings

$0 = ($4,417,665Growth rate)-$1,108,536.80 = $4,417,665Growth rate $1,108,536.80 $1,108,536.80 Growth rate = = 25.1% $4,417,665

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 87. Sustainable growth rate: If Newell Corp. has a ROE of 18.6 percent and a dividend payout ratio of 60 percent, what is its sustainable growth rate?

A) 7.4% B) 2.15 C) % D) 0.47 Ans: A% 8.2% Feedback: ROE = 18.6% Payout Ratio = 60% Plowback ratio = (1 - Payout ratio) = (1 - 0.60) = 40% SGR = Plowback ratio ROE = 0.40  0.186 = 7.44%

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 88. Sustainable growth rate: If Merton Corp. has a ROE of 23.4 percent, what is the plowback ratio needed to achieve a sustainable growth rate of 7 percent?

A) 34% B) 30% C) 24% D) 28% Ans: B Feedback: ROE = 23.4% Plowback ratio = ?

Sustainable growth rate = 7% SGR = Plowback ratio  ROE 0.07 = Plowbackratio  0.23.4 Plowbackratio= 0.07 29.9% 0.234

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 89. Sustainable growth rate: Sterling, Inc., currently has sales of $4,512,644 and net income of $736,253. It has a debt ratio of 47 percent and a dividend payout ratio of 65 percent. The company has total assets of $3,812,832. What is the company's sustainable growth rate?

A) 12.7 B) % C) 23.7 D) % Ans: A18.9 % Feedback: Sales 20.1 = $4,512,644 % Net income = $736,253 Debt ratio = 47% Dividend payout ratio = 65% Total assets = $3,812,832 Plowback ratio= (1-0.65)= 35% Equity ratio=(1-0.47)=53% Equity = 0.53 Total assets= 0.53$3,812,832 = $2, 020, 800.96 Net income= $736, 253 = 36.4% ROE= $2, 020, 800.96 Equity SGR = Plowback ratioROE = 0.350.364=12.74%

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 90. Sustainable growth rate: Courtney Bike Company has a net profit margin of 7.8 percent, a debt ratio of 45 percent, total assets of $2,112,370, and sales of $4,276,990.

If the company has a dividend payout ratio of 60 percent, what is the company's sustainable growth rate?

A) 17.2 B) % C) 15.6 D) % Ans: C11.5 % Feedback: 18.9margin = 7.8% Net profit % = 45% Debt ratio Total assets = $2,112,370 Sales = $4,276,990 Dividend payout ratio = 60% Plowback ratio= (1-0.60)= 40%

Net income Sales Net income =SalesNet PM =$4,276,990  0.078$333,605.22 = = Equity ratio =1-Debt ratio (1-0.45) =55% Equity =0.55  $2,112, 370 = $1,161, 803.50

Net PM=

Net income  Plowback ratio Equity $333,605.22 =  0.40 $1,161,803.50 = 11.49%

SGR =

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Format: Essay Learning Objective: LO 1 91. Explain how the strategic plan, investment plan, and financing plan integrate to help management do financial planning. Ans: Financial planning involves planning over a three- to five-year horizon. It calls for the integration of three basic plans—the strategic plan, the investment plan, and the financing plan. The strategic plan documents the firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities the firm needs to sustain its competitive position. The planning is done by the firm's top management with the financial manager providing key input, and it has to be approved by the board of directors.

The strategic plan identifies the line of business in which the firm will compete, major areas of investment in real assets, and capital expenditures among other things. Next, the investment plan, which includes the capital budget, describes the firm's outlay for plant and equipment. Management will identify a list of potential projects that are consistent with the business strategy and rank them according to value they would create for the shareholders. Senior management then will review the list before revising it in order to comply with the firm's budget constraints. Based on the list prepared in the capital budget, management now needs to decide how to fund the projects. The firm will try and use a blend of internally generated funds and externally raised funds to finance the capital expenditures. Depending on the level of internally generated funds available to the firm, the firm will seek to raise funds in the form of either debt or equity.

Format: Essay Learning Objective: LO 5 92. Discuss the implications of the internal growth rate.

Ans: The internal growth rate (IGR) is the maximum growth rate a firm can sustain without having to raise any finance from external sources. Firms that are small and growing typically have limited access to outside financing. Such firms have a high enough retention ratio to fund growth, generate a high level of net income for every dollar of equity, and use low amounts of leverage or debt financing.

Once a firm reaches a certain size and growth rate , it may be unable to totally fund their growth with retained earnings alone and may have to enter the capital markets to raise funds.

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Format: Essay Learning Objective: LO 5 93. Explain the sustainable growth rate and discuss what it means to a firm's management.

Ans: The sustainable growth rate (SGR) is the maximum growth rate a firm can grow at without needing any external equity financing, holding the level of debt constant. Growing the firm at the sustainable growth rate allows management to avoid costly equity issues, thus reducing the dilution of earnings. Whenever firms grow faster than the SGR, the firm is going to need external financing and may have to resort to debt financing, which increases the company's risk.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 1. A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 2. A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow we would expect the price of the call option to go down as well.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 3. A call option can sometimes be priced higher than the underlying asset.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 4. Neither a call nor a put option can have a negative price.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 5. The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 6. If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 7. In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 8. To price an option using the binomial pricing model, it is important that we know the probability that the asset will increase in value.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 9. When using the binomial pricing model to price an option, the volatility of the underlying asset is represented by the difference between the two possible future values of the underlying asset.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 10. Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the call option is $10.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 11. Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the put option is $10.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 12. Suppose you have sold a put option on a stock with a strike price of $25. If the stock price at expiration is $30, your payoff will be $–5.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 13. A portfolio consisting of one put option and one call option, both with the same exercise price, is called a straddle. A straddle is a good investment strategy for investors who don't know whether an asset's value is likely to go up or down, but think that the volatility of the asset will increase.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 14. If a project has a positive NPV, then the real options that affect the project are not important to estimating the value of the project.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 15. The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to the project.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 16. Incorporating real options will not decrease the value of the project relative to the basic NPV analysis.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 17. After taking into account the value of real options, it is possible that some projects with a negative NPV should be pursued.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 18. A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 19. The option to abandon a project can decrease its value.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 20. Kelvin's Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of advanced commercial thermostats.

The discounted cash flows from commercial thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 21. Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 22. Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the firm will avoid financial distress.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 23. Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: medium 24. By designing compensation plans with performance bonuses, stock-based compensation and stock options corporate boards are attempting to make the payoff function for managers look similar to the payoff function for stockholders.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 25. Financial options can be used to hedge risks such as interest rates and foreign exchange rates . A)True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 26. Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20,000 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 27. Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of wheat with a strike price of $15,000 and an expiration date at the end of the season are selling for $3,000. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel.

A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 28. Hedging is the process of using financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a firm.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 29. Socrates Motor Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock market declines significantly, the company would have to make additional contributions to make up for lost revenue. The company could hedge its risk of a market downturn by periodically purchasing put options on the stock market.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 30. A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He can't raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the proceeds from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. The risk-free interest rate is 0 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel.

A) True B) False Ans: A

31.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium If a firm adds financial options to their debt securities it will increase the interest expense to the firm.

A) True B) False Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 32. An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option, A) the buyer has the obligation to buy the underlying asset and the seller has the B) obligation to sell it.

C) the buyer has the right to buy the underlying asset and the seller has the D) obligation to sell it. the buyer has the obligation to buy the underlying asset and the seller has the right to sell it.

None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 33. An investor (the buyer) purchases a put option from a seller. On the expiration date of a call option, A) the buyer has the obligation to sell the underlying asset and the seller has the right B) to buy it.

C) the buyer has the obligation to sell the underlying asset and the seller has the D) obligation to buy it. the buyer has the right to sell the underlying asset and the seller has the obligation to buy it.

None of the above Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 34. Which one of the following statements is NOT true?

A) The value of a call option can never be negative.

B) The value of a call option can never be more than the value of the underlying C) asset.

D) The value of a call option can never be worth less than the current value of the asset minus present value of the strike price.

The value of a call option can never be worth more than the strike price.

Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 35. Which one of the following statements is NOT true?

A) The value of a put option can never be negative.

B) The value of a put option can never be worth more than the underlying asset.

C) The value of a put option can never be less than the present value of the strike D) price minus the current value of the underlying asset.

All the above statements are true.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 36. Suppose you own a call option on a stock with a strike price of $20 that expires today.

The price of the underlying stock is $15. If you exercise the option and immediately sell the stock, A) you will earn $5.

B) you will lose $5.

C) you will lose $15.

D) you will earn $15.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 37. Suppose you own a put option on a stock with a strike price of $35 that expires today.

The price of the underlying stock is $25. If you purchase the stock and exercise the put option, A) you will earn $10.

B) you will lose $10.

C) you will earn $25.

D) you will lose $25.

Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 38. Consider an option that gives the owner the right to buy a stock for $20 only on the third Friday of May, next year. The option being described is A) an American call option.

