Fundamentals of Corporate Finance, 3rd Edition Test Bank.pdf (22)

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 10. Accounting earnings are a reliable measure of the costs and benefits of a project.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 11. If taken without accompanying changes in cash flow, changes in a company's accounting earnings do not impact the overall value of the firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 12. Allocated costs such as corporate overhead should be included in cash flow calculations.

A) True B) False Ans: B

For exam and test prep, contact excellentessaywriters@gmail.com .

11-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 13. The impact of a project on another project's cash flows should be ignored.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 14. Opportunity costs should always be included in the cash flow calculations of a project.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 15. The research and development costs to date of a project should be considered when analyzing the cash flows of a prospective project.

A) True B) False Ans: B

.

11-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 16. Since our perspective when evaluating a project is that of all of the investors in the firm, creditors as well as stockholders, then we should evaluate the pretax cash flows produced by a project.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 17. Since our perspective when evaluating a project is that of all the shareholders only, then we should evaluate the after-tax cash flows produced by a project.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 18. BioGeological Pharmaceuticals invested $100 million on a heart drug that does not prevent heart disease. BioGeological has since found that the drug does prevent diabetes. When considering whether to market the drug as a diabetic panacea, the firm should consider the $100 million spent while investigating the heart-related effects.

A) True B) False Ans: B

.

11-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 19. When analyzing a project, if the expected future cash flows are denominated in nominal dollars, then the discount rate should represent a nominal rate as well.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 20. Nominal interest rates incorporate the expected rate of inflation.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 21. If the current market price of corn is $100 per bushel and the nominal rate of interest is 10 percent, then the real price of corn next period should also be $100.

A) True B) False Ans: A

.

11-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 22. A progressive tax system means that a taxpayer will pay a higher tax rate for a given dollar of earnings for every successive year.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 23. It is possible for a firm to have one depreciation schedule for tax purposes and another for financial reporting purposes.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 24. The MACRS depreciation tax schedule for three-year equipment provides a depreciation rate for a total of four years.

A) True B) False Ans: A

.

11-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 25. Terminal-year free cash flows may differ from the cash flows provided in the typical year of a project for reasons such as the return/repayment of increases/reductions in additional working capital in the prior years.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 26. If the salvage value, at the time of an asset disposition, is less than the book value of the asset, then the firm will effectively receive a positive cash flow from taxes on the sale.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 27. The expected cash flows for a project are fixed amounts that have zero variability in the projected values.

A) True B) False Ans: B

.

11-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 28. The unadjusted NPV of two projects with different useful lives can be compared to evaluate which project is the better of the two.

A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 29. You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately if the current NPV of the project is positive.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 30. You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately under all circumstances.

A) True B) False Ans: B

.

11-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 31. The cash flows used in capital budgeting calculations are based on: A) historical estimates.

B) forecasts of future cash revenues, expenses, and investment outlays.

C) forecasts of net income.

D) forecasts of retained earnings available for financing projects.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 32. The NPV of a project is estimated by: A) discounting the expected cash flows of a project in the future.

B) discounting only the certain cash flows of a project in the future.

C) discounting the variance of the expected cash flows of a project in the future.

D) None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 33. The ___________ is intended to reconcile changes in the balance sheet cash accounts.

A) capital budgeting cash flow calculation B) accounting statement of cash flows C) accounting statement of income D) None of the above.

Ans: B

.

11-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 34. The term ___________ refers to the fact that these cash flows reflect the amount by which the firm's total after-tax free cash flows will change if the project is adopted.

A) Periodic B) ending cash flows C) Incremental D) None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 35. _________ refers to the cash flow that a project is expected to generate after all operating expenses and taxes have been paid.

A) Incremental cash flow from operations B) Operating income C) EBITDA D) None of the above.

Ans: A

.

11-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 36. In order to calculate free cash flow by starting with incremental cash flow from operations, we should A) subtract the incremental capital expenditures and add the incremental additions to B) working capital.

C) add the incremental capital expenditures and the incremental additions to working D) capital. subtract the incremental capital expenditures and the incremental additions to working capital.

None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 37. The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as: A) the stand-alone principle.

B) the dependent principle.

C) the independent principle.

D) None of the above.

Ans: A

.

11-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 38. The firm's ____________ is used to calculate NOPAT because the profits from a project are assumed to be incremental to the firm.

A) average tax rate B) marginal tax rate C) lowest marginal tax rate D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 39. Additions to tangible assets, intangible assets ,and current assets can be described as: A) cash flows associated with investments.

B) operating cash flows.

C) free cash flows.

D) None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 40. The impact of a project on a firm's overall value depends on A) a firm's accounting earnings.

B) a firm's cash flow.

C) a project's cash flow.

D) None of the above.

Ans: C

.

11-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 41. Which of the following should not be included in a project's cash flow calculations?

A) cash expenses B) cash revenues C) allocated expenses D) None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 42. Corporate overhead allocations should only be taken into account on project analysis if: A) the firm is currently covering all of its overhead allocations.

B) the firm is currently unable to cover all of its overhead allocations.

C) the overhead allocations involve cash expenditures.

D) None of the above.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 43. Brown Mack, Inc., currently has two large manufacturing divisions that share a single plant.

Brown Mack owns the plant but has calculated that $6 million of overhead expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a third manufacturing division, of equal size to the other two divisions, then what overhead cost should the new division take into account on its capital budgeting cash flow analysis?

A) $0 B) $2 million C) $3 million D) $6 million Ans: A

.

11-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 44. A firm is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. If the firm takes that project, then it will reduce the cash revenues of an existing project by $2 million.

What is the free cash flow on the project, per year, if the firm is in the 40 percent marginal tax rate?

A) $2.4 million B) $3.4 million C) $4.6 million D) $5.0 million Ans: B Feedback: Revenue $12,000,000 Cash exp (5,000,000) Deprec exp (1,000,000) Lost revenue (2,000,000) Pretax income $ 4,000,000 Less taxes 1,600,000 Net income $ 2,400,000 Add Deprec 1,000,000 Free Cash Flow/yr $ 3,400,000 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 45. Whenever a project has a negative impact on an existing project's cash flows, then that effect should: A) be ignored.

B) be ignored if the project is evaluated using the correct cost of capital.

C) be included as a negative revenue amount on the new project's cash flow analysis.

D) be included if the impact is limited to noncash expenditures.

Ans: C

.

11-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 46. If a firm has the option of leasing some factory space to another firm or utilizing it for another product line, then if the firm chose the product line how should it handle the lost lease payments on the factory space?

A) Ignore it.

B) Include it as an opportunity cost.

C) Include half of it as additional revenue for the project.

D) None of the above.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 47. Which of the following is the best example of a sunk cost?

A) Future payments on a leased building.

B) Future research and development costs.

C) Historical research and development costs.

D) Historical noncash expenses.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 48. _____________ represent dollars stated in terms of constant purchasing power.

A) Nominal dollars B) Real dollars C) Inflated dollars D) None of the above Ans: B

.

11-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 49. If inflation is anticipated to be 10 percent during the next year while a nominal rate of 20 percent will be earned on U.S. Treasury bills, then what is the accurate real rate of return on these securities?(Round final percentage answer to decimal places.)

A) 20.05% B) 10.01% C) 9.09% D) None of the above.

Ans: C Feedback: 1 + k = (1 + Pe) x (1 + r) 1 + 0.2 = (1 + 0.1) x (1 + r) 1.0909 = 1 + r 0.0909 = r Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 50. If the real return on U.S. Treasury bills is 14 percent while the rate of expected inflation is anticipated to be 8 percent, then what should nominal rate of return be? (Round final percentage answer to decimal places.)

A) 14.05% B) 33.05% C) 23.12% D) None of the above.

Ans: C Feedback: 1 + k = (1 + Pe) x (1 + r) 1 + k = (1 + 0.08) x (1 + 0.14) 1 + k = 1.2312 k = 0.2312

.

11-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 51. If you are discounting a project's cash flows using the nominal cost of capital, then that means that you have taken the following into account: A) the real rate of return.

B) the expected rate of inflation.

C) Both of the above.

D) None of the above.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 52. A tax system in which taxpayers pay a progressively larger share of their income in taxes as their income rises is called: A) a flat tax system.

B) a progressive tax system.

C) a digressive tax system.

D) a political tax system.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 53. For a U.S. corporation with income above $20 million, A) the average tax rate is less than the marginal tax rate.

B) the average tax rate is equal to the marginal tax rate.

C) the average tax rate is greater than the marginal tax rate.

D) None of the above.

Ans: B

.

11-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 54. When compared to the straight-line depreciation method, MACRS has: A) a greater proportion of its depreciation early in the life of the asset.

B) a lesser proportion of its depreciation early in the life of the asset.

C) an equal proportion of its depreciation early in the life of the asset.

D) None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 55. In order for a project to generate a positive net working capital cash flow at the conclusion of a project, A) the project must have generated a cumulative negative cash flow during the life of the B) project.

C) the project must have generated a cumulative positive cash flow during the life of the D) project. the project must have generated a cumulative negative cash flow at the conclusion of the project. the project could not have generated a positive cash flow at the opening of the project.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 56. If you are deciding whether to take one project or another, where the projects have different useful lives, then you could utilize: A) a repeated investment analysis to decide which project is better for the firm.

B) an equivalent annual annuity analysis to decide which project is better for the firm.

C) Either of the above.

D) None of the above.

Ans: C

.

11-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 57. Windy Burgers is trying to determine when to harvest a herd of cows that it currently owns. If it harvests the herd in year 1, the NPV of the project would increase over an immediate harvest by 25 percent. A year 2 harvest would create an NPV increase of 15 percent over that of year 1 and year 3 would create an NPV increase of 7 percent over that of year 2. If the cost of capital is 12 percent for Windy, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.

B) Harvest in year 1.

C) Harvest in year 2.

D) Harvest in year 3.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 58. Stillwater Drinks is trying to determine when to harvest the water from the fountain of youth that it currently owns. If it harvests the water in year 1, the NPV of the project would increase over an immediate harvest by 18 percent. A year 2 harvest would create an NPV increase of 12 percent over that of year 1 and year 3 would create an NPV increase of 8 percent over that of year 2. If the cost of capital is 17 percent for Stillwater, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.

B) Harvest in year 1.

C) Harvest in year 2.

D) Harvest in year 3.

Ans: B

.

11-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 59. The proper time to harvest an asset is when: A) the percentage NPV increase of harvesting a project at a future point in time is at the last date where the increase is greater than the cost of capital.

B) the percentage NPV increase of harvesting a project at a future point in time is at the first C) date where the increase is less than the cost of capital.

D) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is greater than the cost of capital.

None of the above.

Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 60. Norman, Inc., is considering two mutually exclusive projects. Project A is a six-year project with a NPV of $3,000 and Project B is a four-year project with an NPV of $2,278. Project A has an equivalent annual cash flow of $730 and Project B has an equivalent annual cash flow of $750. Which project should the firm select?

A) Choose Project A because it has the higher NPV. B) Choose Project B because it has the lower NPV. C) Choose Project B because it has the higher equivalent annual cash flow.

D) Choose Project A because it has the lower equivalent annual cash flow.

Ans: C Use the following to answer questions 61-64: Ref 11-1 Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.

.

11-22

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 61. Free cash flow: What is Provo's cash flow from operations for 2008?

A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: C Feedback: Provo, Inc. Revenue $10,000,000 5,000,000 - Operating Ex $ 5,000,000 EBITDA 1,000,000 - D&A $ 4,000,000 EBIT 60% x (1 – t) $ 2,400,000 NOPAT 1,000,000 + D&A $ 3,400,000 CF Opns

.

11-23

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 62. Free cash flow: What is Provo's free cash flow for 2008?

A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: B Feedback: Provo, Inc. Revenue $10,000,000 5,000,000 - Operating Ex $ 5,000,000 EBITDA 1,000,000 - D&A $ 4,000,000 EBIT 60% x (1 – t) $ 2,400,000 NOPAT 1,000,000 + D&A $ 3,400,000 CF Opns - Cap Exp $500,000 - Add WC 300,000 FCF $ 2,600,000

.

11-24

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 63. Free cash flow: What is Provo's NOPAT for 2008?

A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: A Feedback: Provo, Inc. Revenue $10,000,000 5,000,000 - Operating Ex $ 5,000,000 EBITDA 1,000,000 - D&A $ 4,000,000 EBIT 60% x (1 – t) $ 2,400,000 NOPAT Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 64. Free cash flow: What is Provo's cash flows associated with investments for 2008?

A) $300,00 B) 0 C) $500,00 D) 0None of the above. $800,00 Ans: C0 Use the following to answer questions 65-68: Ref 11-2 Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.

.

11-25

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 65. Free cash flow: What is Champagne's cash flow from operations for 2008?

A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: C Feedback: Champagne, Inc. Revenue $12,000,000 8,000,000 - Operating Ex $ 4,000,000 EBITDA 1,500,000 - D&A $ 2,500,000 EBIT 70% x (1 – t) $ 1,750,000 NOPAT 1,500,000 + D&A $ 3,250,000 CF Opns

.

11-26

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 66. Free cash flow: What is Champagne's free cash flow for 2008?

A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: A Feedback: Champagne, Inc. Revenue $12,000,000 8,000,000 - Operating Ex $ 4,000,000 EBITDA 1,500,000 - D&A $ 2,500,000 EBIT 70% x (1 – t) $ 1,750,000 NOPAT 1,500,000 + D&A $ 3,250,000 CF Opns - Cap Exp $700,000 - Add WC 500,000 FCF $ 2,050,000

.

11-27

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 67. Free cash flow: What is Champagne's NOPAT for 2008?

A) $1,750,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: A Feedback: Champagne, Inc. Revenue $12,000,000 8,000,000 - Operating Ex $ 4,000,000 EBITDA 1,500,000 - D&A $ 2,500,000 EBIT 70% x (1 – t) $ 1,750,000 NOPAT Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 68. Free cash flow: What are Champagne's cash flows associated with investments for 2008?

A) $500,000 B) $700,000 C) $1,200,000 D) None of the above.

Ans: C Feedback: Cash flows associated with investments equal the purchase of tangible and intangible assets as well as increases in working capital. Therefore, the cash flows associated with investments equal $700,000 + $500,000 = $1,200,000.

.

11-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 69. Marginal and average tax rates: Use the tax rate taken from Exhibit 11.6 to calculate the total taxes paid for Lansing, Inc., this year. Lansing's pretax income was $275,000.

Exhibit 11.6 U.S. Corporate Tax Rate Schedule in 2007 Taxable Income More But Not More Tax Owed Than Than $0 $50,000 15% of amount beyond $0 $50,000 $75,000 $7,500 + 25% of amount beyond $50,000 $75,000 $100,000 $13,750 + 34% of amount beyond $75,000 $100,000 $335,000 $22,250 + 39% of amount beyond $100,000 $335,000 $10,000,000 $113,900 + 34% of amount beyond $335,000 $10,000,000 $15,000,000 $3,400,000 + 35% of amount beyond $10,000,000 $15,000,000 $18,333,333 $5,150,000 + 38% of amount beyond $15,000,000 $18,333,333 ------35% on all income

$22,500 A) B) C) $68,250 D) $90,500 Ans: $107,250 C Feedback: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 x ($275,000 - $100,000) = $22,250 + $68,250 = $90,500

.

11-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 70. Marginal and average tax rates: Use the tax rate taken from Exhibit 11.6 to calculate the average tax rate for Lansing, Inc., this year. Lansing's pretax income was $275,000.

(Round final answer to nearest whole percent.)

Exhibit 11.6 U.S. Corporate Tax Rate Schedule in 2007 Taxable Income More But Not More Than Than Tax Owed $0 $50,000 15% of amount beyond $0 $50,000 $75,000 $7,500 +25% of amount beyond $50,000 $75,000 $100,000 $13,750 +34% of amount beyond $75,000 $100,000 $335,000 $22,250 +39% of amount beyond $100,000 $335,000 $10,000,000 $113,900 +34% of amount beyond $335,000 $10,000,000 $15,000,000 $3,400,000 +35% of amount beyond $15,000,000 $18,333,333 $10,000,000 $5,150,000 +38% of amount $18,333,333 beyond $15,000,000 ------35% on all income A) 8.0% B) 25.0% C) 32.9% D) 39.0% Ans: C Feedback: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 x ($275,000 – $100,000) = $22,250 + $68,250 =$90,500. We see that the taxes due are $90,500 and with pretax income of $275,000, we then have an average tax rate of $90,500 / $275,000 = 32.90%.

.

11-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 71. Computing the terminal-year FCF: Miles Cyprus Corp. purchased a truck that currently has a book value of $1,000. If the firm sells the truck for $5,000 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 30 percent marginal tax rate?