B) a European put option.

C) an American put option.

D) a European call option.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 39. Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which one of the following statements is true?

A) The American call option will never be worth less than the European call B) option. The European call option will never be worth less than the American C) call option. Both options should always have the same value. None of the D) above statements is true.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 40. A straddle is a combination of a put option and a call option on the same asset with the same strike price. Which one of the following statements about a straddle is NOT true?

A) The owner of a straddle will receive a payoff if the price of the underlying asset B) is higher than the strike price at expiration.

C) The owner of a straddle will receive a payoff if the price of the underlying asset D) is lower than the strike price at expiration.

The owner of a straddle will never exercise the put and the call option at the same time.

The owner of a straddle will receive a higher payoff if the price of the underlying asset at expiration is near the strike price.

Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 41. Which of the following changes, when considered individually, will increase the value of a call option?

A) The value of the underlying asset becomes more volatile.

B) The price of the underlying asset goes down.

C) Getting closer to the expiration date (the passage of time).

D) A higher strike price.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 42. Which of the following changes, when considered individually, will increase the value of a put option?

A) An increase in the risk-free interest rate B) Lower volatility of the price of the underlying asset C) A higher strike price D) None of the above Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 43. What happens to the value of call and put options if the volatility of the price of underlying asset decreases?

A) Put options will be worth more, call options will be worth B) less. Put options will be worth less, call options will be C) worth more. Both call and put options will be worth more.

D) Both call and put options will be worth less.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 44. If the price of the underlying asset increases, what happens to the value of call and put options?

A) Put options will be worth more, call options will be worth B) less. Put options will be worth less, call options will be C) worth more. Both call and put options will be worth more.

D) Both call and put options will be worth less.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 45. With everything else constant, as the expiration date gets closer, what happens to the value of call and put options?

A) Call option will be worth more, put options will be worth B) less. Call option will be worth less, put options will be C) worth more. Both call and put options will be worth more.

D) Both call and put options will be worth less.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 46. With everything else held constant, what happens to the value of call and put options if the risk-free interest rate increases?

A) Call options will be worth more, put options will be worth B) less. Call options will be worth less, put options will be C) worth more. Both call and put options will be worth less.

D) Both call and put options will be worth more.

Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 47. The management at Socrates Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to be easily converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the price at which they expect to sell the plant if things go poorly resembles A) the premium of a put option on the plant.

B) the premium of a call option on the plant.

C) the strike price of a put option on the plant.

D) the strike price of a call option the plant.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 48. Socrates Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the company's assets. A group of stockholders has pressured the company's management to begin manufacturing and selling one of the company's concept cars in the hope that it will be a big hit.

Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good of A) the example dividend payout problem.

B) the underinvestment problem.

C) the asset substitution problem.

D) the agency cost of equity.

Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 49. Consider a CEO who holds neither stock nor stock options in the company she runs.

Her payoff function regarding the firm's performance is most likely to resemble A) stockholders.

B) lenders.

C) owners of a call option on the firm.

D) holders of a risk-free bond with coupon payments equal to her salary.

Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 50. Which of the following compensation methods is NOT likely to reduce agency costs between stockholders and managers?

A) Stock compensation—giving the CEO stock in the company as part of her B) salary. A golden parachute—a guaranteed large lump-sum payment in the C) event that the CEO is fired. A higher salary than that of other CEOs in similar D) companies. Performance bonuses—a higher bonus if the company's cash flows are higher then expected.

Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 51. Which of the following reasons is NOT a valid explanation of why managers sometimes choose to take on negative-NPV Projects: A) The NPV analysis does not include a valuable real option to expand the project if B) things go well.

C) If the firm has debt, managers may create value for shareholders by taking on D) some risky negative-NPV projects.

Managers' payoff functions represent the payoffs of lenders. By taking negative-NPV projects, the managers can create value for lenders.

All of the above descriptions are valid explanations for why managers sometimes take on negative NPV projects.

Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 52. As the manager of a sporting goods company, you are presented with a new golf project. An inventor has recently patented the design for a new golf club that makes playing golf much easier. Your company has made contact with the inventor, who is willing to sell the exclusive rights to the technology, but if you don't act fast he will sell the rights to a rival company. You are not certain whether the new golf club will become popular, but your analysts have completed a basic NPV analysis. Given the available information, the project has a positive NPV. However, you know there are several real options associated with the project, including the option to abandon the project and the option to make follow-on investments. Which one of the following statements regarding the project is correct?

A) Based on the NPV analysis, you should accept the project. The value of the B) project may be worth more than the NPV analysis but not less.

C) Based on the NPV analysis, you should accept the project. The NPV analysis contains all the information about the value of the project.

Based on the NPV analysis, you should reject the project. Without additional information about the value of the real options, there is no way to make a decision.

D) Based on the NPV analysis, you should reject the project. The NPV analysis contains all the information about the value of the project.

Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: medium 53. A start-up company is making a decision on whether to develop a new internet social networking site. The site will cost $1 million to develop, but it is unclear whether the new technology critical to the site will work correctly. If development is successful, it will cost an additional $20 million next year to advertise the site to Internet users. If the site becomes popular with Internet users, it is expected to generate a present value of $100 million in advertising revenue. There is a 10 percent chance that the site will be successfully developed and subsequently become popular with Internet users. The company's cost of capital is 15 percent. Should the company pursue project?

A) the No, the project has a negative NPV. B) Yes, the project has a positive NPV. C) It doesn't matter. The project has zero NPV. D) There is not enough information to make a decision.

Ans: D

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 54. The employment contracts for professional athletes often contain options for either the player or the team. Consider one recent contract in Major League Baseball. The player's salary was guaranteed for the first couple years. However, after several years, the team had the option to cancel the contract if the player became injured. If we think of each player as a project for the team, this option feature of the contract is best described as A) the option to defer investment.

B) the option to make follow-on investments.

C) the option to change operations.

D) the option to abandon projects.

Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 55. RealEstates LLP is considering the construction of a new development of condominiums in downtown Austin, Texas. The site for the new development is currently occupied by an office building owned by the city. The project's profitability will depend largely on the population increase in Austin over the next several years.

Rather than buy the site, RealEstates has entered into an agreement with the city to pay $200,000 for the right to purchase the site for $10 million two years from now. The real option embedded in this contract is best described as A) the option to defer investment.

B) the option to make follow-on investments.

C) the option to change operations.

D) the option to abandon projects.

Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 56. Consider a new firm that is working on the first generation of long-awaited consumer jet packs. The project will take a tremendous amount of R&D expenditure. Even if the development is successful, manufacturing the first generation of jet packs is likely to be so expensive that only a select few consumers will be able to afford them. The projected sales of the first generation of jet packs almost certainly won't cover the development and manufacturing costs—the project has a negative NPV. Which of these reasons would validate the firm's decision to pursue the jet pack project?

A) If development is unsuccessful, it can abandon the project before spending B) money on manufacturing.

C) If the project is successful, it may lead to a very profitable second project—a D) cheaper jet pack that will be a positive-NPV project.

Because it is a high-tech firm, the cash flows generated by a project are not important to valuing the company.

None of these reasons support the decision to pursue the project.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 57. A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What sort of financial option does the option to cancel the order resemble?

A) Owning a call option on the value of the new schools B) Owning a put option on the value of the new schools C) Selling a call option on the value of the new schools D) Selling a put option on the value of the new schools Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 58. Purchasing a house is a somewhat complicated process. Typically, if the buyer's offer is accepted by the seller, the transaction will not be completed or “closed” for several weeks. During this time the buyer may gather more information about the house or research other houses in the area. Some home purchase contracts include an option fee. The buyer may pay the seller a few hundred dollars for the right to walk away from the contract prior to closing for any reason. This option fee is the bestoption described as investment.

A) to defer B) the option to make follow-on investments.

C) the option to change operations.

D) a put option on the house.

Ans: A Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 59. The management at Socrates Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles A) the premium of a put option on the plant.

B) the premium of a call option on the plant.

C) the strike price of a put option on the plant.

D) the strike price of a call option on the plant.

Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 60. Franklin Foods has made the decision to invest in a new line of organic microwave dinners. The new line of dinners is a negative-NPV project; paying its suppliers to convert to organic practices will be expensive. However, the company will be in a good position to expand into more profitable lines of food if consumer demand for organic foods grows more then expected. The negative value of the organic dinner project most closely resembles: A) the premium of a put option on future organic projects.

B) the premium of a call option on future organic projects.

C) the strike price of a put option on future organic projects.

D) the strike price of a call option on future organic projects.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium 61. Gnu Homes, Inc., is a developer of planned residential communities. It has entered into an option contract with a land owner outside Austin, Texas. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time Gnu Homes will evaluate population and real estate trends in Austin. Their plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more then the $20 million price. The $20 million purchase price resembles A) the premium price of a put option on the land.

B) the premium price of a call option on the land.

C) the strike price of a put option on the land.

D) the strike price of a call option on the land.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 62. The claim stockholders hold on cash flows in a company with outstanding debt is often described as A) a call option on the firm's assets.

B) a put option on the firm's assets.

C) an interest-free bond with the same value as the firm's assets.

D) none of the above Ans: A

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 63. Which of the following statements is NOT an example of the agency cost of debt?

A) ABC Co. shareholders pressure management to invest in very risky projects in hopes that one of the investments might pay off. The company is highly leveraged, so shareholders have little to lose.

B) ABC Co. has a large amount of debt but very few investment opportunities. The board of directors decides to pay out a large special dividend, and the company subsequently enters bankruptcy. Lenders collect about 60 percent of the face value of the debt.

C) ABC Co. is very close to financial distress. The company has a positive-NPV investment opportunity, but even with the project the company is likely to enter bankruptcy. Investors refuse to invest the additional funds necessary to pursue the project, even though it has a positive NPV. D) Investors are unsure of the value for ABC Co. ABC Co. decides to issue equity to pay down debt. The market assumes that ABC Co.'s managers are issuing equity because they think that the company's stock is overvalued. As a result, the company's stock price falls when the equity issue is announced.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 64. The claim lenders' hold on cash flows in a company with outstanding risky debt is often thought of as A) holding a call option on the firm's assets.

B) holding a put option on the firm's assets.

C) selling a put option on the firm's assets and holding a risk-free bond.

D) selling a call option on the firm's asset and holding a risk-free bond.

Ans: C Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 65. Adding stock options and bonuses for performance to the compensation of a manager is intended to closer align the interest of the manager with A) stockholders.

B) lenders.

C) employees.

D) none of the above.

Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 66. Option payoffs: What is the payoff for a call option with a strike price of $45 if the underlying stock price at expiration is $75?

A) $30 $45 $75 B) None of the C) above D) Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 67. Option payoffs: What is the payoff for a call option with a strike price of $30 if the underlying stock price at expiration is $25?

A) $5 $25 $30 None B) of the above C) D) Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 68. Option payoffs: What is the payoff for a put option with a strike price of $65 if the underlying stock price at expiration is $33?

A) $0 B) $33 C) $32 D) $65 Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 69. Option payoffs: You own a put option on ABC. Co. stock with a strike price of $40.

The current stock price is $40. You will benefit if A) the stock price goes up.

B) the stock price goes down.

C) the stock price stays the same.

D) It doesn't matter; you are indifferent to changes in the stock price.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium 70. Option payoffs: You have sold a call option on ABC Co. stock with a strike price of $40. You do not intend to make any other transactions before the options expiration date. The current stock price is $20. Which of the following statements best describes your hopes for the stock?

A) You want the stock price to fall.

B) You want the stock price to rise.

C) You are indifferent, as long as the stock price stays under $40.

D) It doesn't matter; you are indifferent to changes in the stock price.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: hard 71. Option payoffs: What is the payoff for a put option with a strike price of $20 if the price of the underlying stock at expiration is $18?

A) $0 B) $2 C) $18 D) $20 Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 72. Option valuation: Consider a call option with a strike price of $20, which expires in one year. The risk-free rate of interest is 5 percent. The underlying stock price is $30.

Without arbitrage, which of the following is a possible price for the call option?

A) $0 $8 $15 None B) of the above C) D) Ans: C Feedback: Without arbitrage, the value of the option must fall between $10.96 and $30. Out of the given choices, only $15 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 73. Option valuation: Consider a call option with a strike price of $10, which expires in one year. The risk-free rate of interest is 10 percent. The current underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option?

A) $0 $20.50 B) $21.00 None of C) the above D) Ans: C Feedback: Without arbitrage, the value of the option must fall between $20.91 and $30. Out of the given choices, only $21 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 74. Option valuation: Consider a put option with a strike price of $40, which expires in one year. The risk-free rate of interest is 8 percent. The current underlying stock price is $20. Without arbitrage, which of the following is a possible price for the put option?

A) $0.50 $16.50 B) $25.00 None of C) the above D) Ans: C Feedback: Without arbitrage, the value of the put option must fall between $17.04 and $37.04. Out of the given choices, only $25 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: hard 75. Option payoffs: Kelvin's Thermostats, Inc., stock is currently trading at $20 per share.

There are two types of options written on the stock. Call options with a strike price of $15, which expire next month, are currently trading at $6.00. Put options with a strike price of $15 which expire next month are currently trading at $1.00. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put options. At the end of one month, the price of Kelvin's Thermostats, Inc., is $23.

Who made the most money off of their investment?

A) Steve Carol Paul B) Steve and Carol C) Tied D) Ans: B Feedback: Steve holds ($120) / ($20) per share = 6 shares of stock. His gain is (6 shares) x ($23 per share) – $120 = $18 Carol holds ($120) / ($6 per call option) = 20 call options. The final price of the stock is above the $15 strike price, so her options are in the money. Her gain is ($23 – $15) x (20 call options) – $120 = $40 Paul holds ($120) / ($1 per put option) = 120 put options. The final price of the stock is above the $15 strike price, so his options are out of the money. He received no payoff.

His loss is –$120.

Carol made the most money.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: hard 76. Option payoffs: Haumer Hardware Co. stock is currently trading at $20. There are two types of options written on the stock. Call options with a strike price of $20, which expire next year, are currently trading at $8. Put options with a strike price of $20, which expire next year, are currently trading for $2. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put options. At the end of one year the price of Haumer Hardware Co. stock is $18. Who made the most money off of their investment?

A) Steve Carol Paul B) Steve and Carol C) tied D) Ans: C Feedback: Steve holds ($120) / ($20) per share = 6 shares of stock. The stock went down, so Steve lost money. His loss is (6 shares) × ($18 per share) – $120 = –$12.

Carol holds ($120) / ($8 per call option) = 15 call options. The final price of the stock is below the $20 strike price, so her options are out of the money. There is no payoff from her call options. Her loss is –$120.

Paul holds ($120) / ($2 per put option) = 60 put options. The final price of the stock is below the $20 strike price, so his options are in the money. His gain is ($20 – $18) × (60) – $120 = 0.

Paul broke even, the others lost money.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 77. Binomial pricing: Assume that the stock of Malcolm's Mufflers, Inc,. is currently trading for $18 and will either rise to $20 or fall to $14 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $15?

A) $4.3 B) 9 C) $3.3 D) 3 Ans: A$2.0 Feedback: The payoff from the call option is $5 if the stock price rises 4 if the stock price falls. From the binomial pricing model we can create a and $0 $0.8 portfolio with the following two equations: $5 = ($20 × x) + (1.10 × replicating y) $0 3 = ($14 × x) + (1.10 × y) x = 0.83 shares of stock y = –$10.51 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.83 × $18) + (–10.51) = $4.39

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 78. Binomial pricing: Assume that the stock of Malcolm's Mufflers, Inc., is currently trading for $43 and will either rise to $55 or fall to $17 in one year. The risk-free rate for one year is 8 percent. What is the value of a call option with a strike price of $45?

A) $4.4 B) 0 C) $5.8 D) 4 Ans: D$6.8 4 Feedback: $7.1 from the call option is $10 if the stock price rises and $0 if the stock price The payoff 7 falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $10 = ($55 × x) + (1.08 × y) $0 = ($17 × x) + (1.08 × y) x = 0.263 shares of stock y = –$4.14 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.263 × $43) + (–4.14) = $7.17

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 79. Binomial pricing: ABC, Inc., stock is currently trading for $45 and will either rise to $47 or fall to $42 in one year. The risk-free rate for one year is 5 percent. You own a call option with a strike price of $30, which expires in one year. What is the value of your call option?

A) 0 B) 2.27 C) 12.0 D) 5 16.4 Ans: D Feedback: The payoff from the call option is $17 if the stock price rises 3 and $12 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $17 = ($47 × x) + (1.05 × y) $12 = ($42 × x) + (1.05 × y) x = 1 share of stock y = –28.57 of risk free bonds The value of the option is the value of the replicating portfolio: (1 × $45) + (–28.57) = $16.43

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 80. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $17 and will either rise to $23 or fall to $12 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $25?

A) $0 $6.23 $5.72 B) None of the C) above D) Ans: A Feedback: The payoff from the call option is $0 if the stock price rises and $0 if the stock price falls. This option will never payoff, so it has a value of $0.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 81. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $22 and will either rise to $31 or fall to $18 in one year. The risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $25?

A) $0 B) $1.8 C) 5 D) $3.0 Ans: D0 Feedback: The payoff from the put option is $0 if the stock price rises $4.8 and $7 if the stock price falls. From the binomial pricing model we can create a 5 replicating portfolio with the following two equations: $0 = ($31 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = –0.54 shares of stock y = $16.69 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.54 × $22) + ($16.69) = $4.85

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 82. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $44 and will either rise to $50 or fall to $29 one year. The risk-free rate for one year is 4 percent. What is the value of a put option with a strike price of $40?