A) $1,200 B) $3,800 C) $4,000 D) $5,000 Ans: B Feedback: The gain on the sale was $5,000 – $1,000 = $4,000 Taxes on the gain are: $4,000 x .3 = $1,200 Net cash flow from the sale is $5,000 – $1,200 = $3,800 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 72. Computing the terminal-year FCF: Babaloo Nightclubs, purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 39 percent marginal tax rate?

A) $500 B) $3,705 C) $4,205 D) $9,500 Ans: C Feedback: The loss on the sale was $10,000 – $500 = $9,500 The tax refund on the loss is: $9,500 x .39 = $3,705 Net cash flow from the sale is $500 + $3,705= $4,205

.

11-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 73. Expected cash flows: FireRock Wheel Corp is evaluating a project in which there is a 40 percent probability of revenues totaling $3 million and a 60 percent probability of revenues totaling $1 million per year. Its cash expenses will be $1.0 million while depreciation expense will be $200,000; then what is the expected free cash flow from taking the project if the marginal tax rate for the firm is 30 percent?

A) $200,000 B) $420,000 C) $600,000 D) $620,000 Ans: D Feedback: Expected revenue = 0.4(3,000,000) + 0.6(1,000,000) = $1,800,000 Expected revenue $1,800,000 1,000,000 - Cash Expenses 200,000 - Deprec Expense $ 600,000 EBIT 180,000 - Tax $ 420,000 NI 200,000 + Deprec Expense FCF $ 620,000

.

11-32

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 74. Projects with different lives: Your firm is deciding whether to purchase a durable delivery vehicle or a short-term vehicle. The durable vehicle costs $25,000 and should last five years.

The short-term vehicle costs $10,000 and should last two years. If the cost of capital for the firm is 15 percent, then what is the equivalent annual cost for the best choice for the firm?

(Round final answer to nearest whole dollar.)

A) $5,000, either vehicle B) $5,000, short-term vehicle C) $6,151, short-term vehicle D) $7,458, long-term vehicle Ans: C Feedback:

 (1+k)t  EAC =kNPV   t

(1+k)−1

, therefore the

 (1+0.15 )5   =$7,457.89  EAC durable = 0.15 ( $25,000) 5 + −1 0.15 1 )     (1+0.15 )2   =$6,151.16 EAC short−term = 0.15($10,000  () ( 2 +1 0.15 ) −1

, since we are analyzing costs, we should choose the lowest cost per year, which is the short-term vehicle.

.

11-33

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 75. Projects with different lives: Your firm is deciding whether to purchase a high-quality printer for your office or one of lesser quality. The high-quality printer costs $40,000 and should last four years. The lesser quality printer costs $30,000 and should last three years. If the cost of capital for the firm is 13 percent, then what is the equivalent annual cost for the best choice for the firm? Round to the nearest dollar.

A) $10,000, either printer B) $10,000, lesser quality printer C) $12,706, lesser quality printer D) $13,448, high-quality printer Ans: C Feedback:

 (1+k)t  EAC =kNPV   t

(1+k)−1

; therefore the

= 0.13 ($40,000)

= $13,447.77

 (1+0.13)3  = EAC short−term 0.13 ( $30,000 ) 3 = $12, 705.66 (1+0.13) − 1 , since we are analyzing costs,

we should choose the lowest cost per year, which is the lesser quality printer.

.

11-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 76. When to harvest an asset: Cleveland Millicrum is considering when to harvest its moldy bread supply for antibiotics. It has calculated that the current NPV dollars for harvesting the bread are increasing according to the following schedule. When should the firm harvest the bread? The cost of capital for the firm is 14 percent.

NPV increase if harvested next year over that of harvesting now 25% NPV increase if harvested year 2 over that of harvesting year 1 20% NPV increase if harvested year 3 over that of harvesting year 2 17% NPV increase if harvested year 4 over that of harvesting year 3 13% NPV increase if harvested year 5 over that of harvesting year 4 10% A) Harvest now B) Harvest year 2 C) Harvest year 3 D) Harvest year 4 Ans: C

.

11-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 77. When to harvest an asset: Farmer Ag owns a special species of cotton-producing plant that, if left unharvested, grows a bigger bowl of cotton through time. The NPV, at the beginning of the year that harvesting takes place, is as follows. When should Farmer Ag harvest its cotton?

Assume a discount rate of 14 percent.

NPV1 = $50,000 NPV2 = $60,000 NPV3 = $69,000 NPV4 = $77,280 NPV5 = $85,008 Harvest now A) Harvest in year 1 B) Harvest in year 2 C) Harvest in year 3 D) Ans: D Feedback: NPV1 = $50,000 ===> NPV 0,1 = $50,000 / (1.14) = $43,860 2 NPV 2 = $60,000 ===> NPV 0,2 = $60,000 / (1.14) = $46,168 3 = NPV 3 $69,000 ===> NPV 0,3 = $69,000 / (1.14) = $46,573 4 NPV 4 = $77,280 ===> NPV 0,4 = $77,280 / (1.14) = $45,756 5 NPV 5 = $85,008 ===> NPV 0,5 = $85,008 / (1.14) = $44,150 The current NPV is maximized with a harvest at year 3.

.

11-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 78. When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor?

Assume the cost of capital for Nemo is 10 percent.

A) $3,000, do not purchase the new tractor B) $3,209, purchase the new tractor C) $4,000, purchase the new tractor D) $12,163, purchase the new tractor Ans: B Feedback:

 1   1− (1.10)5  NPV = −$3,000+ $4, 000  0.10    0 = −$3,000+ $15, 163  = $12, 163

 (1 + 0.1  (1 + k )t  )5 = EAC= kNPV  0.1  = ( $12,163) $3,209 t )5 − 1  (1 + 0.1  (1+ k ) − 1 , Since this is greater than the  annual cash flow of $3,100 produced by the old tractor, the new tractor should be purchased.

.

11-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 79. When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent.

A) $2,352, do not purchase the oven B) $6,000, purchase the oven C) $9,668, purchase the oven D) $24,668, purchase the new oven Ans: A Feedback:

 1   1− (1.12)6  NPV = −$15, 000+ $6, 000  0.12     0 = −$15, 000+ $24, 668 = $9, 668

 (1 + k )t   (1+0.12)6  EAC= kNPV   ) = 0.12 ( $9, 668 = $2, 352 t 6 1+0.12 − − +   k ) 1 ( ( ) 1 1   , Since this is   less than the annual cash flow of $4,000 produced by the old oven, the new oven should not be  purchased.

.

11-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 80. The cost of using an existing asset: Small Appliances, Inc., is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital.

A) $11,917 B) $12,500 C) $15,433 D) $50,000 Ans: A Feedback: The EAC for the new machine is

 (1 + k )t   (1+0.09)4  EAC= kNPV   ) = 0.09 ( $50, 000 = $15, 433.43 t 4 1+0.09 − − +   k 1 ( ) ( ) 1 1   , now the  

firm would have to economically incur this additional equivalent cost in year 3. Therefore, the present value of that cost is

$15, 433.43 = $11,917.44 3

(1.09)

.

11-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 81. Briefly explain the two methods of comparing projects with different useful lives.

Ans: The first method involves analytically rolling over each project until the two projects have the same number of years in each. It is similar to finding a common denominator when adding fractions. For instance, if one was comparing a two-year and a three-year project, then one could roll the two-year project over two more times until it is a six-year project. At the same time one would roll over the three-year project one more time until it is a six-year project. Once the two projects are both six-year projects, then the NPV of each of the new adjusted projects can then be calculated so that the highest adjusted NPV project would be selected.

In the chapter, the second method is called the equivalent annual cost (EAC) method.

Using the two projects mentioned above with this method, each project's unadjusted NPV is divided by the appropriate present value interest factor of an annuity

to arrive at the EAC for the project. The project with the greatest positive value should be selected.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 82. Explain why in practice the cash flows associated with a project are not certain cash flows.

Ans: The projected cash flows on a project are in fact just projects based on estimates of cash flows in different scenarios that might develop over the future. In a best case scenario those cash flows are derived from some probability-based distribution of outcome that will influence either the revenues or expenses, or both, involved in a project. In short, since the cash flows are projects about the future, which is by definition ripe with uncertainty, the projections cannot be 100 percent free of prediction error.

.

11-40

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 83. Why is depreciation and amortization added back when calculating free cash flows generated by a project?

Ans: Depreciation and amortization is a noncash expense. Since we are interested in the cash flow produced by a project or a firm, then that means that the general income statement approach to calculating profitability has “over” deducted the expenses from a cash perspective. Since this overdeduction helps to reduce the firm's tax bill, it becomes necessary to add back the noncash expenses after taxes have been deducted from the income stream.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 84. Which of the following statements is correct?

A) Incremental net operating profits after-tax should include sunk costs associated with a project.

B) Incremental net operating profits after-tax should include the effects of financing costs associated with a project.

C) Incremental net operating profits after-tax should exclude the effects of depreciation D) costs associated with a project.

Incremental net operating profits after-tax should exclude the effects of financing costs associated with a project.

Ans: D

.

11-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 85. Which of the following statements is true?

A) The calculation of free cash flow does not include the impact of income taxes.

B) Accounting earnings are an unreliable measure of the costs and benefits of a project.

C) The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the incremental principle.

D) Depreciation expense should not be included in the calculation of incremental net operating profits after-tax.

Ans: B

.

11-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 86. General Mills just is undertaking an analysis on a new cereal. The firm realizes that if they come out with a new product it would affect sales of existing products? What is the best course of action for General Mills in this analysis?

A) Treat the reduction of sales from existing cereals as a sunk cost.

B) Account for the reduction of sales from existing cereals in the projection of cash flows C) on the new product.

D) Include the allocated costs of the new cereal in the sales of the pre-existing products.

Ignore the fact that sales of other products will be affected.

Ans: B

.

11-43

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Difficult Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 87. Operating Cash Flow: Premier Steel, Inc. is considering the purchase of a new machine for $100,000 that has a useful life of 3 years. The firm’s cost of capital is 11.0% and the tax rate is 40%. This machine will be sold for its salvage value of $20,000 at the end of 3-years. The machine will require an investment of $2,500 in spare parts inventory upon installation. The machine will cost $8,000 to ship and $4,000 to install and modify it.

Sales are as follows: year 1 = $90,000; year 2 = $97,500; year 3 = $105,000. Operating expenses are year 1 = $25,000; year 2 = $27,000; year 3 = $29,000. The investment in working capital will be liquidated at termination of the project at the end of year 3.

MACRS Rates

33%

45%

15%

7%

Using MACRS, what is the operating cash flow in year 1?

A) $53,784 B) $35,238 C) $86,999 D) $42,512 Ans: A Feedback: OPERATING Year Sales Revenues Operating expenses Depreciation Income Before Tax Income Taxes Net income Add: depreciation Project Net Cash Flow Useful Life in Years MACRS Rates Invoice Cost Shipping Install & Modify Depreciable Cost Basis

.

CASH FLOWS 1 2 $ 90,000 $97,500 (25,000) (27,000) (36,960) (50,400) 28,040 20,100 11,216 8,040 16,824 12,060 36,960 50,400 53,784 62,460 3

33% $100,000 $ 8,000 $ 4,000 $112,000

Tax Rate 45%

3 $105,000 (29,000) (16,800) 59,200 23,680 35,520 16,800 52,320 40%

15% 7%

11-44

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 88. Average versus Marginal Tax Rate: Suppose Franklin Corporation had pre-tax income of $300,000 in 2010 and that the firm would have paid $100,250.00 in federal income taxes. What is Franklin’s average income tax rate? (Round off to the nearest 0.1%) A) 39.0% B) 34.7% C) 33.4% D) 38.6% Ans: C Feedback:

Average tax rate is equal to total income tax divided by taxable income.

Income tax on first $100,000 = $22,250 Income tax on next $200,000 = 39% × ($300,000 - $100,000) = .39 × $200,000 = $78,000 Thus, total tax = $22,250 + $78,000 = $100,250

AverageTaxRate=

.

In co m eTa x $100,25 = = .3342,or33.4% TaxableIncome 0 $300,00 0

11-45

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 89. Which of the following should not be included in a schedule of cash flows from operations when evaluating a capital project?

A) Fixed costs.

B) Sunk costs.

C) Depreciation and amortization.

D) Variable costs.

Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 90. Which of the following is an example of a fixed cost?

A) Cost of equipment purchased for an assembly line to be used in the production of a new product.

B) Assembly costs associated with the production of a new product.

C) Labor costs associated with the production of a new product.

D) Shipping costs associated with the sale of a new product.

Ans: A

.

11-46

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 91. Your firm is evaluating the merits of several different machines. Machine A has a useful life of 5-years, generates an NPV of $53,250, an IRR of 13.6% and an equivalent annual cost of $10,316. Machine B has a useful life of 3-years, an NPV of $61,051, an IRR of 12.5%, and an equivalent annual cost of $9,724. Machine C has a useful life of 4-years, generates an NPV of $55,225, an IRR of 15.2% and an equivalent annual cost of $7,535 Machine D has a useful life of 7-years, generates an NPV of $64,020, an IRR of 11.4% and an equivalent annual cost of $8,885.

Which machine should be purchased and why?

A) Machine C, because it has the highest IRR. B) Machine D, because it has the highest NPV. C) Machine A, because it has the most positive EAC D) Machine B, because it has the shortest useful life.

Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 92. Equivalent Annual Cost: Your firm is considering an investment that will cost $750,000 today. The investment will produce cash flows of $250,000 in year 1, $400,000 in year 2, and $600,000 in year 3. The discount rate that your firm uses for projects of this type is 11.75%.

What is the investment's equivalent annual cost? (Round off to the nearest whole dollar) A) $163,613 B) $225,008 C) $68,888 D) $92,845 Ans: D Feedback: Equivalent Annual Cost

.

PV of 11-47

Test Bank

Fundamentals of Corporate Finance 3e

Year 0 1 2 3

Estimated Cash Flows at Cash Flows 11.75% ($750,000) 250,000 223,714 400,000 320,306 600,000 429,941 Total PV of CF's $973,960 Minus Cost ($750,000) Net Present Value $223,960 EAC $92,845 Discount Rate 11.75%

PV = $223,960; N = 3, I% = 11.75%; Thus PMT (EAC) = $92,845

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 93. When is the appropriate time to harvest an asset?

A) That point in time where harvesting the asset yields the largest internal rate of return.

B) That point in time where harvesting the asset yields the smallest payback.

C) That point in time where harvesting the asset yields the largest accounting rate of return.

D) That point in time where harvesting the asset yields the largest net present value.

Ans: D

.

11-48

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 12: Evaluating Project Economics Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 1. Total variable costs for a firm do not vary directly with the number of units sold.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comrpehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2. A project with a higher proportion of fixed costs will have cash flows and accounting profits that are more sensitive to changes in revenues than an otherwise identical project with a lower proportion of fixed costs.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 3. A synonym for pretax operating cash flow is EBIT. A) True B) False Ans: B

.

12-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 4. Distinguishing between fixed and variable costs will enable one to calculate the sensitivity of EBITDA to changes in revenue.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 5. EBITDA is more sensitive to changes in revenue than EBIT. A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 6. Depreciation and amortization can be considered a fixed cost of the firm, for accounting breakeven purposes.

A) True B) False Ans: A

.

12-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 7. Operating leverage is a measure of the sensitivity of net income to changes in revenue.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehensnion AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 8. The degree of pretax cash flow operating leverage will change for different levels of revenue.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 9. If a firm's degree of accounting operating leverage is 1.12, a 10 percent increase in revenue should result in a 12.0 percent increase in EBIT. A) True B) False Ans: B Feedback: 1 percent increase in revenue will result in a 1.12% change in EBIT. Hence, for 10% change in revenue, the increase in EBIT = 10% × 1.12 = 11.2%

.

12-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 10. If Tunemony Craft had an increase in EBIT of 24 percent with an degree of accounting operating leverage of 1.2, then the firm must have had a 20 percent increase in revenue if no other changes were involved.

A) True B) False Ans: A Feedback: When EBIT had an increase of 24%, the increase in revenue = 24% ÷ 1.2 = 20% Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 11. If The Tower of Pizza has a cash flow degree of operating leverage equal to 1.15, then a 20 percent increase in revenue should drive a 35 percent increase in pretax operating cash flow.

A) True B) False Ans: B Feedback: 1 percent change in revenue will result in 1.15% increase in the pretax operating cash flow.

Hence, for 20% increase in revenue, the increase in the pretax operating cash flow = 20% × 1.15 = 23%.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 12. Taxes do not enter into the equation for the degree of cash flow of operating leverage because both fixed costs and pretax operating cash flows are measured on a pretax basis.

A) True B) False Ans: A

.