A) $0 B) $2.2 C) 0 D) $3.1 Ans: B4 $5.5 Feedback: 4 The payoff from the put option is $0 if the stock price rises and $11 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.04 × y) $11 = ($29 × x) + (1.04 × y) x = –0.52 shares of stock y = $25.08 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.52 × $44) + ($25.08) = $2.20

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 83. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $23.50 or fall to $9 in one year. The risk-free rate for one year is 3 percent. What is the value of a put option with a strike price of $18 that expires in three months?

A) $0 B) $2.7 C) 5 D) $4.2 Ans: C3 $5.7 Feedback: 3 The payoff from the put option is $0 if the stock price rises and $9 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($23.50 × x) + (1.03 × y) $9 = ($9 × x) + (1.03 × y) x = –0.62 shares of stock y = $14.16 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.62 × $16) + ($14.16) = $4.23

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 84. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $29 and will either rise to $32 or fall to $5 in one year. The risk-free rate for one year is 2 percent. What is the value of a put option with a strike price of $30?

A) $0 B) $0.4 C) 1 D) $1.7 8 Feedback: The payoff from the put option is $0 if the stock price rises Ans: D $2.0 and $25 if the stock price falls. From the binomial pricing model we can create a 8 replicating portfolio with the following two equations: $0 = ($32 × x) + (1.02 × y) $25 = ($5 × x) + (1.02 × y) x = –0.93 shares of stock y = $29.05 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.93 × $29) + ($29.05) = $2.08

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 85. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $18 and will either rise to $30 or fall to $12 in one year. The risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $15?

A) $0 B) $2 C) $5 D) $6 Ans: B Feedback: The payoff from the put option is $0 if the stock price rises and $3 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $3 = ($12 × x) + (1.00 × y) x = –0.167 shares of stock y = $5 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.167 × $18) + ($5) = $2

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 86. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $2.60 and will either rise to $10 or fall to $0 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $5?

A) $0 B) $2.3 C) 5 D) $3.6 Ans: C5 $3.7 Feedback: 0 The payoff from the put option is $0 if the stock price rises and $5 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($10 × x) + (1.01 × y) $5 = ($0 × x) + (1.01 × y) x = –0.5 shares of stock y = $4.95 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.5 × $2.6) + ($4.95) = $3.65

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 87. Binomial pricing: You own a share of common stock in ABC, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. The risk-free rate for one year is 0 percent. You also own an American put option on the stock with a strike price of $20, which expires in one year. What is the value of the put option, and what would be the net payoff from exercising the option now?

A) Option Value: $3.33 – Net Payoff B) $2 Option Value: $3.33 – Net C) Payoff $6 Option Value: $5.33 – D) Net Payoff $2 Option Value: $5.33 – Net Payoff $6 Ans: C Feedback: First, we can calculate the value of the put option with the binomial model. The payoff from the put option is $0 if the stock price rises and $8 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $8 = ($12 × x) + (1.00 × y) x = –0.44 shares of stock y = $13.33 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.44 × $18) + ($13.33) = $5.33 The payoff from exercising the put option now is the option strike price minus the current stock price: $20 – $18 = $2

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 88. Binomial pricing: You are fortunate enough to own a put option with a strike price of $50 on the stock of ABC, Inc. The current stock price is $4. When the option expires, you expect the stock price to be either $2 or $5. The risk-free rate of interest is zero.

What is the value of your option?

A) 0 B) 45 C) 46 D) 48 Ans: C Feedback: The payoff from the put option is $45 if the stock price rises and $48 if the stock price falls. When the put option pays off in either state, the value of the option is the PV of the strike price minus the current stock price. ($50 / 1.00) – $4 = $46

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 89. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $18 or fall to $12 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $10?

A) $0 B) $2.0 C) 0 D) $2.3 Ans: A3 $5.0 Feedback: 0 The payoff from the put option is $0 if the stock price rises and $0 if the stock price falls. Either way the put option has no payoff. The value of this put option is $0.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 90. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $21 and will either rise to $30 or fall to $18 in one year. The risk-free rate for one year is 0 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $25, and both expire in one year. What is the value of your portfolio?

A) $0 B) $25.0 C) 0 D) $6.00 $6.50 Ans: D Feedback: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together. The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $5 = ($30 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.417 shares of stock y = –$7.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.417 × $21) + (-7.5) = $1.25 The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = -0.583 shares of stock y = $17.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.583 × $21) + ($17.5) = $5.25 The total value of the straddle is $1.25 + $5.25 = $6.50

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 91. Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $16 and will either rise to $50 or fall to $2 in one year. The risk-free rate for one year is 8 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $15, and both expire in one year. What is the value of your portfolio?

A) $0 B) $15 C) $21.4 D) 0 Ans: D$18.5 2 Feedback: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together.

The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $35 = ($50 × x) + (1.08 × y) $0 = ($2 × x) + (1.08 × y) x = 0.729 shares of stock y = –$1.35 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.729 × $16) + (–1.35) = $10.32 The payoff from the put option is $0 if the stock price rises and $13 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.08 × y) $13 = ($2 × x) + (1.08 × y) x = –0.271 shares of stock y = $12.54 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.271 × $16) + ($12.54) = $8.20 The total value of the straddle is $10.32 + $8.20 = $18.52

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 92. Binomial pricing: Consider two call options written on different stocks. Both call options have a strike price of $15 and expire one year from today. The first option is written on LowVol Co., whose current stock price is $16. One year from now, shares of LowVol Co. will either rise to $18 or fall to $14. The second option is written on HighVol, Inc., whose current stock price is also $16. One year from now shares of HighVol Inc. will either rise to $22, or fall to $0. The risk-free interest rate is 0 percent.

Which call option is worth more?

A) The call option on LowVol is worth more.

B) The call option on HighVol is worth more.

C) They are both worth the same amount.

D) There is not enough information to make a comparison.

Ans: B Feedback: First we can price the LowVol call option. The payoff from the LowVol call option is $3 if the stock price rises and $0 if the stock price falls.

From the binomial pricing model we can create a replicating portfolio with the following two equations: $3 = ($18 × x) + (1.00 × y) $0 = ($14 × x) + (1.00 × y) x = 0.75 shares of stock y = –$10.50 of risk free bonds The value of the option is the value of the replicating portfolio: (0.75 × $16) + (10.50) = $1.50 Next we can price the HighVol call option. The payoff from the HighVol call option is $7 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $7 = ($22 × x) + (1.00 × y) $0 = ($0 × x) + (1.00 × y) x = 0.32 shares of stock y = $0 of riskfree bonds The value of the option is the value of the replicating portfolio: (0.32 × $16) + ($0) = $5.09 The HighVol call option is worth more.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 93. Binomial pricing: Consider a call option and a put option both written on ABC, Inc. stock. Both options have a strike price of $20 and expire in one year. The stock of ABC, Inc., is currently selling for $20. In one month the stock will be at either $24 or $18. The risk-free rate is 0 percent. Which is worth more, the put option or the call option?

A) The put option is worth more.

B) The call option is worth more.

C) They are worth the same.

D) There is not enough information.

Ans: C Feedback: The payoff from the call option is $4 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $4 = ($24 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.67 shares of stock y = –$12 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.67 × $20) + (– 12) = $1.33 The payoff from the put option is $0 if the stock price rises and $2 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($24 × x) + (1.00 × y) $2 = ($18 × x) + (1.00 × y) x = -0.333 shares of stock y = $8 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.333 x $20) + ($8) = $1.33 The call and the put options are worth the same. Note that this is a special case where interest rates are zero. With a positive interest rate, the call will be worth more than the put.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 94. Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

A) B) C) D)

Buy one call option and one put option on the stock with a strike price of $60.

Buy one call option with a strike price of $60 and sell short one call option with a strike price of $80. Buy one put option at a strike price at $60 and sell short one put option with a strike price of $40.

Buy one share of the underlying stock. In addition, buy two call options, one with a $40 strike price, and one with a $80 strike price.

Buy one share of the underlying stock, and a put option with a strike price of $60.

Sell short call two call options—one with a strike price of $40 and one with a strike price of $80.

Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 95. Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

A) B) C) D)

Buy $20 in risk-free bonds, and sell short one call option with a strike price of $60.

Buy $20 in risk-free bonds, and buy one put option with a strike price of $60.

Buy one share of stock, and buy one call option with a strike price of $60.

Buy one share of stock, and sell one put option with a strike price of $60.

Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 96. Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

A) B) C) D)

Buy one put option of the stock with a strike price of $60. Sell short a call option with a strike price of $120.

Buy $60 in zero-interest bonds. Sell short one call option with a strike price of $60. Sell short one put option with a strike price of $60.

Buy one share of stock. Sell one call option with a strike price of $120.

Buy one share of the stock. Sell short two call options with a strike price of $60.

Buy one call option with a strike price of $120.

Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 97. Combining options: Suppose you are creating a portfolio that consists of zero-interest bonds, stock from a single company, and call and put options on the stock. Holding which of the following combination of securities will give the payoff shown in the following diagram?

A) B) C) D)

Buy one call option with a strike price of $40 and one put option with a strike price of $80.

Buy one call option with a strike price of $80 and one put option with a strike price of $40.

Sell one call option with a strike price of $40 and one put option with a strike price of $80.

Sell one call option with a strike price of $80 and one put option with a strike price of $40.

Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 98. Risk management: OilDog Co. is a privately owned oil drilling and hot dog producing company with a significant amount of debt. Most of the company's cash flows come from the very safe hot dog unit of the business. With only the assets in place, the company is very likely to avoid financial distress for the foreseeable future. Avoiding financial distress is very important to the owners, who founded the company. The company is considering a new oil field project, determined to have a positive NPV. Because of the nature of oil prices, the project is very risky. At any oil price above $110 the project would add value to the company. However, if oil prices were to fall below $90 the losses could push the entire business into financial distress. The risk-free interest rate is 0 percent. Which one of the following strategies would allow the firm to pursue the positive-NPV project while hedging the oil price risk?

A) The firm purchases call options with a strike price of $120 for each barrel of oil it B) expects to produce. Each call option costs $5.

C) The firm sells call options with a strike price of $120 on each barrel of oil it D) expects to produce. Each option costs $5.

The firm purchases put options with a strike price of $120 on each barrel of oil it expects to produce. Each option costs $5.

The firm sells put options with a strike price of $120 on each barrel of oil it expects to produce. Each option costs $5.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 99. Risk management: Consider a wheat farmer who expects to produce 50,000 bushels of wheat at the end of this season. To hedge the risk associated with wheat prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $7.50 per and a premium of $0.30 per bushel. He also sells an equal amount of call options with a strike price of $7.50 per bushel and a premium of $0.43 a bushel. Which of the following statements is NOT correct?

A) From this transaction the farmer can pocket $6,500 immediately.

B) If wheat prices go up substantially, the farmer will earn more money.

C) The put options guarantee that the farmer will receive at least $7.50 per bushel at D) the end of the season.

The farmer has guaranteed that he will sell his wheat for $7.50 a bushel.

Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 100. Real options: Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for three years in exchange for payments of $550 per month. At the end of the lease, the customer can choose to purchase the SUV for $15,000. What sort or option does this resemble?

A) A put option on the SUV with a strike price of $15,000 B) A call option on the SUV with a strike price of $15,000 C) A put option on the SUV with a strike price of $19,800 D) A call option on the SUV with a strike price of $19,800 Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: hard 101. Risk management: CoolHaus, Inc., is a manufacturer of residential air conditioning equipment. Air conditioning equipment requires a lot of copper. In six months the company will purchase its copper supply for the next two years. Management is very concerned about the volatility of copper prices. Assume the risk-free rate of interest is 0 percent. Which of the following transactions will ensure the company does not have to pay more then $8,100 per ton of copper six months from now?

A) The company purchases a put option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

B) The company purchases a call option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

C) The company sells a put option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton and an expiration date six months from now.

D) The company sells a call option for the necessary amount of copper with a strike price of $8,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 102. When a company issues convertible bonds with a $1,000 par value that can be converted to 10 shares of common stock, each bond includes A) A put with an exercise price of $100 per share B) A call with an exercise price of $100 per share C) A put with an exercise price of $10 per share D) A call with an exercise price of $10 per share Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium 103. What are the options to purchase common stock that are bundled with the common shares that are being sold in an IPO are called?

A) puts B) convertibles C) warrants D) preferred stock Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 104. What is the value of the conversion feature if the company can issue either for a par value of $1000: 20 year, semiannual plain vanilla bonds at 6.5% or 20 year, semiannual 4.8% convertible bonds (convertible to 15 shares of common stock) a. $811.23 b. $540.82 c. $217.02 d. $188.77 Ans:D Feedback: A 20 year semiannual bond paying a coupon rate of 4.8%, if the market requires a coupon rate of 6.5% is only worth $811.23, so the conversion option is worth $188.77

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Format: Essay Learning Objective: LO 1 105. Describe the difference between American call options and American put options.

Include in your answer a description of the option premium, the option strike price, the expiration date, and the payoff function.

Ans: The buyer of an American call option pays the seller a premium for the right to purchase the underlying asset at the strike price, before or on the expiration date.

Because the buyer of the option has the right, but not the obligation, to purchase the asset, he will only exercise the option if the asset is worth more than the strike price. The payoff function for a call option is zero until the value of the underlying asset reaches the strike price. If the price of the underlying asset is above the strike price, the payoff function is equal to the difference between the asset price and the strike price.

The buyer of an American put option pays the seller a premium for the right to sell the underlying asset at the strike price, before or on the expiration date.

Because the buyer of the option has the right, but not the obligation, to sell the asset, he will only exercise the option if the asset is worth less than the strike price. The payoff function for a put option is zero if the value of the underlying asset is higher than the option's strike price. If the value of the underlying asset is lower than the strike price, the payoff of the put option is equal to the difference between the strike price and the underlying asset price.

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Format: Essay Learning Objective: LO 2 106. Name the factors that affect the value of a call option and explain the direction of the effects.

Ans: Five factors affect the value of a call option.

The Strike Price of the Option—All else equal, the lower the strike price of the call option, the more valuable the option is. This is true because with a low strike price, the underlying asset price will not have to be as high for the option to be “in the money.”

The Price of the Underlying Asset—All else equal, the higher the price of the underlying asset, the more valuable a call option on the asset is. If the price of the underlying asset is higher, it is more likely to be above the strike price at the expiration date.

The Volatility of the Underlying Asset—All else equal, the higher the volatility of the price of an asset, the more a call option is worth. With higher volatility, the price of the underlying asset has a higher chance of going significantly down or up before the expiration date. Because the call option will only be exercised if the underlying asset price is above the strike price, the benefits from the upside of volatility outweigh the negatives from the downside of volatility.

Time until Expiration of the Option—All else equal, the longer until an option expires, the more it is worth. The effect of the time until expiration is similar to the effect of volatility. With more time until maturity, the price of the underlying asset is more likely to significantly increase or decrease.

The Risk-Free Interest Rate—The value of a call option increases with the risk-free interest rate. The present value of the strike price decreases with the risk-free rate. Since a call option involves paying the strike price in the future, a higher risk-free rate increases the value of the option.

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Format: Essay Learning Objective: LO 3 107. You're brought in to consult on a project for Object Steel Corp., which is considering whether or not to build a new high-tech manufacturing facility. Give four examples of real options that you would consider when evaluating the project.

Ans: Real options fall into four categories: options to defer investment, options to change operations, options to abandon projects, and to make follow-on investments. Many examples of real options might be included in this steel project. The following list gives one example from each category of real option.

The option to defer investment. The firm may consider postponing the project until it has more information about the costs and benefits of the project. For example, the company may learn that the plant will be less profitable then expected. Suppose that during the next year costly environmental regulations are enacted, or the price of steel goes down. The company should take these considerations into account when deciding if now is the best time to build the plant.

The option to change operations. The company must consider whether it will have the flexibility to change the way the plant is operated. For example, if the demand for steel falls, it might be able shut down the plant temporarily and reduce costs. Alternatively, it might be able to produce other metals, such as bronze or brass, if it becomes more profitable to do so.

The option to abandon the project. The company should consider what it might be able to do with the project if it fails or it becomes unprofitable to continue. It might decide to construct the facility in such a way that it can accommodate other manufactures in the event it has to liquidate the plant.

The option to make follow-on investments. The firm should consider whether any follow-on investments may spring from this project. For example, it might consider whether it can expand the plant to increase production if demand for steel is high. It might also consider whether the new production process might be retrofitted to its existing plants, if the project is successful.

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Format: Essay Learning Objective: LO 4 108. What are agency costs in corporate finance, and how do they relate to options?

Ans: Agency costs arise when the interests of stockholders, lenders, and managers are not perfectly aligned. These costs often arise because the payoff functions for these different claimholders look like different types of options.

One broad category is the agency costs of debt. When the firm has debt, the payoff function of stockholders looks similar to a call option on the firm's assets.

The face value of debt is similar to the strike price on a call option. Because of this option-like payoff function, the stockholders have an incentive to take actions that increase the value of the stockholder's claim, but may reduce the total value of the firm. Examples of agency problems from debt include the dividend payout problem, the asset substitution problem, and the underinvestment problem.

Another broad category of agency costs is the agency costs of equity. This describes the difference between the interests of stockholders and managers. The payoff function for a salary-only manager is similar to a portfolio consisting of a risk-free bond and a put option. If the company performs well, the manager is not likely to see much additional benefit. However, if the company enters financial distress, the manager is likely to be fired and lose much of his or her future wealth. This option-like payoff gives the managers an incentive to avoid risky projects that might increase the probability of financial distress, even if the project has a positive NPV. Turning down positive-NPV projects reduces the total value of the firm. Often the compensation for senior managers contains additional payoffs for good performance to more closely align their incentives with those of shareholders.