12-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 13. If there is no uncertainty regarding costs, volatility in pretax operating cash flows and accounting operating profits will be driven entirely by changes in revenue and operating leverage.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 14. Operating profits and operating cash flow describe the same item.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 15. A firm that has zero fixed costs will have a degree of cash flow operating leverage equal to one.

A) True B) False Ans: A

.

12-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 16. An increase in the proportion of a project's costs that are fixed will increase the degree of operating leverage for the project.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 17. Break-even analysis tells us how many units must be sold in order for a project to break even on a cash flow or an accounting basis.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 18. If a project fails to break even from a pretax operating cash flow perspective, then the firm is going to put more cash into the project to keep it going.

A) True B) False Ans: A

.

12-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 19. The pretax operating cash flow (EBITDA) break-even point is determined by how many units will have to be sold in order to cover the firms fixed cash expenses.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 20. The per-unit contribution margin is defined as the total sales price less its total variable cost.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 21. The crossover level of unit sales is the level at which one fixed/variable cost combination of production will begin to generate higher levels of operating cash flows than another fixed/variable cost combination of production.

A) True B) False Ans: A

.

12-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 22. The crossover level of unit sales can be calculated for any two alternatives that have the same level of operating leverage.

A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 23. The accounting operating profit (EBIT) break-even point tells us how many units must be sold to avoid an accounting operating loss.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 24. The accounting operating profit break-even points are smaller than the corresponding pretax operating cash flow break-even points for a project with positive costs.

A) True B) False Ans: B

.

12-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 25. An economic break-even point is the number of units that must be sold each year during the life of the project so that the difference of present value of cash inflows and present value of cash outflows is one.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 26. The economic break-even point considers a single year rather than the entire life.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 27. The economic break-even point focuses on the cash flows or profits from operations rather than after-tax free cash flows associated with the project.

A) True B) False Ans: B

.

12-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 28. The NPV of a project will equal $0 when the present value of the annual FCFs from the project, PV (FCF), equals the present value of net nonrecurring investments.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 29. An analysis in which a firm would like to know the effect of a price change on the NPV of a project, holding all other variables and forecasts constant, is one type of sensitivity analysis.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 30. If a firm knows that a price change will have an effect on a number of other forecast variables, such as the sales forecast, then the firm might require scenario analysis rather than sensitivity analysis.

A) True B) False Ans: A

.

12-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 31. Within a simulation analysis, the firm will need to come up with some distributional assumptions concerning the forecast inputs, such as the mean and variance of the sales forecast.

A) True B) False Ans: A Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 32. Simulation analysis has the benefit of providing a pinpoint accurate forecast of a project's NPV. A) True B) False Ans: B Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 33. Sensitivity analysis involves examining the sensitivity of the output from an analysis, such as the NPV to changes in individual assumptions.

A) True B) False Ans: A

.

12-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 34. The economic break-even point focuses on the after-tax free cash flows associated with the project for its entire life.

A) True B) False Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 35. EBITDA stands for: A) earnings before interest, taxes, and amortized depreciation.

B) earnings before interest, taxes, depreciation, and amortization.

C) earnings before interest and taxes.

D) earnings before interest, taxes, dividend, and accrued expenses.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 36. Revenue minus variable and fixed costs best describes: A) EBIT. B) EBITDA. C) NOPAT. D) EAT. Ans: B

.

12-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 37. Another name for EBITDA is: A) pretax operating cash flow.

B) accounting operating cash flow.

C) net income before tax.

D) net income after tax.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 38. Compared to an identical project with a lower proportion of fixed costs, a project with a higher proportion of fixed costs will have: A) a higher degree of sensitivity of EBITDA to a change in revenues.

B) a lower degree of sensitivity of EBITDA to a change in revenues.

C) no discernible difference of a change in sensitivity of EBITDA to a change in revenues.

D) a stable net income stream as a function of revenues.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 39. If a firm is about to operate in an environment in which there will be a great deal of variability in the level of revenues, then the firm: A) should structure its cost structure to have high fixed costs and higher total variable costs.

B) should structure its cost structure to have high fixed costs and consequently lower per C) unit variable costs.

D) should structure its cost structure to have low fixed costs and consequently higher per unit variable costs. should leave the cost structure unchanged.

Ans: C

.

12-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 40. The degree of pretax cash flow operating leverage provides us with: A) a measure of how sensitive pretax operating cash flows are to changes in revenue.

B) a measure of how sensitive accounting operating profits are to changes in revenue.

C) a measure of how sensitive NOPAT is to changes in tax rates.

D) a measure of how sensitive accounting operating profits are to changes in tax rates.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 41. _____ is a measure of the sensitivity of EBITDA or EBIT to changes in revenue.

A) Total leverage B) Financial leverage C) Operating leverage D) Combined leverage Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 42. Depreciation and amortization are treated like fixed costs: A) in the calculation of the degree of pretax cash flow operating leverage.

B) in the calculation of the degree of accounting operating leverage.

C) for cash flow purposes.

D) for computing dividend.

Ans: B

.

12-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 43. If the degree of accounting operating leverage is 1.3 for a firm, then a 10 percent increase in revenue should drive a: A) 12% increase in pretax operating cash B) flows. 13% increase in EBIT. 30% C) increase in EBIT. 1.3% increase in pretax D) operating cash flows.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 44. Which of the following statements is true?

A) The degree of pretax cash flow operating leverage remains same for any level of B) revenue.

C) The higher the proportion of fixed costs to variable costs in a project, the greater the D) sensitivity of pre-tax operating cash flows to changes in revenue.

Depreciation and amortization are deducted to get pretax operating cash flows.

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: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 45. 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

.

12-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 46. 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 Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 47. 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 in the numerator, B) whereas pre-tax operating cash flow does not.

C) Pre-tax operating cash flow break-even point includes income taxes in the denominator, D) 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 operating profit break-even point does not.

Ans: C Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 48. The economic break-even point is the number of units that must be sold each year over the life of a project in order for the NPV of that project to equal to _____.

A) $0 $1 the present value of B) cash inflows the present C) value of investment D) Ans: A

.

12-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 49. The difference between revenue and variable cost is called: A) total contribution.

B) net profit.

C) EBIT. D) EAT. Ans: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 50. Which of the following statements is true of the economic break-even point?

A) It is the number of units that must be sold for accounting operating profit to equal $0.

B) It is the level of unit sales at which cash flows or profitability for one project alternative C) switches from being lower than that of another alternative to being higher.

D) It is the number of units that must be sold each year during the life of a project so that the NPV of a project equals $0.

It is the number of units that must be sold for pretax operating cash flow to be $0.

Ans: C

.

12-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 51. Sancore Inc. decided to invest in a project costing $35,000. It is assumed that all of $8,000 working capital will be recovered at the end of the project, which is four years. The opportunity cost of capital is 10%. Compute the present value of net non-recurring investment of the project. (Do not round intermediate calculation. Round the final answer to the nearest dollar.)

A) $36,71 B) 3 C) $45,65 D) 7 Ans: C$46,71 3 Feedback: $35,65 PV(Net Non-Recurring Investments) = $35,000 + $8,000 (1.1)4 7 = $46,713 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 52. Astroscope Tours finds that if it were to increase its price by 10 percent, it would have a 6 percent reduction in the NPV of its new 3-Hour Tour. Considering other things to be unchanged, Astroscope's analysis could be described as: A) Monte Carlo simulation.

B) break-even analysis.

C) sensitivity analysis.

D) variance analysis.

Ans: C

.

12-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 53. If a firm were interested in knowing the effect of a single input change on the net present value of a project, then the firm would most likely want to perform: A) a Monte Carlo simulation.

B) a scenario analysis.

C) a sensitivity analysis.

D) a break-even analysis.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 54. If a firm wanted to find the effect of a change in the variable cost per unit of production on the net present value of a project, then the firm might perform: A) a sensitivity analysis.

B) a scenario analysis.

C) a Monte Carlo simulation.

D) a cash flow simulation.

Ans: A Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 55. At times, when a firm is considering an alternative such that a set of variables affecting a project are interrelated, then analysis that considers this interrelation could be performed. This is called: A) a sensitivity analysis.

B) a scenario analysis.

C) a Monte Carlo simulation.

D) a horizontal analysis.

Ans: B

.

12-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 56. A firm is considering two distinct set of circumstances that assume high inflation and low inflation. In the high inflationary set of circumstances, the price per unit will be affected as well as the variable and fixed costs. If the low-inflation set of circumstances is considered the baseline, then the analysis concerning the high inflationary circumstances could be considered: A) a sensitivity analysis.

B) a scenario analysis.

C) a Monte Carlo simulation.

D) a horizontal analysis.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 57. Scenario analysis can help a firm to: A) understand the degree of uncertainty that a different set of project-affecting B) circumstances may hold.

C) eliminate all of the uncertainty that a different set of project-affecting circumstances may D) hold. transform a risky project into a risk-free project. understand the degree of certainty that a similar set of project-affecting circumstances may hold.

Ans: A

.

12-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 58. If a project holds an 80 percent probability of high demand and a 20 percent probability of low demand, then the expected value of the net present value of the two different demand assumptions would give us a weighted average net present value for the project. Such an analysis is called: A) a sensitivity analysis.

B) a scenario analysis.

C) a simulation analysis.

D) a horizontal analysis.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 59. An analysis in which each of the inputs and assumptions for a project takes on a separate assumed distribution whereby a computer draws on each of those input and assumption distributions to create a distribution for the NPV of the entire project is called: A) a sensitivity analysis.

B) a scenario analysis.

C) a simulation analysis.

D) a horizontal analysis.

Ans: C

.

12-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: ComprehensApplicationion AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 60. Ottomony has analyzed a new type of all-in-one retail center where the NPV of the project has an expected value with a distribution that yields a standard deviation of $25 million. Ottomony came to this conclusion by analyzing the individual input distributions for the project. This analysis is called: A) a sensitivity analysis.

B) a scenario analysis.

C) a simulation analysis.

D) a horizontal analysis.

Ans: C Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 61. If a firm is interested in the distribution of the NPV for a project that it is considering, then the firm should be most interested in: A) a sensitivity analysis.

B) a scenario analysis.

C) a simulation analysis.

D) a horizontal analysis.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 62. Which of the following mathematical expressions is used to calculate the degree of pretax cash flow operating leverage?

A) 1 + (FC / EBITDA) B) 1 + (FC / EBIT) C) 1 + [(FC + Depreciation and Amortization) / EBITDA] D) 1 + [(FC + Depreciation and Amortization) / EBIT] Ans: A

.

12-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 63. Which of the following project risk analyses is best able to analyze the effect of a single input, uncorrelated with other inputs, on the NPV of a project?

A) Sensitivity analysis B) Scenario analysis C) Simulation analysis D) Horizontal analysis Ans: A Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 64. Which of the following project risk analyses is best able to analyze the effect of a single set of circumstances, with correlated inputs, on the NPV of a project?

A) Sensitivity analysis.

B) Scenario analysis.

C) Simulation analysis.

D) Contribution analysis.

Ans: B Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 65. A change in sales price of a product sold by a firm will probably involve a reduction in the number of units sold, as well as the possibility of a change in the cost structure of the firm's product in question. If a firm were interested in the entire price change effect on the NPV of a project, then it would be interested in: A) sensitivity analysis.

B) scenario analysis.

C) simulation analysis.

D) contribution analysis.

Ans: B

.

12-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 66. An analytical method that uses a computer to quickly examine a large number of scenarios and obtain probability estimates for various values in a financial analysis is known as: A) risk analysis.

B) credit analysis.

C) capital structure analysis.

D) simulation analysis.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 67. Which of the following mathematical expressions is used to calculate the degree of accounting operating leverage?

A) 1 + (FC / EBITDA) B) 1 + (FC / EBIT) C) 1 + [(FC + Depreciation and Amortization) / EBITDA] D) 1 + [(FC + Depreciation and Amortization) / EBIT] Ans: D

.

12-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 68. Sparran Craft had sales of $2.24 million last year for which the total cost was $2 million. If the firm had fixed costs of $600,000 on sales of 56,000 books, then what is the firm's per-unit contribution? (Round the final answer to the nearest whole dollar.)

A) $20.0 B) 0 C) $19.0 D) 0 Ans: C$15.0 0 Feedback: $10.0= 56,000 units Unit sales 0 $2,240,000 Sales = Total fixed costs = $600,000 Total variable costs = Total costs –Total fixed costs = $2,000,000 – $600,000= $1,400,000 Unit variable costs = $1,400,000 / 56,000 = $25.00 per unit Sale price/unit = $2,240,000 / 56,000 = $40 per unit Unit contribution margin = $40.00 – $25.00 = $15.00

.

12-25

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 69. Oeta Works has a degree of pretax cash flow operating leverage of 1.25. If the firm's EBITDA was $1,000 last year while its depreciation and amortization expense was $50 in the same year, then what was the firm's degree of accounting operating leverage?

A) 1.26 B) 1.30 C) 1.32 D) 1.35 Ans: C Feedback:

FC Degree of pretax cash flow operating leverage EBITDA = FC  FC = $250 1.25= 1+ $1,000 FC+D&A 1+ Degree of accounting operating leverage =EBITDA−D&A 1+

1+

$250 + $50 = 1.315789 1.32 $1, 000 − $50

Degree of accounting operating leverage =

.

12-26

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 70. Synthgration has a degree of pretax cash flow operating leverage equal to 1.266. If the firm's EBITDA was $1,500 last year while its depreciation and amortization expense was $100 in the same year, then what was the firm's degree of accounting operating leverage?

A) 1.29 B) 1.33 C) 1.36 D) 1.39 Ans: C Feedback:

FC Degree of pretax cash flow operating leverage EBITDA = 1+

1.266= 1+

FC  FC = $399 $1,500

FC+D&A Degree of accounting operating leverage =EBITDA−D&A 1+

1+

$399 + $100 = 1.35642857  1.36 $1, 500 − $100

Degree of accounting operating leverage =

.

12-27

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 71. Mussubsound Audotec Inc. had EBIT of $1,850 last year with fixed costs equal to $500 (depreciation and amortization not included) and depreciation and amortization equal to $150.

What was Mussubsound Audotec's degree of accounting operating leverage?

A) 1.25 B) 1.35 C) 1.38 D) 1.40 Ans: B Feedback:

FC+D&A FC + D & A Degree of accounting operating leverage = 1+ EBITDA − D & A=1+ EBIT = =

1.35

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 72. Dupaudio Inc. had EBITDA of $3,000 and EBIT of $2,750, with fixed cash expense of $600 last year. What was Dupaudio's 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 Degree of accounting operating leverage = 1+ EBITDA − D & A=1+ EBIT

=

.

1.31

12-28

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 73. Metkia Inc. had a degree of accounting operating leverage equal to 1.841 during the most recent period. If the firm's EBITDA was $4,800 and depreciation and amortization was equal to$600, then what was Metkia's fixed cash expenses during the same period?

(Round your answer to the nearest whole dollar.)

A) $1,54 B) 8 C) $2,93 D) 2 Ans: B$2,32 4 Feedback: $2,88 FC+D&A 6 1+ Degree of accounting operating leverage =EBITDA−D&A = 1.841

FC + $600 1 + $4,800 – $600

Degree of accounting operating leverage = FC = $2,932.2

= 1.841

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 74. Ergotone Audio had a degree of accounting operating leverage equal to 1.60 during the most recent period. If the firm's EBITDA was $3,000 and its fixed costs were equal to $1,250, then what was Ergotone 's depreciation and amortization expense during the same period?(Round the final answer to the nearest whole dollar.)

A) $344 B) $507 C) $377 D) $404 Ans: A Feedback:

FC+D&A Degree of accounting operating leverage =EBITDA−D&A 1+

$1,250 +D & A Degree of accounting operating leverage = $3,000 –D & A 1+

D & A = $343.75

.

= 1.60 = 1.60

12-29

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 75. Resoneffect Inc. has a degree of pretax cash flow operating leverage equal to 1.12. If the firm's EBITDA was $2,000 last year while its depreciation and amortization expense was $150 in the same year, then what was the firm's degree of accounting operating leverage? (Round the final answer to two decimal places.)

A) 1.09 B) 1.21 C) 2.09 D) 2.18 Ans: B Feedback:

FC Degree of pretax cash flow operating leverage EBITDA = 1+

FC+D&A Degree of accounting operating leverage =EBITDA−D&A 1+

Degree of accounting operating leverage =

.

12-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 76. Silevector has a degree of pretax cash flow operating leverage equal to 1.341. If the firm's EBITDA was $2,500 last year while its depreciation and amortization expense was $200 in the same year, then what was the firm's degree of accounting operating leverage? (Do not round the intermediate calculations. Round your final answer to two decimal places) A) 2.54 B) 1.96 C) 1.46 D) 2.39 Ans: C Feedback:

.