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 1. Globalization refers to the removal of barriers to free trade and the closer integration of national economies.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 2. While production of goods has been moved overseas, American consumers only purchase domestic goods.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 3. The production of goods and services has also become highly globalized.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 4. Integration of the financial system globally is a result of deregulation of foreign exchange markets, money and capital markets, and banking systems.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 5. A transnational corporation is a business firm that operates in more than one country but is headquartered or based in its home country.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 6. Wal-Mart is a transnational corporation.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 7. Differences in legal systems and tax codes have no impact on the way firms operate in foreign countries.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 8. Legal systems can vary on simple matters, such as opening a business, selecting a site location, and hiring employees.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 9. English is the world's social language.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 10. English is the official business language, but not the world's social language.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 11. Cultural views shape business practices and people's attitudes toward business.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy 12. Both China and the nations that formerly made up the Soviet Union are currently moving toward centrally planned economies.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 13. Country risk has no effect on a firm's cash flows.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 14. Stockholder wealth maximization is the accepted goal for firms in all countries around the world.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 15. The European manager's goal is to earn as much wealth as possible for the firm while considering the overall welfare of all stakeholders.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 16. European firms focus on maximizing market share rather than stockholder wealth.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy 17. Japanese managers focus on maximizing market share rather than stockholder wealth.

A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 18. The foreign exchange market is a group of international markets connected electronically where currencies are bought and sold in wholesale amounts.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 19. Tokyo is the largest foreign exchange trading center.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 20. When a U.S. bank in Chicago gives a quote of £0.5089/$, it is a direct quote.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 21. If the exchange rate is the price in foreign currency for a dollar, the quote is called direct quote.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: medium 22. The bid quote is the rate at which the dealer will sell foreign currency.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 23. The decision to accept international projects with a positive NPV increases the value of the firm and is consistent with maximizing stockholder wealth.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 24. Most companies find it easier to estimate the incremental cash flows for foreign projects than for domestic projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 25. To convert the project's future cash flows into another currency, we need to come up with projected or forecast exchange rates.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 26. To convert the project's future cash flows into another currency, we need to use today's spot exchange rates.

A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium 27. If a firm is located in a country with a relatively unstable political environment, management will require a lower rate of return on capital projects.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 28. A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United States.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: medium 29. Long-term loans of a Eurocurrency made to multinational corporations and governments of poor credit quality are called Eurocredits.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: medium 30. Eurodollar and other Eurocurrency bonds have all characteristics identical to similar U.S corporate bonds.

A) True B) False Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 31. Evidence of globalization include A) Consumers in many countries buy goods that are purchased from a number of B) countries, other than just their own.

C) Goods and services are produced around the world.

D) The financial system has also become highly integrated.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 32. Which one of the following statements about multinational firms is NOT true?

A) A multinational corporation is a business firm that operates in more than one B) country but is headquartered or based in its home country.

C) Multinational corporations are owned by domestic stockholders only.

Multinational corporations may purchase raw materials from one country, obtain financing from a capital market in another country, and produce finished goods with labor and capital equipment from a third country.

D) All of the above Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 33. Factors that can cause international business transactions to differ from domestic deals include all EXCEPT: A) Exchange rate risk, legal systems, and country risk.

B) Legal systems, cultural factors, and economic systems.

C) Exchange rate risk, country risk, and size of market.

D) Economic systems, cultural factors, and country risk Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 34. Which ONE of the following statements about the goal of the firm is true?

A) Stockholder value maximization is the accepted goal for firms in India.

B) Firms in Germany focus on maximizing corporate wealth.

C) The goal of the Japanese business manager is to increase the wealth and growth D) of the keiretsu.

All of the above Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy 35. Which ONE of the following statements about the goal of the firm is true?

A) Corporate wealth maximization is the accepted goal for firms in India.

B) Firms in Australia focus on maximizing corporate wealth.

C) The goal of the Japanese business manager is to increase the wealth and growth D) of the keiretsu.

Private-sector firms in China focus on providing full employment in the economy.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 36. Economic benefits provided by the foreign exchange markets include: A) A mechanism to transfer purchasing power from individuals who deal in one B) currency to people who deal in a different currency.

C) A way for corporations to pass the risk associated with foreign exchange price D) fluctuations to professional risk-takers.

A channel for importers and exporters to acquire credit for international business transactions.

All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 37. The three largest foreign exchange markets based on daily volume are A) London, New York, and Tokyo.

B) New York, Tokyo, and Zurich.

C) London, Tokyo, and Zurich.

D) London, New York, and Singapore.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 38. The major participants in the foreign exchange markets are A) multinational commercial banks, large investment banking firms, and domestic B) C) D)

firms.

multinational commercial banks, local banks and domestic firms. multinational commercial banks, large investment banking firms, and small currency boutiques that specialize in foreign exchange transactions.

None of the above Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 39. Which ONE of the following statements is true?

A) Equilibrium occurs at the price at which the quantity of the currency demanded B) exactly equals the quantity supplied.

C) Whatever causes U.S. residents to buy more or fewer foreign goods shifts the D) demand curve for the foreign currency.

Whatever causes foreigners to buy more or fewer U.S. goods shifts the supply curve for the foreign currency.

All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 40. If the foreign exchange rate is the price in foreign currency for a dollar, then the exchange rate quote is called A) an American quote.

B) an indirect quote.

C) a direct quote.

D) a cross quote.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 41. A European quote is the same as A) an American quote.

B) an indirect quote.

C) a direct quote.

D) a cross quote.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 42. Which ONE of the following is an indirect quote from an American perspective?

A) £0.5125/$ B) $0.006900/ C) ¥ D) $1.5637/€ Ans: A¥115.23/€ Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 43. The bid quote represents the rate at which A) the dealer will buy foreign currency from you.

B) the dealer will sell foreign currency to you.

C) you can buy the foreign currency from the dealer.

D) None of the above.

Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 44. The ask quote represents the rate at which A) the dealer will buy foreign currency from you.

B) the dealer will sell foreign currency to you.

C) you can sell the foreign currency to the dealer.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy 45. The difference between the forward rate and the spot rate is called the A) cross exchange rate.

B) forward premium or forward discount.

C) indirect quote.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 46. When performing capital budgeting analysis on international projects, managers A) find it more difficult to estimate the incremental cash flows for foreign projects B) have to deal with foreign exchange rate risk on international capital investments.

C) must incorporate a country risk premium when evaluating foreign business D) activities.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 47. The ways that a foreign government can affect the risk of a foreign project include: A) Change tax laws in a way that adversely impacts the firm.

B) Impose laws related to labor, wages, and prices that are more restrictive than C) those applicable for domestic firms.

D) Disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project.

All of the above.

Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy 48. The ways that a foreign government can adversely affect the risk of a foreign project include all EXCEPT: A) Change tax laws in a way that adversely impacts the firm.

B) Impose laws related to labor, wages, and prices that are more restrictive than C) those applicable for domestic firms.

D) Remove tariffs and quotas on any imports.

Disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy 49. Country risk should be incorporated into the international capital budgeting analysis by A) adjusting the firm's discount rate for the additional risk.

B) increasing cash flow estimates from the project.

C) doing nothing.

D) None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 50. The Euromarkets are A) vast, largely unregulated money and capital markets existing in Tokyo, Hong B) Kong, and Singapore.

C) vast, regulated money and capital markets with major financial centers in the D) United Kingdom. vast, regulated money and capital markets with major financial centers in the euro zone.

None of the above.

Ans: A

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 51. The Eurocurrency market is the A) medium-term portion of the Euromarket.

B) short-term portion of the Euromarket.

C) long-term portion of the Euromarket.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy 52. Which ONE of the following statements about Eurocredits is true?

A) The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities.

B) Eurocredits are denominated in all major Eurocurrencies, although the dollar is C) the overwhelming favorite.

D) Eurocredits are short- to medium-term loans made to multinational corporations and governments of medium to high credit quality.

All of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 53. Long-term debt sold by a foreign firm to investors in a foreign country and denominated in that country's currency is called a A) Eurobond.

B) municipal bond.

C) foreign bond.

D) currency bond.

Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 54. Long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated A) Samurai bonds.

B) Eurobonds.

C) foreign bonds.

D) currency bonds.

Ans: B Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: medium 55. Which one of the following statements about Eurobonds is NOT true?

A) Multinational firms can use Eurobonds to finance international or domestic B) projects.

C) Eurobonds are bearer bonds and do not have to be registered.

D) Eurobonds are bonds that have to be registered.

Eurobonds also pay interest annually.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 56. Spot rate: Venkat Ram purchased a pair of dress shoes in Italy for €131.25. If the spot exchange rate is $1.5621/€, what is the dollar cost of the shoes?