12-31

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 77. Treguard Inc. 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 Treguard?

A) 567 plates B) 1,700 C) plates D) 1,900 Ans: Bplates 1,622 Feedback: plates FC

EBITDABreak−Even=

= $8,500 =1,700 Price−UnitVC $15−$10

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 78. SileCuatro has produced 22,000 tins in a year. The pretax operating cash flow (EBITDA) break-even point is 22,000 tins. If the fixed costs for the product is $1,500,000 and the variable cost per tin is $298, then what price can SileCuatro charge per tin if the firm needs to break even on a pretax operating cash flow basis? (Round to nearest whole dollar.)

A) $366 B) $298 C) $268 D) $372 Ans: A Feedback: FC EBITDA Break-even = Price – Unit VC $1,500,000 22,000 = Price – $298 Price = $366.18

.

12-32

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 79. AchtTre has found that its pretax operating cash flow basis break-even number of glasses sold is 550,000 pairs. If each pair is sold for $15 and the variable cost per unit is $10, then what is the amount of AchtTre's fixed costs?

A) $887,000 B) $1,558,00 C) 0 D) $2,750,00 Ans: C0 $1,582,00 Feedback: 0 FC EBITDA Break ̶ even = Price – Unit VC FC 550,000 = $15 – $10 = FC

.

$2,750,000

12-33

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 80. Ranbow Inc.is about to introduce a new LED clock and has determined that it will charge $35 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 $4,000 per year, with variable costs of $6 per clock. Otherwise the fixed costs will be $800, with variable costs of $16 per clock. Above what level of expected sales should Ranbow Inc. choose the high fixed cost alternative to maximize pretax operating cash flow?

A) 320 units B) 352 units C) 3200 units D) 500 units Ans: A Feedback: COEBITA =

FCAlt 1 – FCAlt 2 Unit ContributionAlt 1– Unit ContributionAlt 2

=

$4,000 – $800 $29 – $19 = 320 units

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 81. Dreiphosis Corp. 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 $12,000 per year versus the $3,000 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $33. The firm will charge $66 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 1,000 books. What is the contribution margin under the low-capacity machine scenario?

A) $41 B) $24 C) $32 D) $46 Ans: B

.

12-34

Test Bank

Fundamentals of Corporate Finance 3e

Feedback: COEBITA

=

1,000

=

FC Alt 1 – FCAlt 2 Unit ContributionAlt 1 – Unit Contribution Alt 2 $3,000 – $12,000 ($66 – $33)

Unit ContributionAlt 2

–

Unit ContributionAlt 2

= $24

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 82. ElecHuit 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 $11,000 per year versus the $2,500 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $32. The firm will charge $62 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 850 books. What is the variable cost per unit under the low-capacity machine scenario?

A) $25 B) $42 C) $35 D) $89 Ans: B Feedback: COEBITDA 850

FCAlt 1 – FCAlt 2

= =

Unit ContributionAlt 1– Unit ContributionAlt 2 $11,000 – $2,500 ($62 – $32) – Unit ContributionAlt 2

Unit ContributionAlt 2 = $20 VClow capacity = $62 – $20 = $42

.

12-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 83. 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 550 yards of cement per month. The price of a yard of cement is $62, and the variable costs for a large truck are $22 per yard. The variable costs for a small truck are $44 per yard, and the fixed costs for the small truck are $12,000.

What are the fixed costs associated with the large truck?

A) $20,00 B) 0 C) $12,00 D) 0 Ans: C$24,10 0 Feedback: $35,00 0

.

12-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 84. CoTres's Brakes is introducing a new revolutionary brake-pad for vehicles that will never wear out. CoTres's will sell the pads for $150 a pair and they will cost $100 in variable costs to produce. If cash fixed expenses are $2,500 per year and the depreciation and amortization expenses are $900 per year, then what is the accounting operating profit break-even point for the company?

A) 86 B) pairs C) 28 D) pairs Ans: D57 pairs Feedback: 68 pairs

.

12-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 85. Mexmagnet is introducing a new game system that promises to never become outdated.

Mexmagnet will sell the systems for $225, and it will accrue $150 in variable costs to produce. If cash fixed expenses are $30 million per year and the depreciation and amortization expenses are $7.5 million per year, then what is the accounting operating profit break-even point for Mexmagnet?

A) 621,000 B) units C) 415,077 D) units Ans: D200,000 units Feedback: 500,000 units

.

12-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 86. EpicSept 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 EpicSept choose the high fixed cost alternative?

A) 60 units B) 90 units C) 120 D) units Ans: D180 units Feedback: (FC+D&A) − FC+D A ( − + Alt1 ($5,000+$2,000) ($2,000 $500) CO EBIT = = & )Alt2 $50 −$25 (Unit ContribAlt1 −Unit ContribAlt2)

=180 tools

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 87. Sechssonic has found that it is indifferent between purchasing a high-capacity vacuum sealing machine or a lower capacity machine as long as sales are 200 units per month. The price of each sealed beam light is $50. The high-capacity machine has cash expenses of $10,000 per month, while the other alternative has cash expenses of $5,000 per month and depreciation and amortization expenses of $2,000 per month. Under high capacity, the variable costs per unit are $10; and they are $40 for the other alternative. If the firm bases its decisions on the accounting 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) $5,000 Ans: A Feedback: CO

EBIT

=

(FC+D&A) − FC+D − ($5,000+ $2,000) ( & A )Alt2=200units= ($10,000+D & AAlt1) Alt1  Alt1 −Unit ContribAlt2) $40 −$10 (Unit Contrib

D & A Alt1=$3,000

.

12-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 88. SeptSeven has found that it is indifferent between purchasing a high-capacity vacuum component assembly machine or a lower capacity machine as long as sales are 1,900 units per month. The price of each calculator is $70. The high-capacity machine has cash expenses of $100,000 per month and depreciation and amortization expenses of $30,000 per month, while the alternative has cash expenses of $30,000 per month and depreciation and amortization expenses of $5,000 per month. Under the low-capacity alternative, variable costs per unit are $60. If the firm bases its decisions on the accounting operating profit break-even, then what is the variable cost per unit under the high-capacity alternative?

A) $10 B) $47 C) $60 D) $70 Ans: A Feedback: (FC+D&A) Alt1− + & A) Alt 2 ($100,000+$30,000)−($30, 000+$5,000) ( FC D =1,900 units =  C OEBIT = Unit ContribAlt1 −$10 (Unit ContribAlt1 −Unit Contrib Alt 2 )

Unit ContribAlt1 = $60  Unit VC = $10

.

12-40

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 89. OutCinq manufactures snow boards. The firm has fixed costs of $1,500,561. The snow boards sell for $235 each and have a variable cost of $92 each. What is the pretax operating cash flow break-even point for OutCinq? (Round to the nearest unit) A) 9,566 units B) 10,493 C) units D) 11,565 Ans: Bunits 6,565 units Feedback: EBITDA Break- even

= = =

FC Price – Unit VC $1,500,561 $235 – $92 10,493.43

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 90. Cino Inc. earned from its brake pads manufacturing unit revenue of $560,000 and depreciation and amortization for the unit was $50,000. The company sells its product to customers at a price of $100. Further, the financial statement reveals that the EBIT for the year was $80,000.

The variable cost for each unit of brake pad is $60. What is the amount of fixed cost that leads to the EBIT as provided in the financial statement?

A) $88,000 B) $90,000 C) $94,000 D) $105,000 Ans: C Feedback: EBIT = Revenue – VC – FC – D & A $80,000 = $560,000 – ($60 × 5,600 units) – FC – $50,000 FC = $94,000

.

12-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 91. The management Dior Corp. is planning to invest in a machine which has a four-year life. The initial investment of the project is $8,000, the annual addition to working capital is equal to $4,000. The fixed cost would be $4,000. The unit contribution margin is $15. The firm’s marginal tax rate is 35%. The present value of net non-recurring investments would be $18,928.

FCFt is $5,971.Compute the economic break even. (Round your intermediate calculation to whole dollar amount and final answer to the nearest whole unit.)

A) 1,218 units B) 1,305 units C) 1,280 units D) 1,880 units Ans: A Feedback: EBITt = (FCFt – D&At + Cap Expt + Add WCt ) ÷ (1 – t) = ($5,971 – $2,000 + $0 + $4,000) ÷ (1 – 0.35) = $12,264 Revenuet – VCt = EBITt + D&At + FCt = $12,264 + $2,000 + $4,000 = $18,264 Economic Break-EvenT = (Revenue – VC) / Unit contribution = $18,264 / $15 = 1,218 units

.

12-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 2 Level of Difficulty: Analysis Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 92. 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:

The degree of pretax cash flow operating leverage considers pretax operating cash flows (EBITDA), while the degree of accounting operating leverage considers accounting operating profits (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.

.

12-43

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 93. Soleon, Inc. had the following financial data for the fiscal year ending September 30, 2014.

Sales $1,937,813 Depreciation and amortization $70,657 Fixed costs $132,456 Earnings before interest and taxes $564,441 Calculate the firm's degree of pre-tax cash flow operating leverage during fiscal 2014?

A) 1.21 B) 1.46 C) 1.17 D) 1.85 Ans: A Feedback:

DegreeOf Pre − taxOperatingLeverage =1+

FixedCosts FC =1+ Pre − taxOperatingCashFlows EBITDA

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 94. Briefly discuss the advantages of knowing the economic break-even point.

Ans: The economic break-even point accounts for both taxes and investment associated with the project hence they are more comprehensive measures. The economic break-even point help a financial manager assess the overall economic viability of a project. This measure tells the manager how low unit sales can get before a project destroys stockholder value.

.

12-44

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysi AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 95. Discuss the differences between scenario analysis and sensitivity analysis.

Ans: Sensitivity analysis is an examination of the sensitivity of the results from a financial analysis to changes in individual assumptions. Scenario analysis an analytical method concerned with how the results from a financial analysis will change under alternative scenarios.

In sensitivity analysis, an analyst might examine how a project’s NPV changes if there is a decrease in the value of individual cash inflow assumptions or an increase in the value of individual cash outflow assumptions. A scenario analysis helps in examining how the attractiveness of the project might vary under different economic scenario.

.

12-45

Fundamentals of Corporate Finance 3e

.

Test Bank

12-46

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 13: The Cost of Capital

1.

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Systematic risk is the only risk that investors require compensation for bearing.

A) B) True Ans: False A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Using a 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.

2.

A) B) True Ans: False A

3.

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The finance balance sheet is based on market values, just like the accounting balance sheet.

A) B) True Ans: False B

.

13-1

Fundamentals of Corporate Finance 3e

4.

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If the market value of a firm's assets is greater than the book value of its 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) B) True Ans: False A

5.

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The beta of a 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

6.

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Due to the magic of diversification, the risk associated with the assets of a firm must be less than the risk associated with the financing, or debt and equity that a firm is utilizing for its assets.

A) True B) False Ans: B

.

13-2

Fundamentals of Corporate Finance 3e

7.

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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. This means that the before-tax cost of capital for the firm must be between 10 and 12 percent.

A) True B) False Ans: B

8.

9.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a firm finances the purchase of an asset with cash, then it has zero financial cost to the firm.

A) B) True Ans: False B Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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) B) Ans:

10.

.

True False A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt typically describes debt that will mature in two years or more.

A) B) True Ans: False A

13-3

Fundamentals of Corporate Finance 3e

11.

12.

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt is generally viewed as a permanent financing source for a firm.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

13.

14.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The historic cost of long-term debt is the appropriate cost of debt for WACC calculations.

A) True B) False Ans: B Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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: A

.

13-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The yield to maturity for an annual coupon paying bond will always be equal to the coupon rate. A) B)

15.

True False Ans: B

16.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The yield to maturity is the discount rate that makes the present value of coupon and principal payments equal to the price of the bond.

A) True B) False Ans: A

17.

18.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The current cost of bank debt of a firm can be determined by asking the firm's banker.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

13-5

Fundamentals of Corporate Finance 3e

19.

Test Bank

Format: True/False Learning Objective: LO 2 Level Of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

20.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

21.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Estimates of expected returns based on market security prices will be reliable in all types of markets, including those deemed less efficient than others.

A) True B) False Ans: B

.

13-6

Fundamentals of Corporate Finance 3e

22.

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The cost of equity for a 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

23.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

24.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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.

A) True B) False Ans: A

25.

.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The market risk premium for the future is always perfectly known, and it is 6.51 percent.

A) True B) False Ans: B

13-7

Fundamentals of Corporate Finance 3e

26.

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

27.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The current cost of preferred equity can be found by taking the ratio of the annual dividend on the preferred stock to the current price of preferred shares.

A) True B) False Ans: A

28.

29.

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The CAPM can only be used to determine the cost of common equity.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The proportions of debt and equity used to determine the weighted average cost of capital for a firm is based on the market value of debt and equity outstanding.

A) True B) False Ans: A

.

13-8

Fundamentals of Corporate Finance 3e

30.

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The correctly calculated weighted average cost of capital for a 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

31.

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The estimated cost of capital the financial manager use for efficiency projects tends to be higher than the cost of capital used to evaluate new projects.

A) True B) False Ans: B

32.

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

13-9

Fundamentals of Corporate Finance 3e

33.

Test Bank

Format: Multiple choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

34.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Firms have no way to directly estimate the discount rate that reflects the risk of A) B) C) D) Ans:

35.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A firm's overall cost of capital is A) B) C) D) Ans:

.

a publicly traded security. its debt securities. the incremental cash flows from a particular project.

None of the above C

less than its cost of debt. a weighted average of the costs of capital for the collection of individual projects that the firm is working on. best measured by the cost of capital of the riskiest projects that the firm is working on.

None of the above B

13-10

Fundamentals of Corporate Finance 3e

36.

37.

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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) the same as the accounting balance sheet, but it is based on historical values.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The value of the cash flows that the assets of a firm are expected to generate must equal A) the value of the cash flows claimed by the equity investors.

B) the value of the cash flows claimed by the debt investors.

C) the value of the cash flows claimed by both the equity and debt investors.

D) the revenue produced by the firm.

Ans: C

38.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The beta for a firm can be estimated by A) B) C) D) Ans:

.

adding up the betas of the individual projects of the firm. taking the weighted average of the beta for the individual projects of the firm. taking the simple average of the beta for the individual projects of the firm.

None of the above B

13-11

Fundamentals of Corporate Finance 3e

39.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A firm can be viewed as A)

a portfolio of individual projects, each with its own risks, cost of capital, and returns.

B) C) D)

a collection of equity shares comprising it. a collection of debt instruments financing it. a portfolio of all individual projects in the industry, each with its own risks, cost of capital, and returns.

A

Ans:

40.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 by the firm.

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

D) None of the above Ans: A

41.

.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 based on security prices will not be reliable.

D) None of the above Ans: C

13-12

Fundamentals of Corporate Finance 3e

Test Bank

42.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When estimating the cost of debt capital for a firm, we are primarily interested in

43.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt typically describes

44.

A) the weighted average cost of capital.

B) the cost of long-term debt.

C) the coupon rate of the debt.

D) None of the above Ans: B

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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Which of the following need to be excluded from the calculation of a 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

.

13-13

Fundamentals of Corporate Finance 3e

45.

46.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When analyzing a firm's cost of debt, we are typically interested in A) B) C) D)

the cost of the debt on the date that the analysis is being completed. the coupon rate on the firm's bonds. the cost of the debt and cost of preferred stock on the date that the analysis is being completed.

None of the above Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

47.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Appllication AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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) B) C) D)

$60. $30. $30 plus or minus the prorate portion of the discount or premium that the bond was purchased for. $60 plus or minus the prorate portion of the discount or premium that the bond was purchased for.

Ans: B

.

13-14

Fundamentals of Corporate Finance 3e

48.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Bond issuance costs include

49.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Income taxes have the effect of

50.

Test Bank

A) investment banking B) fees. legal fees.

C) accountant fees. All of D) the above Ans: D

A) increasing the cost of debt for a firm.

B) decreasing the cost of debt for a firm.

C) decreasing the cost of equity for a firm.

D) Both B and C are correct Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Bellamee, Inc. has semiannual bonds outstanding with five years to maturity, and the bonds are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds? Round your final percentage answer to two decimal places.

A) 4.5% B) 7.0% C) 9.0% D) 9.2% Ans: C Feedback: Semiannual coupon payment = $1,000 × 7% ÷ 2 = $35 The semiannual YTM can be calculated as 4.5% by entering the following data in a financial calculator.

PMT = 35, PV = –920.87, FV = 1,000, N = 10 Hence, the YTM = 2 × 4.5% = 9%

.

13-15

Fundamentals of Corporate Finance 3e

51.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity, and the bonds 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? Round your final percentage answer to two decimal places.

A) 3.5% B) 7.00% C) 7.12% D) 8.00% Ans: C Feedback: Using the formula for pricing bonds, we have

$1,080.29= $40 x 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 Now, we adjust for EAR:(1+ 2 )2− 1 = 0.0712= 7.12%

.

13-16

Fundamentals of Corporate Finance 3e

52.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and the bonds 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%? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places.

A) 6.250% B) 8.125% C) 12.500% D) 12.890% Ans: B 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%

.

13-17

Fundamentals of Corporate Finance 3e

53.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective PackMan Corporation has semiannual bonds outstanding with nine years to maturity and the bonds 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? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places.

A) 7.050% B) 8.225% C) 11.750% D) 12.095% Ans: A 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%

.

13-18

Fundamentals of Corporate Finance 3e

54.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 marginal tax rate to be 33%?

A) 2.55% B) 3.34% C) 5.17% D) 7.71% Ans: C Feedback: Total debt = $50M – $12 = $38M Weighted average pretax cost of debt = 7% × (20/38) + 8.5% × (18/38) = 7.71% After-tax cost of debt = 7.71% × (1 – 0.33) = 5.17%

55.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The appropriate risk-free rate to use when calculating the cost of equity for a firm is

56.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The average risk-premium for the market from 1926 to 2012 was

A) a long-term Treasury rate.

B) a short-term Treasury rate.

C) an equal mix of short-term and long-term Treasury rates.

D) None of the above Ans: A

A) 8.00%. 7.50%. 5.71% .

B) 6.51% + the Treasury C) rate.

D) Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy

.

13-19

Test Bank

Fundamentals of Corporate Finance 3e

57.

58.

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The recommended model to estimate the cost of common equity for a firm is A) the one-stage constant growth dividend model.

B) the multistage –growth dividend model.

C) the capital asset pricing model(CAPM).

D) None of the above Ans: C Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective 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) 15.57% D) 23.60% Ans: B Feedback: 𝑅 The equation for CAPM is∶𝐸(𝑅 𝑖)= 𝑅𝑟𝑓 + 𝛽[𝐸(𝑅)− 𝑖 𝑚

𝑟𝑓 ].

𝐼𝑓 𝛽𝑖=1.3,𝑅𝑟𝑓=0.08,𝑎𝑛𝑑 𝐸(𝑅𝑚)=0.12,𝑡ℎ𝑒𝑛 𝑤𝑒 ℎ𝑎𝑣𝑒 𝐸(𝑅𝑖)= 0.08+1.3 ×[0.12−0.08]=0.132=13.20%

59.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective 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) 10.60% C) 15.14% D) 16.00% Ans: D

.

13-20

Fundamentals of Corporate Finance 3e

Test Bank

Feedback:

The equation for the CAPM is : E(Ri ) = Rrf +  i E(Rm ) − Rrf   .

If  i = 1.4,Rrf = 0.09,and E(Rm ) − Rrf = 0.05,then we have = 0.16= 16.00% E(Ri ) = 0.09+1.40.05

60.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective Radical VenOil, 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' beta if the marginal tax rate is 35 percent?

A) 1.0 B) 1.28 C) 1.60 D) 4.10 Ans: C Feedback:

The equation for the CAPM is: E ( Ri) = R +i E (Rm) − R  . rf rf   If E(R i ) = 0.228,Rrf = 0.10,and E(Rm ) = 0.18,then we have − 0.10 ===  i = 1.60 0.228= 0.10+  i  0.18

61.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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:

.

13-21

Fundamentals of Corporate Finance 3e

Test Bank

Since the price of common shares is given as well as the expected growth in dividend and the next expected dividend, we can use the following:

kcs=

D1 +g= $2.10 +0.03=0.15=15% $17.50 P 0

62.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective UltraFlex Diving Boards, Inc. 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:

the Since the price of common shares is given as well as ected growth in dividends exp and the last paid dividend, we can use the following : D (1+g) $1.501.04 D +g= + 0.04= 0.10 = 10% kcs = 01 + g = 0 P P0 $26.00

63.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Turquoise Electronics, Inc. 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 its cost of equity capital if the price of its common shares is currently $25.71?

A) B) C) D)

7.27% 8.00% 18.00% The problem is not solvable with the information that is given.

Ans: B Feedback: D1 = D0 × (1 + g1) = $1.87 × 1.10 = $2.057 kcs = (D1 / P0) + gc = (2.057 / $25.71) + 0= 8%

.

13-22

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Round your final percentage answer to 1 decimal place.

64.

A) 7.00% B) 8.00% C) 9.00% D) 10.00% C Ans: Feedback:

We can use the common stock pricing equation to solve tof the cosfor common equity capital : 2 $1.00(1.1 ) (1.05) ; Trial and error gives us =k $1.00(1.1) $1.00(1.1) + + 0.09 $28.76= ) cs 2 )(+ kcs12 (1+ kcs ) (1 + )kcs(kcs − 0.05

2

65.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Round your final percentage answer to 1 decimal place.

A) 9.5% B) 10.5% C) 11.5% D) 12.5% Ans: C Feedback: We can use the common stock pricing equation to solve for the cost of common equity capital.

.

13-23

Test Bank

Fundamentals of Corporate Finance 3e

$18.37 =

$1.50(1.09) $1.50(1.09) + (1+𝑘 𝑐𝑠) (1+𝑘 )𝑐𝑠 2

2

+

$1.50(1.09) (1+𝑘 )𝑐𝑠 3

3

+

$1.50(1.09)3(1.02) (𝑘 .02)(1+𝑘 𝑐𝑠−0 𝑐𝑠) 3

By trial and error method, the valuecsof k be found out as 11.5%. can

66.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Round your final answer to nearest percentage.

A) 13% B) 14% C) 15% D) 16% Ans: B Feedback: We can use the common stock pricing equation to solve for the cost of common equity capital. $21.12= $1.75(1.10) $1.75(1.10)2 $1.75(1.10) 2(1.05) $1.75 + + + (1+𝑘)2𝑐𝑠 (1+𝑘) 𝑐𝑠 (1+𝑘𝑐𝑠) 3 (𝑘𝑐𝑠−0.05)(1+𝑘) 𝑐𝑠 3 By trial and error method, the valuecsof k be found out as 14%. can

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective .

13-24

Fundamentals of Corporate Finance 3e

67.

Test Bank

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? Round your final answer to nearest percentage.

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 the cost of preferred equity. kps = Dps / Pps = $3.50 / $38.89 = 9%.

68.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Round your final answer to nearest percentage.

A) 6.50% B) 7.00% C) 7.50% D) 8.00% Ans: B Feedback: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps / Pps = $1.86 / $26.57 = 7%.

69. .

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The 13-25

Fundamentals of Corporate Finance 3e

Test Bank

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) 11.75% C) 12.00% D) 12.25% Ans: C Feedback: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps / Pps = $2.34 / $19.50 = 12%.

70.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective In order to use a firm’s WACC to evaluate its 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 firm.

B)

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

The project should have conventional cash flows.

Both A and B above D

C) D) Ans:

71.

Format: Multiple Choice Learning Objective: LO3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, t what is the expected return on a common share with a beta equal to 2?

A) B) 8.0% C) D) 10.0% Ans: 12.0% 16.0% D Feedback: E(Ri) = Rrf + βi [E(Rm) – Rrf] = 0.04 + 2.0 × 0.06 = 0.04 + 0.12 = 0.16=16.0%

.

13-26

Fundamentals of Corporate Finance 3e

72.

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective 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 B) 1.30 C) 1.57 D) None of the above Ans: B Feedback: E(Ri) = Rrf + βi [E(Rm) – Rrf] ➔ 0.213 = 0.07 + βi [0.18 – 0.07] ➔ βi= 1.30

73.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 million B) $45.0 million C) $75.0 million D) $75.3 million Ans: D Feedback: MV of assets = MV of liabilities + MV of equity = (1.01 × $30,000,000) + (3,000,000 × $15) = $75,300,000

74.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective 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) B)

.

0.96 1.24 13-27

Fundamentals of Corporate Finance 3e

Test Bank

C) D) 1.28 Ans: None of the above B Feedback:



n Asset portfolio

75.

=

2



i =1

xi i = 0.4(0.4)+ 0.6(1.8)= 1.24

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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) 14.0% C) 15.8% D) 20.0% Ans: C Feedback: kFirm = xDebtkDebt + xEquitykEquity = (0.35 × 0.08) + (0.65 × 0.2) = 0.158=15.8%

76.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Assume there are no taxes.

A) B) C) D) Ans:

13.0% 14.0% 15.0% 16.0% C

Feedback: xDebt = 200 / 500 = 0.4, xEquity = 300 / 500 = 0.6 kFirm = xDebtkDebt + xEquitykEquity = (0.4 × 0.09) + (0.6 × 0.19) = 0.15=15% Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium .

13-28

Fundamentals of Corporate Finance 3e

77.

Test Bank

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Assume there are no taxes.

A) 19.75% B) 24.00% C) 32.50% D) 58.00% Ans: B Feedback: xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75 kFirm = xDebtkDebt + xEquitykEquity, ➔ 0.1975 = (0.25 × 0.07) + (0.75 × kEquity) ➔ kEquity = 0.2400=24% Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Assume there are no taxes.

78.

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

79.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Swirlpool, Inc. has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. The firm is financed with 60 percent common shares and 40 percent debt. 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% 13-29

Fundamentals of Corporate Finance 3e

Test Bank

B) 12.00% C) 12.72% D) 14.00% Ans: C Feedback:

The formula forWACCis: WACC = xDebtkDebt pretax(1−t) + xpsk = 0.4  0.08 (1−0.4) + 0.6  0.18= 0.1272  cs =12.72%

80.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Maloney's, Inc. has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. The firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt. 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) 11.64% D) 12.60% Ans: C Feedback: Noting that the proportion of debt and equity is 𝑥𝐷𝑒𝑏𝑡 = $2,000,000/($3,000,000 + $2,000,000) = 0.4,𝑥𝐶𝑆 = $3,000,000/($3,000,000 + $2,000,000) = 0.6 The formula for WACC is: WACC = 𝑥𝐷𝑒𝑏𝑡𝑘𝐷𝑒𝑏𝑡 𝑝𝑟𝑒𝑡𝑎𝑥(1-t) + 𝑥𝑝𝑠𝑘𝐶𝑆 = 0.4 × 0.06×(1-0.4) + 0.6×0.17 = 0.1164

81.

.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. The firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt. What is the after-tax weighted average cost of capital for Ronnie's, if it is subject to a 35 percent marginal tax rate?

13-30

Fundamentals of Corporate Finance 3e

Test Bank

A) B) 6.05% C) D) 9.6% Ans: 8.75% 13.65% B Feedback: The weightage for debt and equity are calculated as follows: 𝑥𝐷𝑒𝑏𝑡=$750,000,000/($750,000,000 + 250,000,000)=0.75 𝑥𝑐𝑠=$250,000,000/($750,000,000 + 250,000,000)=0.25 WACC = xDebt kDebt pretax × (1 – t) + xps kcs=0.75 × 0.12 × (1 – 0.35) + 0.25 × 0.15 = 0.096 = 9.6%

82.

Format: Multiple Choice Learning Objective: LO1,2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Poly's Parrot Shops has found that its cost of common equity capital is 17 percent. It has 7year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Poly's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places.

A) 10.20% B) 11.76% C) 11.88% D) 13.32% Ans: D Feedback: xDebt = $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 xcs = $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 Coupon payment = $1,000 × 7% / 2 = $35 By entering the following data in a financial calculator, the YTM, which is the cost of debt, of the bond can be calculated as 12%.

PMT = 35, PV = –767.03, FV = 1,000, N = 14.

WACC = xDebt kDebt pretax × (1 – t) + xps kcs= 0.4 × 0.12 × (1 – 0.35) + 0.6× 0.17 = 0.1332 = 13.32%

Format: Multiple Choice Learning Objective: LO1,3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective

.

13-31

Fundamentals of Corporate Finance 3e

83.

Test Bank

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. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt.

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) 11.76% C) 11.88% D) 13.32% Ans: D Feedback:

Noting that the proportion of debt and equity is

= 0.4, 000) xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, = 0.6 000) 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(Ri ) = Rrf +  i E(Rm ) − Rrf   E(Ri)=0.08+1.50.14−0.08 = 0.17

The formula forWACC is: WACC = xDebtkDebt pretax(1− t) + xpsk = 0.4  0.12(1−0.35) + 0.6  0.17= 0.1332  cs =13.32%

84.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective 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. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Droz's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places.

A) B) C) D) Ans:

.

10.20% 11.76% 11.88% 13.32% D 13-32

Test Bank

Fundamentals of Corporate Finance 3e

Feedback:

Noting that the proportion of debt and equity is = 0.4, 000) xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, = 0.6 000) 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 ( Ri ) = Rrf +  i E(Rm ) − Rrf   = 0.17 E(Ri)=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 ( YTM/2=6%YTM

+ $1,000PVIF (YTM  /2,14) /2,14)

=12%=k Debt pretax

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

85.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Which type of project do financial managers typically use the highest cost of capital when evaluating?

A) Extension projects B) New product projects Efficiency projects C) Market expansion projects D) Ans: B

86.

.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Briefly explain why the book value of debt might not reflect the current cost of debt for a 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 13-33

Fundamentals of Corporate Finance 3e

Test Bank

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.

87.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 a firm.

Ans:

88.

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Discuss the two major conditions for when a firm may use its current weighted average cost of capital to evaluate a new project's cash flows.

Ans:

.

The first condition that must hold is that the growth rate in dividends must be constant for the foreseeable future of a 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.

a) The first condition is that the proportions of capital (debt, common shares, and preferred shares) that a 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. b) The second condition is that the level of systematic risk inherent in the overall portfolio of projects a firm is currently taking on must be the same as the level of systematic risk for the new project.

13-34

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 14: Working Capital Management

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 2. Net working capital is important because it is a measure of a firm’s 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 Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 3. Working capital management involves making decisions regarding the use and sources of current assets.

A) True B) False Ans: A

.

14-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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

.

14-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 8. Days' payables outstanding (DPO), which tells how long, on average, 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

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 9. Day’s payables outstanding (DPO) is computed as number of days in a year divided by accounts payable turnover.

A) True B) False Ans: A

.

14-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 10. An efficient firm with good working capital management should have a high average collection period compared to that of its industry.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 11. The flexible current asset management strategy calls for management to invest large amounts in cash, short-term investments, and inventory.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 12. The flexible current asset management strategy is perceived to be a high-risk and low-return course of action for management to follow.

A) True B) False Ans: B

.

14-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 13. The restrictive current asset management strategy is a high-risk, high-return alternative to a flexible strategy.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 14. 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 15. 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

.

14-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 17. 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Trade credit is a cheap loan from the supplier.

A) True B) False Ans: B

.

14-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 19. The aging schedule shows the breakdown of the firm's accounts receivable by their date of sale.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 20. The conflict between carrying costs and shortage costs is called the working capital trade-off.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 21. A firm that employs just-in-time management has to increase its investment in working capital.

A) True B) False Ans: B

.

14-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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 Bloomcode: Kno wledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 24. Under the maturity matching strategy, a firm funds all seasonal working capital needs with short-term borrowing.

A) True B) False Ans: A

.

14-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 25. Short term funding strategy calls for all seasonal working capital and a portion of the permanent working capital and 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 27. A factor is an individual or financial institution that buys accounts receivable without recourse.

A) True B) False Ans: A

.

14-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 28. Which 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 current C) 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

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 29. Which of the following statements is NOT true?

A) If cash balances become too small, it may lead the firm to bankruptcy.

B) C) D) Ans:

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

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

The downside of holding too much cash is that the returns on cash are low.

B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 30. 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

.

14-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 31. The cash conversion cycle A) shows how long a firm keeps its inventory before selling it.

B) begins when a firm invests cash to purchase the raw materials that would be used to produce the goods that the firm manufactures. begins when a firm uses its cash to purchase raw materials and ends when the firm C) collects cash payments on its credit sales. estimates how long it takes on average for a firm to collect its outstanding accounts D) receivable balance.

Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 32. Which of the following statements is NOT true?

A) The cash conversion cycle begins when a firm invests cash to purchase the raw materials that would be used to produce the goods that the firm manufactures.

The cash conversion cycle begins when the firm uses its cash to purchase raw B) 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' C) payables outstanding.

D) 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 a firm to pay for its purchases.

Ans: B

.

14-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 33. The operating cycle A) begins when a firm receives the raw materials that would be used to produce the goods B) that the firm manufactures.

C) begins when a firm uses its cash to purchase raw materials and ends when the firm D) collects cash payments on its credit sales. cannot be measured without knowing the days' payables outstanding. does not end 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 34. Which of the following statements is true when managing working capital accounts?