A) $205.03 B) $84.02 C) €131.25 D) €84.02 Ans: A Feedback: Cost of shoes in Italy = €131.25 Spot rate = $1.5621/€ Dollar cost of shoes = €131.25 × $1.5621/€= $205.03

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 57. Spot rate: Starling Corporation purchased some components from a Mexican manufacturer. They have to pay 110 million Mexican pesos for the goods today. The spot rate today is MP10.3540/$. What is the dollar cost of this payable? Round to the nearest dollar.

A) $110,000,000 B) $10,623,913 C) $11,110,235 D) $1,138,940,0 Ans: B00 Feedback: Cost of payables = MP 110,000,000 Spot rate = MP 10.3540/$ Dollar cost of payables = MP 110,000,000 / MP 10.3540/$= $10,623,913.46 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 58. Spot rate: Tantrix, Inc., purchased its inventory from an Indian manufacturer at a cost of Rs.5,325,000. The dollar cost of this payable is $125,634.07 at today's spot rate.

What is the spot rate today?

A) $4.2385/Rs. B) $42.3850/R C) s.

D) Rs.42.3850/ $ Feedback: Rs. Inventory cost to firm = Rs. 5,325,000 Ans: C Dollar4.2385/$ cost of purchase = $125,634.07 Spot rate at which the foreign currency revenue was converted: Rs.5,325,000 $125,634.07=Rs.42.3850 This is the same as $0.0236/Rs.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 59. Spot rate: Suppose a Tata Nano car is priced at Rs. 100,000 in New Delhi and $3,129 in New York. In which place is the car more expensive if the spot rate is $0.0242/Rs.?

A) In New Delhi B) In New York C) It is same in both places.

D) It cannot be determined.

Ans: B Feedback: Cost of car in New York = $3,129 Cost of car in New Delhi = Rs. 100,000 Spot rate = $0.0242/Rs. Dollar cost in New Delhi = Rs. 100,000 × $0.0242/Rs.? = $2,420 The cost of the car is the higher in New York based on the spot rate!

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 60. Spot rate: If the spot rate is quoted as $0.009369/¥, what is the exchange rate in terms of yen per dollar?

A) ¥0.009369/ B) $ C) ¥0.936900/ D) $ Ans: C¥106.7350/ $ Feedback: ¥16.7350/$ Spot rate = ¥0.009369/$ Direct quote = 1/ $0.009369/¥ = ¥106.7350/$

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 61. Spot rate: Given that the spot rate is $1.5136/€ and the 90-day forward quote is $1.4974/€, we can say that A) the U.S. dollar is at a forward premium against the euro.

B) the U.S. dollar is at a forward discount against the euro.

C) the euro is at a forward premium against the U.S. dollar.

D) the dollar is at neither a premium nor a discount against the euro.

Ans: A Feedback: Since the forward quote of $1.4974/€ implies that fewer dollars will be needed to purchase the euro compared to the spot rate of $1.5136/€, we can say that the U.S. dollar is at a forward premium against the euro.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 62. Spot rate: Given that the spot rate is ¥106.74/$ and the 180-day forward quote is ¥100.37/$, we can say that A) the U.S. dollar is at a forward premium against the yen. the B) yen is at a forward premium against the U.S. dollar. the yen C) is at a forward discount against the U.S. dollar. the dollar is D) at neither a premium nor a discount against the yen.

Ans: B Feedback: Since the forward quote of ¥100.37/$ implies that fewer yen will be needed to purchase a dollar compared to the spot rate of ¥106.74/$, we can say that the U.S. dollar is at a forward discount against the yen, or that the yen is at a forward premium against the U.S. dollar.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 63. Forward rate: Celio, Inc., sold equipment to an French firm and will receive €1,249,425 in 30 days. If the company entered a forward contract to sell the euros at the 30-day forward rate of $1.5512/€, what is the dollar revenue received?

A) $1,249,42 B) 5 C) $805,457 D) $1,938,10 Ans: C8 $1,312,22 Feedback: 4 euro revenue = €1,249,425 Expected 30-day forward rate = $1.5512/€ Dollar revenue received = €1,249,425 × $1.5512/€= $1,938,108 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 64. Forward rate: Baljit, Inc., purchased machinery from a Japanese firm and will have to pay ¥278.45 million in 90 days. The bank quotes a forward rate of ¥105.46/$ to buy the required yen. What is the cost to Baljit in U.S. dollars?

A) $2,640,33 B) 8 C) $2,784,50 D) 0 Ans: A$2,936,53 4 Feedback: $2,714,30 Cost of machinery = ¥278.45 million 0 rate = ¥105.46/$ Forward Cost of equipment in dollars = ¥278,450,000 / ¥105.46/$ = $2,640,337.57

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 65. Forward rate: John Travers is planning a holiday to Thailand but is concerned that the U.S. dollar will decline in value before he makes his trip. His travel agent has planned a trip for him for a total cost of 41,250 Thai baht. John plans to purchase the bahts forward and is given a dollar estimate of $1,247.17 based on the 30-day forward quote.

What is the forward rate?

A) THB41.2500/ B) $ C) THB33.0785/ D) $ Ans: B$0.0242/THB $1.2471/THB Feedback: Cost of trip = THB 41,250 Cost of trip based on forward rate = $1,247.17 30-day forward quote = THB 41,250 / $1,247.17 = THB 33.0745/$ Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 66. Bid-ask spread: A local bank has requested foreign exchange quotes for the Swedish krona from Citibank. Citibank quotes a bid rate of $0.1652/SK and an ask rate of $0.1667/SK. What is the bid-ask spread?

A) 1.2% B) 2.1% C) 0.9% D) 0.65 Ans: C% Feedback:

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 67. Bid-ask spread: A foreign exchange dealer is willing to buy the New Zealand dollar (NZ$) at $0.7621/NZ$ and will sell it at a rate of $0.7714/NZ$. What is the bid-ask spread on the Danish krone?

A) 0.2% B) 2.1% C) 0.9% D) 1.2% Ans: D Feedback:

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: medium 68. Bid-ask spread: Banco Herrero wants to make a bid-ask spread of 0.55 percent on its foreign exchange transactions. If the ask rate on the Mexican peso (MP) is MP10.4192/$, what does the bid rate have to be?

A) MP10.3619/ B) $ C) MP10.4192/ D) $ Ans: AMP10.4249/ $ Feedback: MP10.2165/ $

The ask rate will have to be MP10.3619/$ to provide a 0.55 percent bid-ask spread.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 69. Cross rate: Bartman Corporation observes that the Swiss franc (SF) is being quoted at $0.6164/SF, while the Swedish krona (SK) is quoted at $0.1981/SK. What is the SK/SF cross rate?

A) SK0.3214/S B) F C) SK3.1116/S D) F Ans: BSK0.4183/S F Feedback: SK2.1467/S To find the SK/SF cross rate, divide the Swiss franc quote by the Swedish krona quote.

CrossFrate = $0.6164/SF / $0.1981/SK = SK3.1116/SF Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 70. Cross rate: Xecor Pharma just received revenues of $2,372,300 in Australian dollars (A$). The only quotes management received are A$2.0651/£ and $1.8538/£. What is the U.S. dollar value of the company's revenues? Round to the nearest dollar.

A) $4,397,77 B) 0 C) $4,899,03 D) 7 Ans: C$2,129,53 3 Feedback: $9,081,83 Revenues received by Xecor Pharma = $2,372,300 4 To determine the A$ /$ cross rate, you divide the A$ to £ quote by the $/£ quote.

Cross rate = A$2.0651/£ / $1.8538/£ = A$1/1.140/$ U.S. dollar value of their revenue = $2,372,300 / A$1.1140/$ = $2,129,533

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 71. Cross rate: Trident Corp. recently purchased machinery parts worth 23.5 million Mexican pesos (MP). Management needs to find out the U.S. dollar cost of the payables. It has access to two quotes for Canadian dollars (C$): C$1.0774/$ and C$0.0981/MP. What will it cost Trident to purchase 23.5 million Mexican pesos?

Round to the nearest dollar.

A) $2,531,89 B) 0 C) $2,305,35 D) 0 Ans: C$2,139,73 5 Feedback: $1,987,32 Foreign currency payables = MP 23.5 million 5 To find the MP/$ quote, divide the C$/MP quote by the C$/$ quote.

Cross rate = C$0.0981/MP / C$1.0774/$ = $0.0910525/MP Dollar cost of payables = MP23,500,000 × $0.0910525/MP = $2,139,735 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 72. Cross rate: Dresdner Bank has offered the following exchange rate quotes on Indian rupees (Rs): Rs.83.7612/£ and $1.8654/£. What is the cross rate between the Indian rupees and the U.S. dollar?

A) Rs. B) 44.9025/$ C) Rs. D) 49.9375/$ Ans: ARs. 51.2134/$ Feedback: Rs. To find the Rs./$ cross rate, divide the Rs/£ quote by the $/£ quote.

Cross36,7122/$ rate = Rs.83.7612/£/ $1.8654/£= Rs.44.9025/$

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 73. Forward premium: The spot rate on the London market was £0.5434/$, while the 90-day forward rate was £0.5519/$. What is the annualized forward premium or discount on the U.S. dollar for the period? Round to one decimal place.

A) 1.6% B) premium C) 6.2% D) premium Ans: B6.3% discount Feedback: 1.6% discount

The British pound is at a forward discount of 1.6 percent against the U.S. dollar as it takes more pounds to buy a dollar at the forward rate. Or the U.S dollar is at a 90-day forward premium of 1.56 percent against the British pound.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 74. Forward premium: Bank of America quoted the 180-day forward rate on the Japanese yen at $0.009702/¥. The spot rate was quoted at $0.009466/¥. What is the forward premium or discount on the Japanese yen? Round off to the nearest percent.

A) 7% premium B) 7% discount C) 5% premium D) 5% discount Ans: C Feedback:

The Japanese yen is at a 5 percent forward premium against the dollar.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 75. Forward premium: State Bank of India has offered a spot rate quote on Indian rupees (Rs) of Rs. 42.47/$. The Indian rupee is quoted at a 30-day forward premium of 7.65 percent against the dollar. What is the 30-day forward quote?

A) Rs B) 43.5622/$ C) Rs D) 41.5687/$ Ans: DRs 45.1226/$ Feedback: Rs = Rs. 42.47/$ Spot rate 42.7404/$ 30-day forward premium on the dollar = 7.65%

The 30-day forward rate is Rs. 42.7404/$.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 76. Hedging: Tamcon Industries has purchased equipment from a Brazilian firm for a total cost of 1,272,500 Brazilian reals (BR). The firm has to pay in 30 days. Citicorp has given the firm a 30-day forward quote of $0.6123/real. Assume that on the day the payment is due, the spot rate is at $0.6317/BR. How much would Tamcon save by hedging with a forward contract? Round to the nearest dollar.

A) $24,687 B) $803,83 C) 8 D) $779,15 Ans: A2 $31,278 Feedback: Foreign currency payables = BR 1,272,500 Spot rate on payment date = $0.6317/BR Dollar cost of payables = BR 1,272,500 × $0.6317/BR = $803,838.25 30-day forward rate = $0.6123/BR Cost if hedged at forward rate = BR 1,272,500 × $0.6123/BR = $779,151.75 Cost savings = $803,838.25 – $779,151.75 = $24,686.50 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 77. Hedging: Kapona Industries has purchased equipment from a Korean firm for a total cost of 11,500,000 Korean won. The firm has to pay in 90 days. J. P. Morgan has given the firm a 90-day forward quote of $0.0009791/won. Assume that on the day the payment is due, the spot rate is at $0.001004/ won. How much would Kapona save by hedging with a forward contract? Round to the nearest dollar.

A) $68 B) 7 C) $33 D) 8 Ans: D$15 2 Feedback: $28 Foreign currency payables = 11,500,000 Korean won 6 Spot rate on payment date = $0.001004/ won Dollar cost of payables = 11,500,000 won × $0.001004/ won= $11,546 30-day forward rate = $0.0009791/won Cost if hedged at forward rate = 11,500,000 won × $0.0009791/won= $11,259.65 Cost savings = $11,546.00 – $11,259.65 = $286.35

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 78. Hedging: Carrington Industries sold equipment to a Mexican firm. Payment of 41,275,000 pesos will be due in 30 days. Carrington has the option of selling the pesos at a 30-day forward rate of $0.09739/peso. If it waits 30 days to sell the pesos, the expected spot rate is $0.09596/peso. How much additional dollar revenue will Carrington get by selling forward the pesos? Round to the nearest dollar.

A) $24,68 B) 7 C) $83,83 D) 8 Ans: C$59,02 3 Feedback: $31,27 Foreign currency receivables = MP 41,275,000 8 Spot rate on payment date = $0.09596/peso Dollar revenues from receivables = MP 41,275,000 x $0.09596/peso= $3,960,749 30-day forward rate = $0.09739/peso Revenues if hedged at forward rate = MP 41,275,000 × $0.09739/peso = $ 4,019,772.25 Additional revenues received = $4,019,772.25 – $3,960,749 = $59,023.25 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 79. Hedging: Palermo Corp. sold equipment to a French firm. Payment of €4,275,000 will be due in 90 days. Palermo has the option of selling the euros at a 90-day forward rate of $1.5922/€. If it waits 90 days to sell the euros, the expected spot rate is $1.5645/€.

How much dollar revenue will Palermo lose by not selling forward the euros? Round to the nearest dollar.

A) $124,68 B) 7 C) $118,41 D) 8 Ans: B$159,02 3 Feedback: $131,27 Foreign currency receivables = €4,275,000 8 on payment date = $1.5645/€ Spot rate Dollar revenues from receivables = €4,275,000 × $1.5645/€ = $6,688,237.50 90-day forward rate = $1.5922/€ Revenues if hedged at forward rate = €4,275,000 × $1.5922/€ = $ 6,806,655 Additional revenues lost by not hedging = $6,688,237.50 – $ 6,806,655 = $118,417.50

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard 80. Loan pricing: Zylex Corporation's German unit is looking to borrow €4.5 million from Deutsche Bank. Deutsche Bank quotes a rate of three-month LIBOR plus 0.5 percent for the 90-day loan. Currently, the three-month LIBOR is 4.175 percent. If the exchange rate on the payoff date is €0.8334/$, what is the dollar cost of the loan?

A) $63,107.45 B) $126,214.9 C) 0 D) $39,143.76 Ans: A$56,357.99 Feedback: Amount Zylex plans to borrow = €4.5 million Term of loan = 90 days Interest cost = LIBOR + 0.5% = 4.175 % + 0.5% = 4.675% Interest cost in euros = €4,500,000 × 0.04675 × (90/360) = €52,593.75 Spot rate on payoff date = €0.8334/$ Dollar interest cost = €52,593.75 / €0.8334/$ = $63,107.45 Format: Essay Learning Objective: LO 3 81. What are the six factors that can cause international business transactions to differ from domestic deals?

Ans: The six factors are foreign exchange risk, differences in legal systems and tax codes, the divergence of the language for communication purposes in business and socialization, cultural differences, differences in economic systems, and country risk. These six factors can cause international business transactions to differ from domestic deals.

The uncertainty of future exchange rate movements is called foreign exchange rate risk, or just exchange rate risk. Differences in legal systems and tax codes can also impact the way firms operate in foreign countries. There are two important levels of communication in international business deals: business communication and social communication. Although English is the official business language, it is not the world's social language.

Cultural views also shape business practices and people's attitudes toward business. An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed. Country risk refers to political uncertainty associated with a particular country and hence, its impact on a firm's cash flows.

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Format: Essay Learning Objective: LO 1 82. How does the goal of the firm vary across countries?

Ans: Stockholder wealth maximization is the accepted goal for firms in the United States, as well as in some other countries that share a similar heritage, such as the United Kingdom, Australia, India, and Canada. In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth. The European manager's goal is to earn as much wealth as possible for the firm while considering the overall welfare of all stakeholders. In Japan, companies form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of the Japanese business manager is to increase the wealth and growth of the keiretsu. As a result, they might focus on maximizing market share rather than stockholder wealth.

In China, which is making a transition from a command economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms. The large state-owned companies have an overall goal that can best be described as maintaining full employment in the economy while the new private-sector firms fully embrace the Western standard of stockholder wealth maximization.

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Format: Essay Learning Objective: LO 5 83. Describe the global debt markets.

Ans: The international debt markets can be classified into the Eurocurrency market, the Eurocredit market, and the long-term bond market. The Eurocurrency market is the short-term portion of the Euromarket. The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate, or LIBOR, which is the short-term interest rate that major banks in London charge one another. The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities. These loans, which are short- to medium-term loans of a Eurocurrency to multinational corporations and governments of medium to high credit quality, are called Eurocredits.

Eurocredits are denominated in all major Eurocurrencies, although the dollar is the overwhelming favorite.

International bonds fall into two generic categories: foreign bonds and Eurobonds. Foreign bonds are long-term debt sold by a foreign firm to investors in another country and denominated in that country's currency. Foreign bonds may have colorful nicknames: foreign bonds sold in the United States are called Yankee bonds, and yen-denominated bonds sold in Japanese financial markets by non-Japanese firms are called Samurai bonds. Firms sell foreign bonds when they need to finance projects in a particular foreign country.

Eurobonds are long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated.

Multinational firms can use Eurobonds to finance international or domestic projects. Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from similar U.S corporate bonds. Eurobonds are bearer bonds and do not have to be registered. Eurobonds also pay interest annually.

While historically almost all Eurocurrency bonds were sold without credit ratings, today, more than half of the Eurodollar bonds sold in Europe have credit ratings.

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