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

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

D) 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 35. Which of the following statements is true? = DSO +DSI + DPO A) Cash conversion cycle B) = DSO +DSI − DPO Cash conversion cycle C) = DSO−DPO Cash conversion cycle D) None of the above.

Ans: B

.

14-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 36. Which of the following statementsNOT is true? = DSO+DSI − DPO A) Cash conversion cycle B) = DSO +DSI Operating cycle C) Both A and B D) None of the above Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 37. 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:

= DSO + DSI Operating cycle = 32+ 10 = 42 days

.

14-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 38. 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 your final answer to the nearest dollar.

A) $9,190 B) $14,68 C) 5 D) $29,10 Ans: C5 $69,33 Feedback: 9 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: Hard Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 39. 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 your final answer to the nearest dollar.

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

receivables Accounts receivablesAccounts = 50 days = $433,450365 Credit sales365 Accounts receivables = 50$1,187.53=$59,376.71

DSO=

.

14-14

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 40. 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)? Round your answers to the nearest whole number.

A) 43 B) days C) 32 D) days Ans: A49 days Feedback: 26 Inventory = $44,233 DSI= days =31.5 days

COGS 365

$512,902 365

Operating cycle = DSO + DSI DSO = Operating cycle – DSI = 74 – 31.5 = 42.5 days OR 43 days

Reference: 14-1: Use the following information to answer questions 41-42: You are provided the following working capital information for the Ridge Company: Ridge Company Account Inventory $12,890 Accounts receivable 12,800 Accounts payable 12,670 Credit sales Cost of goods sold

.

$124,589 99,630

14-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-1 41. What is the operating cycle for Ridge Company? Round your final answer to the nearest whole number.

A) 47 B) days C) 85 D) days Ans: B36 days Feedback: 51 days

OR 85 days.

.

14-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-1 42. What is the cash conversion cycle for Ridge Company? Round your final answers to one decimal place.

A) 83.5 days B) 38.3 days C) 129.9 D) days 46.4 Ans: Bdays Feedback:

.

14-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 43. Wolfgang Electricals estimates that the company takes 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: Cash conversion cycle = DSO + DSI – DPO = 34 + 54 – 31 = 57 days

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 44. Renald Corp. estimates that the company takes 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 C) days 57 D) days 46 Ans: Adays Feedback: Cash conversion cycle = DSO + DSI – DPO = 45 + 43 – 27 = 61 days

.

14-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 45. 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 credit 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:

DSO= Accounts receivables = $97,900 =110.3 days Credit sales365 $324,000365

$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

OR 125 days

.

14-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 46. 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. Do not round your intermediate calculations.

A) $34,087 B) $126,90 C) 0 D) $71,203 Ans: A$56,322 Feedback: Net sales = $423,000 Credit sales = (0.3 × $423,000) = $126,900

= (DSO+DSI ) − DPO Cash conversion cycle 47.9 = 86.3 − DPO DPO = 38.4 days DPO =

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

Accounts payables= 38.4 $887.67= $34, 086.53 OR $34,087 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 47. The flexible current asset investment strategy A) has a high percent of current assets to sales, is generally perceived to be a low-risk and low-return course of action.

B) calls for management to invest large amounts in cash, short-term investments, and inventory.

C) leads to high levels of accounts receivable.

D) All of the above Ans: D

.

14-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 48. Which 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 strategy calls for management to invest large amounts in cash, short-term C) investments, and inventory.

D) The 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

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 49. A restrictive current asset investment strategy calls for A) levels of current assets kept to a minimum.

B) a firm barely investing in cash, marketable securities 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 50. The restrictive current asset management 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 shortage costs.

D) None of the above Ans: A

.

14-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 51. Which of the following statements is true?

A) Financial shortage costs arise mainly from illiquidity—shortage of cash or a lack of B) 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 52. 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 credit policies.

D) All of the above.

Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 53. Which of the following statements about working capital trade-off is true?

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

C) If carrying costs are greater than shortage costs, then the firm will maximize value by D) 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

.

14-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 54. Which 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 an B) optimal management strategy.

C) If carrying costs are smaller than shortage costs, then the firm will maximize value by D) 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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 55. The aging schedule A) shows the breakdown of a firm's accounts receivable by their date of sale.

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

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

D) All of the above.

Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 56. Which of the following statements is NOT true?

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

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

An informal line of credit is a special type of collateralized loan.

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

Ans: C

.

14-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 57. Senter Corp. sells its goods with terms of 2/10 EOM, net 30. What is the implicit cost of the trade credit? Round your final percentage answer to 2 decimal places. Do not round your intermediate calculations.

A) 18.50% B) 30.00% C) 44.59% D) 21.89% Ans: C Feedback: Credit terms = 2/10 EOM, net 30 Effective annual rate = (1 + (Discount / Discounted price)) 365 / days credit – 1 = (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 Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 58. Kearns, Inc. sells its goods with terms of 3/15 EOM, net 60. What is the implicit cost of the trade credit? Round your final answer to the nearest whole percent. Do not round your intermediate calculations.

A) 15% B) 45% C) 34% D) 28% Ans: D Feedback: Credit terms = 3/15 EOM, net 60 Effective annual rate= (1 + (Discount / Discounted price))365 / days credit – 1 = (1 + 3 / 97)365/45 – 1 = (1.0309)8.1111 – 1 = 1.2800 – 1 = 0.28, or 28%

.

14-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 59. Which of the following statements is true of economic order quantity (EOQ)?

A) The EOQ mathematically determines the minimum total inventory cost.

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

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

D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 60. Which of the following statements is NOT true of economic order quantity (EOQ)?

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

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

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

The EOQ is directly proportional to the sales per period.

Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 61. Which of the following statements about just-in-time inventory managementNOT policy is true?

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

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

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

C) It eliminates obsolescence or loss to theft.

D) Ans: C

.

14-25

Fundamentals of Corporate Finance 3e

Test Bank

Reference 14-2: Use the following to answer questions 62-63: 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.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-2 62. What is the number of cars per order? Round your final answer to the nearest whole number.

A) 80 cars B) 101cars C) 58 cars D) 113 cars Ans: C Feedback:

EOQ = =

 per period 2 Reorder costsSales Carrying cos ts

2  $1,100  700 = 113.3 $120

The number of cars per order = 113 cars.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-2 63. How many orders will the dealer need to place this year? Round your answer to the whole number.

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

Number orders

.

14-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 64. 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, calculate the optimal order size using the EOQ formula. Round your final answer to nearest whole number.

A) 124 clocks B) 161 clocks C) 15,294 D) clocks Ans: A26,154 clocks Feedback:

EOQ = =

 Sales per period 2  Reorder costs Carryingcosts

2$6510,000 = 123.7 $85

The optimal order size = 124 clocks.

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 65. Which 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 and B) 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 collection time.

Processing delay is one of the components of the collection time.

Ans: C

.

14-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 66. 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 sales on average are $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 the opportunity cost of funds is 5 percent. What will the firm's savings be from using the lockbox?

A) $3,427.50 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 Opportunity cost of funds = 0.05 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) × 0.05 = $68,550 × 0.05 = $3,427.50

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 67. 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 your final answer to the nearest dollar.

A) $3,621 B) $2,389 C) $39,82 D) 0 Ans: B$1,100 Feedback: Average daily sales = $18,100 Collection time saved = 2.2 days Savings from mail float = 2.2 days × $18,100 = $39,820 Savings from the lockbox = $39,820 × 0.06 = $2,389

.

14-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 68. Which of the following statements about maturity matching strategy is true?

A) All seasonal working capital needs are funded with short-term borrowing.

B) As the level of sales varies seasonally, short-term borrowing fluctuates with the level of C) seasonal working capital.

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 Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 69. Which of the following statements about short-term funding strategy is true?

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

C) The downside to this strategy is that a portion of a firm’s long-term assets must be D) periodically refinanced over their working lives.

It can take advantage of an upward-sloping yield curve and lower a firm’s overall cost of funding.

All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 70. Which of the following statements is NOT true?

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

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

All permanent working capital and fixed assets are funded with long-term debt when firms use a maturity matching strategy.

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

Ans: A

.

14-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. 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? Round your final percentage answer to two decimal places.

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 × 0.08 = $4,000 Effective borrowing amount = $50,000 – $4,000 = $46,000 Interest expense = $50,000 × 0.085 = $4,250 Effective interest rate = Interest expense / Effective borrowing amount = $4,250 / $46,000 = 9.24%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. 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? Round your final percentage answer to two decimal places.

A) 10.00% B) 11.11% C) 8.00% D) 12.50% Ans: B Feedback: Amount to be borrowed = $63,000 Stated annual interest rate = 10% Compensating balance = 10% Amount deposited as compensating balance = $63,000 × 0.10 = $6,300 Effective borrowing amount = $63,000 – $6,300 = $56,700 Interest expense = $63,000 × 0.10 = $6,300 Effective interest rate = $6,300 ÷ $56,700 = 11.11%

.

14-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. Good Homes Furnishings is borrowing $225,000. The loan requires a 10 percent compensating balance, and the effective interest rate on loan is 8.25 percent. What is the stated APR on this loan? Round your final percentage answer to two decimal places. Do not round your intermediate calculations.

A) 10.00% B) 11.11% C) 7.43% D) 8.25% Ans: C Feedback: Amount to be borrowed = $225,000 Effective interest rate = 8.25% Compensating balance = (0.10 × $225,000) = $22,500 Effective borrowed amount = $225,000 – $22,500 = $202,500 Interest expense = Effective interest rate × Effective borrowing amount = 0.0825 × $205,500 = $16706.25.

Stated interest rate = $16,706.25 / $225,000 = 7.43%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. 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 your final percentage answer to 1 decimal place. Do not round your intermediate calculations.

A) 10.0% B) 9.5% C) 7.4% D) 8.5% Ans: B Feedback: Amount to be borrowed = $375,000 Compensating balance = (0.08 × $375,000) = $30,000 Effective interest rate = 10.326% Effective borrowed amount = $375,000 – $30,000 = $345,000 Interest expense = Effective interest rate × Effective borrowing amount = 0.10326 × $345,000 = $35,625.

Stated interest rate = $35,625 / $375,000 = 9.5%

.

14-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. 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? Round your final percentage answer to 2 decimal places.

A) 8.00% B) 7.25% C) 6.58% D) 8.25% Ans: C Feedback: Line of credit limit = $1,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.5% Amount borrowed = $600,000 Unused balance = $400,000 Annual fee = $400,000 × 0.005 = $2,000 Interest expense = $600,000 × 0.0625 = $37,500 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($37,500 + $2,000) / $600,000 = 6.58%

.

14-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. 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 your final percentage answer to one decimal place.

A) 8.5% B) 7.2% C) 9.0% D) 8.1% Ans: D 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 × 0.005 = $13,500 Interest expense = $2,300,000 × 0.075 = $172,500 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($172,500 + $13,500) / $2,300,000 = 8.09% OR 8.1%

77.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 your final percentage answer to two decimal places.

A) 7.50% B) 6.45% C) 6.25% D) 7.15% Ans: B Feedback: Line of credit limit = $2,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.6% Amount borrowed = $1,500,000

.

14-33

Fundamentals of Corporate Finance 3e

Test Bank

Unused balance = $500,000 Annual fee = $500,000 × 0.006 = $3,000 Interest expense = $1,500,000 × 0.0625 = $93,750 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($93,750 + $3,000) / $1,500,000 = 6.45%.

78.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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? Round your percentage answer to one decimal place.

A) 35.5% B) 32.9% C) 27.8% D) 31.1% Ans: A Feedback: Accounts receivables sold = $150,000 Factor discount = 2.875% Simple monthly interest cost of factoring = 2.875 / (100 –2.875) = 2.875 / 97.125 = 0.0296 Simple annual interest cost of factors loan = 0.0296 × 12 = 35.5%.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. 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 × 0.03 = $3,750

.

14-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. 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: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 81. What are some strategies that financial managers can follow in managing their working capital accounts?

Ans: When managing working capital accounts, financial managers need to do the following: Delay paying accounts payable as long as possible without suffering any penalties.

Maintain minimal raw material inventories without causing manufacturing delays.

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

Maintain minimal finished goods inventories without losing sales.

Offer customers the most attractive credit terms possible on trade credit to maximize sales while minimizing the risk of nonpayment.

Collect cash payments on accounts receivable as fast as possible to close the loop.

.

14-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 82. Explain working capital trade-off.

Ans: The optimal current asset management strategy of a firm 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 out 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 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 83. How does a just-in-time inventory management work?

Ans: In a just-in-time 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 material 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.

.

14-36

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 15 How Firms Raise Capital Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. Most businesses are started when an entrepreneur who has a vision is given seed funding by institutional investors.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. The initial seed money usually comes from the entrepreneur or other founders.

A) True B) False Ans: A

.

15-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. The bootstrapping period usually lasts for at least five years.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. Venture capitalists are individuals or firms that help privately held businesses by providing funds in the bootstrapping process.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. Angel investors are investors who come to the rescue of firms threatened by takeovers.

A) True B) False Ans: B

.

15-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Traditional sources of funding, such as from financial and insurance firms, work for new or emerging businesses despite the presence of only intangible assets.

A) True B) False Ans: B

.

15-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. A venture capitalist may exit an investment by selling common stock in an initial public offering.

A) True B) False Ans: A

.

15-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

15-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. Underwriting is the risk-bearing part of investment banking.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

15-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. In a best-effort offering, the underwriter promises to make its “best effort” to sell all securities at a certain price.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. Underpricing is defined as offering new securities for sale at a price below their true value.

A) True B) False Ans: A

.

15-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. If the offer price is set too high, the issuing firm will lose under a best-effort agreement.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

15-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25. Bootstrapping and venture capital financing are part of the public market operations of a business.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 27. The biggest drawback of private placements involves restrictions on the resale of the securities.

A) True B) False Ans: A

.

15-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Transactions, in which a public company sells unregistered stock to an investor, such as a hedge fund or some other institutional investor, are called PIPE transactions.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 29. The major disadvantage of a PIPE transaction to issuers is that the funding cost is higher as compared to making a public offer.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

15-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31. The initial seed money usually 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32. Bootstrapping is the process by which A) many entrepreneurs raise seed money and obtain other resources necessary to start their businesses. the entrepreneur often fleshes out his or her ideas and makes them operational.

B) most businesses are started by an entrepreneur.

C) None of the above D) Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. Which of the following statements is NOT true?

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

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

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

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

D) Ans: D

.

15-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. Which of the following statements is true?

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

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

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

C) All of the above statements are true.

D) Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. Which of the following statements is NOT true?

A) Venture capitalists bear a substantial amount of risk when they fund a new business.

B) Venture capitalists’ sole function is to provide financing for new firms.

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

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

D) Ans: B

.

15-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. Tactics that venture capitalists use to reduce the risk of their investment include A) funding the ventures in stages, requiring entrepreneurs to take charge of all important business decisions . funding the ventures completely in the beginning, requiring entrepreneurs to make B) personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize. funding the ventures in stages, requiring entrepreneurs to make personal investments, C) syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize.

None of the above D) Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Which of the following statements is NOT true?

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

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

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

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

Ans: B

.

15-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 acceptable.

D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 public.

B) selling to a strategic buyer, selling to a financial buyer, and buying out the founder.

C) selling to a strategic buyer, selling to a financial buyer, and offering stock to the public.

D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. A typical venture capital fund may generate annual returns of A) 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.

12 percent on the money that it invests, compared with an average annual return for the B) S&P 500 of about 20 percent.

12 percent on the money that it invests, compared with an average annual return for the C) S&P 500 of about 25 percent.

None of the above D) Ans: A

.

15-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Advantages of going public include all EXCEPT A) larger amount of capital can be raised this way than the amount that can be raised through private sources. the cost of going public is less compare to debt financing.

B) going public can enable an entrepreneur to fund a growing business without giving up C) control. additional equity capital can usually be raised through follow-on seasoned public D) offerings at a low cost.

Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. Which 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 that can be raised through private sources.

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

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

Ans: C

.

15-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. 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 stock sale.

B) the investment banker actually buys the stock from the firm.

C) 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 D) underwriter pays.

Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. With a best-effort underwriting A) the investment banking firm makes no guarantee to sell the securities at a particular price. the investment banker does not bear the price risk associated with underwriting the issue.

B) the compensation is based on the number of shares sold.

C) All of the above D) Ans: D

.

15-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Which of the following statements is NOT true?

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

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

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

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

Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. Basic services investment bankers provide when bringing securities to market include A) origination.

B) underwriting.

C) distribution.

D) All of the above Ans: D

.

15-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following statements is NOT true?

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

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

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

D) Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

15-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 the first day of trading. priced between 10 and 15 percent above the price at which they close at the end of the B) first day of trading. priced between 10 and 15 percent below the price at which they close at the end of the C) first day of trading. priced between 2 and 5 percent above the price at which they close at the end of the first D) day of trading.

Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. 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. What is the underpricing spread?

A) $51 million B) $15 million C) $66 million D) None of the above Ans: B Feedback: Underwriter's gross spread ($22 − $17) = $5 per share.

Number of shares sold = ($66 million ÷ $22 per share) = 3 million.

Underwriting cost = ($5 per share × 3.0 million shares) = $15.0 million

.

15-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. 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. What is the underpricing on this issue?

A) $9,900,000 B) $24,900,000 C) $15,000,000 D) None of the above Ans: A Feedback: Stock price at end of the first day = $22(1.15) = $25.30 First-day underpricing = ($25.30 − $22) = $3.30 per share.

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

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. 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. 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 above Ans: C Feedback: Total cost to the firm of selling the IPO = $15,000,000 + $350,000 + $9,900,000 = $25,250,000

.

15-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. 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? (Round your intermediate calculations to two decimal places.)

A) $13.60 million B) $20.60 million C) $6.94 million D) $7.57 million Ans: C Feedback: Stock price at end of the first day = $19.30 × (1.18) = $22.77 First-day underpricing = ($22.77 – $19.30) = $3.47 per share.

Number of shares outstanding = ($38.6 million ÷ $19.3 per share) = 2 million.

Total underpricing = ($3.47 per share × 2,000,000 shares of stock) = $6,940,000

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. 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) $6.94 million D) None of the above Ans: A 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 × 2.0 million shares) = $13.6 million

.

15-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. 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) $13,606,000 B) $20,818,000 C) $20,610,000 D) None of the above Ans: B Feedback: Stock price at end of the first day = $19.30 (1.18) = $22.774 First-day underpricing = ($22.774 − $19.30) = $3.474 per share.

Total underpricing = ($3.474 per share × 2,000,000 shares of stock) = $6,948,000 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 × 2.0 million shares) = $13.6 million Total cost to the firm of selling the IPO= $13,600,000 + $270,000 + $6,948,000 = $20,818,000

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. 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 million C) $20.6 million D) $22.8 million Ans: D Feedback: Change in price on the 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

.

15-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58. Bethesda Biosys issues an IPO on a best-effort basis. The company's investment bank demands a spread of 18 percent of the selling price. The average selling price remains at $25 per share.

Four million shares are issued. What are the net proceeds for the issuer?

A) $82 million B) $92 million C) $100 million D) None of the above Ans: A Feedback: Underwriting spread = $25 × 0.18 = $4.5 Proceeds to issuer = ($25 – $4.5) × 4 million = $82 million

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank demands a spread of 20 percent of the selling price. Five million shares are issued. The average selling price remains at $31. What are the net proceeds per share for the issuer?

A) $27.50 B) $22 C) $31 D) $24.8 Ans: D Feedback: Number of shares issued = 5 million Underwriting spread = 20% × $31 = $6.2 Proceeds to issuer = ($31 – $6.2) = $24.8 per share

.

15-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank demands a spread of 20 percent of the selling price. Five million shares are issued. The average selling price remains at $31. How much did the investment bank receive?

A) $22.0 million B) $27.5 million C) $31.0 million D) None of the above Ans: C Feedback: Underwriting spread = 20% × $31 per share × 5 million shares = $31 million Proceeds to underwriter = $31 million

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. Dienz Pharma plans to issue an IPO on a best-effort basis. The company's investment bank demands a spread of 16 percent of the selling price. The selling price is $32 per share. Three million shares are issued. What are the proceeds for the issuer?

A) $96.00 million B) $78.75 million C) $80.64 million D) None of the above Ans: C Feedback: Number of shares issued = 3 million Underwriting spread = $32 × 0.16 = $5.12 Proceeds to issuer = ($32 – $5.12) × 3 million shares = $80.64 million

.

15-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. The most likely reason that underpricing of new issues occurs more frequently than overpricing is the: Underwriters’ desire to reduce the risk of a firm commitment.

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

B) Underwriters earn low rates of return.

C) Issuing firms demand that equity be underpriced.

D) Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. 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 Feedback: Stock price at end of the first day = $61.00 First-day underpricing = ($61.00 – $50.00) = $11.00 per share.

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

Underwriting cost = ($6.00 per share × 500,000 shares) = $3 million Total cost to the firm of selling the IPO= $3,000,000 + $600,000 + $5,500,000 = $9,100,000

Format: Multiple Choice Learning Objective: LO 5

.

15-25

Fundamentals of Corporate Finance 3e

Test Bank

Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Which of the following statements is NOT true?

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

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

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

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

D) Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. Which of the following statements is NOT true of shelf registration?

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 sell them as needed.

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

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

Ans: A

.

15-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. 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 raise capital as needed. a shelf registration statement can cover multiple securities, but there is a penalty if C) authorized securities are not issued. costs associated with selling the securities are reduced because only a single registration D) statement is required.

Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. 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? (Round your final answer to the nearest unit of share.)

A) 1,358,081 shares B) 1,276,596 shares C) 1,200,000 shares D) None of the above Ans: A Feedback: 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

.

15-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. Why is the total cost of bringing a general cash offer to the market lower than issuing an IPO? A) General cash offer does not include a large underpricing B) Underwriting spreads are smaller in case of general cash offer C) There is less risk involved with a general cash offer than an IPO D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. Which 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.

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

B) The biggest drawback of private placements involves restrictions on the resale of the C) securities.

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

Ans: B

.

15-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. Which 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.

In private placements, there are no restrictions on the resale of the securities.

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

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

D) Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Advantages of private placements include A) lower cost of funds.

B) more willingness among private lenders 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

.

15-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Which of the following statements is NOT true?

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

Private equity firms invest in more mature companies.

B) Agency problems tend to be more in firms owned by private equity investors than in C) public firms.

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

Ans: C

Format: Multiple Choice Learning Objective: LO 6 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Level of Difficulty: Medium 73. 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 the firm's management team. facilitating mergers and acquisitions that help improve the competitive positions of the C) companies in which they invest.

All of the above D) Ans: D

.

15-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. Which of the following statements is NOT true of PIPE transactions?

A) PIPE transactions are registered with the SEC. B) PIPE transaction gives issuers faster access to capital.

C) 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 D) they would sell in the public markets.

Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Which of the following statements is true of PIPE transactions?

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

As part of the PIPE contract, the company often agrees to register the restricted securities B) 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 C) 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 D) investment bank but result in a cost increase of 7 to 8 percent of the proceeds.

Ans: B

.

15-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. 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% B) 8.25% C) 9.75% D) None of the above Ans: C Feedback: Prime rate = PR = 7.5% Maturity risk premium = MAT = 0.75% Default risk premium = DRP = 1.5% The loan rate = k = PR + DRP + MAT = 7.5% + 1.5% + 0.75% = 9.75%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. 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 rate plus 2 percent. 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 both the firms?

A) 6.45% for Firm A, 7.75% for Firm B B) 6.45% for Firm A, 8.45% for Firm B C) 5.75% for Firm A, 8.45% for Firm B D) None of the above Ans: B Feedback: Prime rate =PR = 5.75%; Maturity risk premium = MAT = y10-year − yT-bill = 4.24% − 3.54% = 0.70% Borrowing rate for Firm A = kA = Prime rate + MAT = 5.75% + 0.70% = 6.45% Borrowing rate for Firm B = kB = Prime rate + 2% + MAT = 5.75% + 2% + 0.70% = 8.45%

.

15-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. 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% B) 7.225% C) 6.500% D) None of the above Ans: A Feedback: Prime rate =PR = 6.5%; Default risk premium = DRP = 1.5% Maturity risk premium = MAT = y5-year − yT-bill = 4.25% − 3.25% = 0.725% Borrowing rate for firm A = ki = PR +DRP+ MAT = 6.5% + 1.5% + 0.725% = 8.725%

.

15-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. 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 for this transaction?

A) 4.55% B) 5.05% C) 7.75% D) 9.55% Ans: B Feedback: ki = 2.75 + 1.80 + 0.50 = 5.05%

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 highrisk investments, and much of their risk-averse behavior is mandated in regulations that restrict their conduct.

Second, 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. New firms whose primary assets are often intangibles, such as patents or trade secrets, find it difficult to secure financing from traditional lending sources.

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,

.

15-34

Fundamentals of Corporate Finance 3e

Test Bank

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.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 giving up control. · After the IPO, there is an active secondary market in which stockholders can buy and sell i shares. · Publicly traded firms find it easier to attract top management talent and to better motivat current managers if a firm's stock is publicly traded.

There are also several disadvantages of 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 represent a 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 a quarterly financial statements encourages managers to focus on short-term profits rather long-term wealth maximization.

.

15-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 advantages of a PIPE transaction to issuers are 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.

.

15-36

Fundamentals of Corporate Finance 3e

Test Bank

Chapter: 16 Capital Structure Policy Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. A higher fraction of debt indicates a lower degree of financial leverage.

A) B) True Ans: False B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. When calculating free cash flow, it is important to include interest and principal payments.

A) True B) False Ans: B

.

16-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. The enterprise value of a firm is the value of equity minus the value of debt.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

16-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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: LO2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Under the M&M assumptions with taxes, the value of a 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

.

16-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. 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

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. Issuing debt is less expensive than issuing stock.

A) True B) False Ans: A

.

16-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

16-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Unlike direct bankruptcy costs, indirect costs are not considered transaction costs.

A) True B) False Ans: B

.

16-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. Indirect bankruptcy costs will often increase when a firm is in financial stress and it may even push the company into bankruptcy.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. More debt in a firm’s 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: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders.

A) True B) False Ans: A

.

16-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. Without debt in the capital structure, there are no asset substitution or underinvestment problems.

A) True B) False Ans: A

.

16-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2,3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 27. Firms have a difficult time selling equity when it is in financial distress.

A) True B) False Ans: A

.

16-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Industries with large amounts of tangible assets typically use little debt.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30. Managers often focus on cash flows, but reported accounting earnings are a better indicator of a firm's economic health.

A) True B) False Ans: B

.

16-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO Appendix Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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) common stock.

B) bonds.

C) equity options.

D) preferred stock.

Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. The optimal capital structure of a firm A) minimizes the cost of financing the firm's projects.

B) minimizes interest payments to creditors.

C) maximizes overall value of the firm.

D) Both A and C. Ans: D

.

16-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. M&M Proposition 1 assumes all of the following except that, A) there are no taxes.

B) there are no costs to acquire information.

C) there are no transactions costs.

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

Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. A firm's enterprise value is given as: 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. A financial restructuring A) will not change the value of a firm's real assets under M&M Proposition 1.

B) includes financial transactions that change the capital structure of the firm.

C) means that a firm has issued equity to retire debt.

D) Both A and B. Ans: D

.

16-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 long term debt and the cost of equity.

C) the cost of any long term 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. M&M Proposition 2 states that the cost of a firm's common stock is directly 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) Both A and B. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. According to M&M Proposition 2, the cost of a firm's equity A) increases with the increase of debt-to-equity ratio.

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

C) increases with the increase of cost of debt.

D) decreases with increase of required rate of return on the firm's underlying assets.

Ans: A

.

16-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. Financial risk A) refers to the effect that a firm's financing decisions have on the riskiness of the cash flows that the stockholders will receive. increases a firm's business risk.

B) decreases a firm's business risk.

C) is related to how debt affects the business decisions of a firm.

D) Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 firm’s real investment decisions, such as R&D and PP&E. Information or transaction costs.

C) All of the above D) Ans: D

.

16-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. 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. How much is Dynamo worth today?

A) $1,765 B) $1,500 C) $2,143 D) None of the above Ans: B Feedback:

V

Firm

=

CF $150 = =$1,500 i 0.1

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. 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. How much are your cash flows today?(Round the answer to two decimal places.)

A) $12.38 B) $15 C) $4.50 D) $150 Ans: A Feedback:

V

Firm

=

CF $150 = = $1,500 i 0.1

Cash flows to stockholders = Cash flows – Interest payments = $150 − ($1,500) × (0.25) × (0.07) = $123.75 Therefore, your 10% share = $123.75 × 0.1 = $12.375 OR $12.38

.

16-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. 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. 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 stockholders, how much debt should they issue?

A) $321 B) $375 C) $600 D) $225 Ans: D Feedback:

V

Firm

=

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 − $375 = $225

.

16-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. 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. How much does Dynamo currently pay as 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 $37.50 D) $37.50 and $60 Ans: B Feedback:

V

Firm

=

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1500 = $375 Interest payment on debt before restructuring = $375 ×$26.25 0.07 = Total debt after restructuring = 0.4 × $1,500 = $600 Interest payment on debt after restructuring = 0.07 × $42 $600 =

.

16-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. 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. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per annum after the restructuring as per the M&M Proposition 1?

A) $15 and $60 B) $60 and $15 C) $10.80 and $22.50 D) $22.50 and $10.80 Ans: D Feedback:

V

Firm

=

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 Interest payment on debt after restructuring = 0.07 × $600 = $42 Cash flows to you after restructuring = 0.10 × ($150 − $42) = $10.80 Note: $42 = Interest payment on debt after restructuring.

.

16-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. 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. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1?

A) Sell $22.50 of stock B) Sell $10.80 worth of stock C) Buy $22.50 worth of debt D) Buy $10.80 worth of debt Ans: C Feedback:

V

Firm

=

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy that much of the new debt issuance.

.

16-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. 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. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows?(Do not round intermediate calculation. Round the final answer to two decimal places.)

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:

V

Firm

=

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 Interest payment on debt after restructuring = 0.07 × $600 = $42 Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80 Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 = $1.575 in interest payments. Since you will receive $10.80 in dividends after the restructuring, your total cash flows are $1.575 + $10.80 = $12.38, the same as before the restructuring.

.

16-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. Cadmium Electronics 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) 9.2% Ans: C Feedback: WACC = xDebt kDebt + xEquity kEquity = (0.40 × 0.08) + (0.60 × 0.12) = 0.104 OR 10.4%

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. 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% B) 10% C) 11% D) None of the above.

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 OR 11%.

.

16-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Swirlpool, Inc. has a WACC of 11%, cost of debt of 8%, and a cost of equity of 12%. What must the debt-to-equity ratio be?

A) 1/2 B) 1/4 C) 1/6 D) 1/3 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 × 0.08 + (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.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. 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) 6.35% C) 8.80% D) 7.44% Ans: A Feedback: WACC with taxes = xDebt kDebt pretax (1 − t) + xEquity kEquity = (0.30 × 0.06 × (1 − 0.35)) + (0.70 × 0.10) = 0.0817 OR 8.17%.

.

16-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. A firm has $300 million in outstanding debt and $900 million 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 OR 10%.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. 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 is of 35%. What percent of the firm’s capital structure is financed with equity?

A) 50% B) 60% C) 70% D) None of the above.

Ans: B Feedback: WACC = 0.085 = (1 − xEquity)kDebt (1 − t) + xEquity kEquity 0.085 = (1 − xEquity) × 0.05 × (1 − 0.35) + (xEquity × 0.12) Solving for xEquity gives you 0.60 OR 60%.

.

16-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity?

A) 12.15% B) 13.15% C) 14.15% D) None of the above.

Ans: B Feedback: kcs = kAssets + (D/E) (kAssets − kDebt) = 0.12 + (1/5) × (0.12 − 0.0625) = 0.1315 OR 13.15%.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. 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 its debt to 7%?

A) 14% B) 14.25% C) 14.50% D) 15% Ans: A Feedback: kcs = kAssets + (D/E) (kAssets − kDebt) = 0.12 + (2 / 5) (0.12 − 0.07) = 0.14 OR 14%.

.

16-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. 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 include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.)

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 + COGS) = ($100 + ($700) (0.05)) / ($100 + ($700) (0.05) + $400) = 25.23%.

Therefore, variable cost percentage is: $400 / ($100 + ($700) (0.05) + $400) = 0.747664 OR 74.77%.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58. 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 include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What is the net income of Banana without and with the debt?

A) $500 and $484.2 B) $484.2 and $500 C) $500 and $465 D) $490 and $500 Ans: C Feedback: Without debt, net income = $1000 − $400 − $100 = $500 With debt, net income = $1000 − $400 − $100 – ($700 × 5%) = $465

.

16-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. 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 include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. Suppose, revenues fall by $300, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same.(Round the answer to one decimal places.)

A) 64.5% and 60% B) 60.0% and 64.5% C) 59.2% and 40.8% D) 40.8% and 59.2% Ans: B Feedback: Without debt, net income = $1000 – $400 – $100 = $500 With debt, net income = $1000 – $400 – $100 – ($700 × 5%) = $465 Without debt, the new net income = $700 − $400 − $100 = $200 Therefore, the percentage change = ($500 − $200) / $500 = 60% With debt, the new net income = $700 − $400 − $100 − $35 = $165 Therefore, the percentage change = ($465 − $165) / $465 = 64.5%

.

16-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. Suppose a firm has a cost of equity of 12%, a D/E ratioof 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?(Round the answer to one decimal place of percentage.)

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%) ➔ kAssets = 11.4% Note that, if D/E ratio changes, kAssets does not change. The new cost of equity is then given as: kcs = 11.4% + (1/3)(11.4% − 7.5%) = 12.6%

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. 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 stockholders. Using the perpetuity model, calculate the value of the firm without debt in the capital structure.

Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar.

A) $350 B) $650 C) $2,917 D) $5,417 Ans: D Feedback: VFirm = [ CF × (1 − t)] / i = [$1,000 × (1 − 0.35) ] / 0.12 = $5,417

.

16-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. 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 stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual.

A) $5,417 B) $5,942 C) $6,392 D) None of the above Ans: B Feedback: VFirm = [ CF × (1 – t)] / i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417 PV of tax shield = $1,500 × 0.35 = $525 VFirm = V Unleveraged+ PV of the tax shield = $5,417 + $525 = $5,942

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. The interest tax shield A) does not affect the WACC. B) makes it less costly to distribute cash to the investors through interest payments than through dividends. is given as: D × (1 − t).

C) Both B and C D) Ans: B

.

16-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. 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 Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. 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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. The use of debt financing A) causes a manager to take on riskier projects in order to make interest payments.

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

C) allows managers to make discretionary interest payments.

D) limits the ability of managers to waste stockholders’ money.

Ans: D

.

16-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. Which of these statements about direct bankruptcy costs is NOT true?

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

Direct bankruptcy costs are less than indirect bankruptcy costs.

B) Direct bankruptcy costs include payments to suppliers on delivery.

C) Direct bankruptcy costs can be reduced by negotiating with lenders.

D) Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. 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 honored.

B) Employees begin to leave the firm.

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

D) A bankruptcy judge orders new projects to be halted.

Ans: C

.

16-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. The use of debt financing A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take. increases agency costs between the stockholders and management by limiting the amount B) of risk the managers take. increases agency costs since managers prefer to keep more retained earnings rather than C) paying dividend.

Both B And C D) Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. The asset substitution problem occurs when A) managers substitute more risky assets for less risky ones to the detriment of bondholders.

B) managers substitute less risky assets for more risky ones to the detriment of bondholders.

C) managers substitute more risky 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.

D) Ans: A

.

16-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. 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 instead of equity holders. the value of investing in a positive NPV project is likely to go to equity holders instead B) of debt holders. management invests in negative NPV projects to reduce their own risk.

C) issuing equity becomes difficult due to increased risk.

D) Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 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 B) $272 C) $259 D) None of the above Ans: A Feedback: After-tax earnings = (Earnings − Interest payments)×(1 − t) Interest payment = $2,000 × 8% = $160 = ($500 − $160) × (1 − 0.3) = $238

.

16-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. A firm plans to issue $1 million worth of debt at an 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 B) $22,500 C) $32,500 D) None of the above Ans: B Feedback: Tax shield = D × kDebt × t = $1,000,000 × 0.09 × 0.25 = $22,500

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. A firm plans to issue $1 million worth of debt at an 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) $350,000 D) $227,500 Ans: C Feedback: VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

.

16-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project?

A) $100 million B) $80 million C) $20 million D) $8 million Ans: C Feedback: Value of Equity of UBM = Value of risk-free debt owner − Value of bonds maturing = $100 million – $80 million = $20 million

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt?

A) $100 million B) $88.8 million C) $48.8 million D) None of the above Ans: C Feedback: E[VBonds] = (0.60 × $80 million) + (0.40 × $2 million) = $48.8 million

.

16-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt?

A) $175 million B) $97.5 million C) $51 million D) $40 million Ans: D Feedback: E[VEquity] = ((0.60 × $200 million) − $80 million) + (0.40 × $0 million) = $40 million

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. 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 ×( $200 million – $80 million)) + ((1 − PSuccess) × $0) = $20 million (PSuccess × ($200 million − $80 million)) = $20 million Therefore, PSuccess must be 1 / 6.

.

16-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. Suppose that, JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm’s management has just identified a project that will require an initial outlay of $10 million and will return a NPV of $16 million, risk-free. The firm currently has no cash.

What would be the net return to stockholders if they took on this project? −$10 million A) $0 million B) $26 million C) $70 million D) Ans: A Feedback: If it takes on the project, the firm will receive its $10 million back, along with the $16 million.

This gives the firm assets worth $96 million, which is still less than the value of outstanding debt. Therefore, the shareholders would be out the $10 million of equity that the firm had to sell in order to take on the project.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. 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) Both A and B Ans: C

.

16-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 81. A firm wishes to undertake a project that costs $150 million. It currently has $10 million in cash on hand and believes that it can raise $75 million in debt and $100 million 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 $10 million. 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, $75 million / $150 million = 0.5 OR 50%.

Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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

.

16-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 83. Which of the following would arise if 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 Appendix Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 84. Which of the following arises when the lessee can have the incentive to use the asset more than the lessor would prefer?

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.

D) All of the above.

Ans: D

.

16-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 LMNO’s 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?(Do not round the intermediate calculation.

Round off final answer to the nearest dollar.)

A) Purchase, the company will be $4,416 better off 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 Ans: B Feedback: Purchase: After-tax annual interest expense = $50,000 × 0.09 × (1 – 0.3) = $3,150 Annual depreciation = $50,000 / 5 = $10,000, so annual tax savings = $10,000 × 0.3 = $3,000 After-tax annual maintenance cost = $1,200 × (1 – 0.3) = $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) After-tax cost of debt = 0.09(1 – 0.3) = 0.063 NPV of after-tax cash flows = (-$990 / 1.063) + (-$990 / 1.0632) + (-$990 / 1.0633) + (-$990 / 1.0634) + (-$50,990 / 1.0635) = $($40,975.07) Lease: After-tax annual lease payment = $12,500 × (1 – 0.3) = $8,750 Interest rate pre-tax = 9% After-tax interest rate= 9% × (1 – 30%) = 6.3% NPV of ($8,750) for 5 years at 6.3% = $36,559.31 So, the total benefit from leasing is $40,975.08 – $36,559.31 =$4,415.77 OR $4,416.00(rounded)

.

16-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 86. One of the conditions that the M&M Propositions required was for not to have 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 a 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.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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.

.

16-40

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 17: Dividends, Stock Repurchases, and Payout Policy Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. When a firm distributes dividends to stockholders, the amount of equity capital invested in the firm is reduced.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. A liquidating dividend is a dividend that is paid to stockholders when a firm is liquidated.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. Under U.S. bankruptcy rules, the proceeds from the sale of a company’s assets are first used to pay liquidating dividend to the shareholders before any other party has a claim on those assets.

A) True B) False Ans: B

.

17-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. Consider an investor who purchases a dividend-paying stock of a public company the day prior to the dividend record date. We would expect this investor to receive a dividend distribution.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. Distributions to the stockholders in the form of a standing discount for products or services that a firm produces are often not thought of as dividends.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. Stock prices react to dividend announcements because the amount of the dividend sends a signal to investors about management's view of the company's prospects.

A) True B) False Ans: A

.

17-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. Dividends reduce the stockholder's investment in a firm.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. Stock prices drop on the ex-dividend date, but usually the drop is less than the amount of the dividend.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. If there are no taxes on dividends, then the price of a stock will not drop on the ex-dividend date.

A) True B) False Ans: B

.

17-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. Private companies often don't announce dividend payments because private company shares are not frequently traded, and the list of shareholders is relatively small.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. The record date should never come before the ex-dividend date.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. Stockholders who don't choose to sell back their shares in a stock repurchase are losing money because the company is only distributing value to the participating shareholders.

A) True B) False Ans: B

.

17-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. A Dutch auction tender offer stock repurchases always take place at a price higher than the market price of the stock.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Targeted share repurchases always occur at a price higher than the current market quoted price for a stock.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. Open-market stock repurchases are a convenient way for a company to distribute large amounts cash.

A) True B) False Ans: B

.

17-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. In a realistic situation, a firm’s dividend policy does not affect the firm value.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. A large regular dividend always denotes a firm with a low level of cash that also has many new project alternatives.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Dividend policy can help a firm maintain a desired capital structure.

A) True B) False Ans: A

.

17-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. Stock repurchases are a stronger indication of free cash flow than dividends.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. Compared to raising regular cash dividends, initiating an open-market stock repurchase is generally not as strong a positive signal to the investors because the repurchase can easily be canceled or scaled back before it is completed.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. In a world with no taxes, no information or transaction costs, a fixed real investment policy, a dividend policy should not affect the value of a firm.

A) True B) False Ans: A

.

17-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. Traditionally, capital gains taxes on repurchases have been higher than the taxes on dividends.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. Suppose that the government raises short and long-term capital gains taxes while leaving all other taxes unchanged. This tax rate change would encourage companies to increase the use of stock repurchases rather than issuing dividends.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. Dividend reinvestment programs allow investors to reinvest the dividends they receive into a company's stock without paying taxes on the dividends, or a transaction fee on the stock purchase.

A) True B) False Ans: A

.

17-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25. Some companies have been known for paying dividends to current stockholders while simultaneously raising capital through a new equity issue. Generally, this behavior is explained by the need to discipline managers by regularly exposing the company to the extra scrutiny involved in an equity issue.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 26. It is unethical for a corporate board to conduct a large tender offer for stock repurchase when the board members have private information indicating that the company's share price is too low.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 27. Paying a stock dividend does not involve the distribution of any value to the company's stockholders.

A) True B) False Ans: A

.

17-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Although stock splits do not add any value to a firm, investors tend to react positively to stock splits because management isn't likely to initiate a stock split if the firm's prospects are poor.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 29. A key distinction between stock dividends and stock split is that stock dividends are typically regularly scheduled events, whereas stock splits tend to occur infrequently during the life of a company.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30. Surveys conducted of managers tell us that they primarily see regular cash dividends as a way to precisely adjust the leverage ratio to the target suggested by the trade-off theory of capital structure.

A) True B) False Ans: B

.

17-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31. Which of the following types of dividend is most likely to be used to distribute the revenue from a one-time sale of a large asset?

A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32. Which of the following types of dividend is used to distribute any remaining value when a company's assets are being sold as the company is terminated?

A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: D

.

17-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level Of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. Consider a company that had unexpected higher earnings last quarter, and it intends to pay out some additional value to shareholders. Which of the following types of dividend is the company likely to use?

A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. Which of the following steps in the dividend payment process for a public company usually results in a change in the company's stock price?

A) Public announcement B) Ex-dividend date C) Payable date D) Both Public announcement and Ex-dividend date Ans: D

.

17-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. The shares of Milton, Inc. fell sharply today after the company announced that it is increasing its regular cash dividend distributions. Which of the following explanations may explain investors' negative reaction?

A) Changes in regular cash dividends are made frequently so that the company's management can adjust for changes in short-term earnings.

Investors previously believed the company had many lucrative growth opportunities. By B) announcing higher regular cash dividends, the company is sending a signal that it doesn't have enough positive NPV projects to use all the money.

Investors expected that the company would announce a stock repurchase rather than a C) cash dividend increase. Since a change in dividend policy is commonly viewed as a weaker signal than a stock repurchase. The share price fell on the news of the dividend increase.

None of these D) Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. Which of these examples does NOT meet the strict definition for a dividend?

A) Steel Gen Corp regularly distributes $0.05 to each shareholder for every share they own.

B) Chalone Vineyards once offered their investors discounts on wine in proportion to the number of shares they owned.

Churchill Downs, Inc. which operates several horse racing tracks, including the location C) for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012).

Both Chalone Vineyards once offered their investors discounts on wine in proportion to D) the number of shares they owned and Churchill Downs, Inc. which operates several horse racing tracks, including the location for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012) Ans: C

.

17-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Jupiter, Co. will be distributing $40 million to shareholders through a special dividend. The company has 160 million shares outstanding. If you own 100 shares of Jupiter, Co. how much will you receive? Ignore taxes.

A) $400 B) $100 C) $25 D) None of these Ans: C Feedback: The dividend payment will be ($40 million / 160 million shares) = $0.25 per share.

With 100 shares you will receive 100 × $0.25 = $25.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. Mercury, Co. has announced it will pay its regular cash dividend of $0.45 per share. If dividends are taxed, about how much do you expect the price of Mercury, to drop on the exdividend day? The tax rate on dividends is 15 percent. (Round your final answer to two decimal places.)

A) $0.07 B) $0.38 C) $0.45 D) $0.52 Ans: B Feedback: The price would be expected to drop by the amount investors receive after taxes $0.45 × 85% = $0.38

.

17-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. You own 10,000 shares of Mars, Co. which is currently trading for $11.50 per share. The company has announced that it will soon pay a special dividend of $1.50 per share. Tomorrow is the ex-dividend day. Ignoring taxes, what do you expect your block of shares will be worth tomorrow?

A) $15,000 B) $100,000 C) $115,000 D) $200,000 Ans: B Feedback: With no taxes you expect that the company's stock will drop by $1.50 to $10.00. Your holdings will be worth 10,000 × $10 = $100,000

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. Doorstep, Co. stock is currently trading at $25.70 per share. The company pays a regular cash dividend of $0.40 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved.

A) $0.40 B) $25.24 C) $25.30 D) $25.36 Ans: C Feedback: The new stock price would be $25.70 − $0.40 = $25.30

.

17-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Daniel, Co. stock is currently trading at $38.15 per share. The company pays a regular cash dividend of $0.80 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved.

A) $37.47 B) $37.35 C) $37.32 D) $37.23 Ans: B Feedback: The new stock price would be $38.15 − $0.80 = $37.35

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. Ferrico, Co. is currently trading at $37.00 per share. The company is paying a regular cash dividend of $0.40 per share and an extra dividend of $0.10 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places.)

A) $36.43 B) $36.50 C) $36.58 D) $37.00 Ans: C Feedback: The price would be expected to drop by the amount investors receive after taxes ($0.40 + 0.10) × 85% = $0.425 The new stock price would be $37.00 − $0.425 = $36.58

.

17-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Moon, Co. is currently trading at $22.00 per share. The company is paying a regular cash dividend of $0.30 per share, and an extra dividend of $0.05 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places) A) $21.70 B) $21.65 C) $21.60 D) $21.55 Ans: A Feedback: The price would be expected to drop by the amount investors receive after taxes ($0.30 + $0.05)× 85% = $0.2975 The new stock price would be $22.00 − $0.2975 = $21.70

.

17-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. Bright Capital, Inc. is being liquidated. The company's assets can be sold for $20 million. It will cost $18 million for the company to meet all its previous obligations and to pay-off debt holders. The company has 30 million shares outstanding. If you own 2,000 shares, how much do you expect to receive in liquidating dividends? Ignore taxes. (Round your final answer to two decimal places.)

A) $0.00 B) $133.33 C) $266.66 D) $1,200.00 Ans: B Feedback: Shareholders will receive the residual claim after other claimholders have been paid $20 million − $18 million = $2 million This $2 million will be distributed on a pro-rata basis.

As a holder of 2,000 shares, you will receive $2 million × (2,000 shares / 30 million shares) = $133.33

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. You own 20,000 shares of stock in Casi-knows, Inc. which has just sold one of its large resort hotels for $300 million. Management intends to return the entire revenue from the sale to shareholders by issuing a special dividend. If Casi-knows has 20 million shares outstanding, how large a dividend payment do you expect to receive?

A) $20,000 B) $200,000 C) $300,000 D) $1,000,000 Ans: C Feedback: The $300 million will be distributed on a pro-rata basis. You will receive $300 million × (20,000 shares / 20 million shares) = $300,000.

.

17-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Earmark, Co. has a policy of returning a minimum of 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.35 per share. In each of the first three quarters the company paid a regular cash dividend of $0.10 per share. What combination of dividends could the company's board approve to meet their target payout percentage?

A) A regular cash dividend of $0.10 per share.

B) A regular cash dividend of $0.10 per share and an extra dividend of 0.56 per share.

C) A regular cash dividend of $0.10 per share and an extra dividend of $0.46 per share.

D) A regular cash dividend of $0.10 per share and an extra dividend of $0.16 per share.

Ans: D Feedback: The company earned $0.35 × 4 quarters = $1.40 per share this year. To achieve the 40 percent target, the firm must distribute $1.40 × 40% = $0.56 per share to shareholders. The company has already distributed $0.10 × 3 quarters = $0.30 per share.

The company could meet the target by distributing another $0.26 per share through a regular dividend of 0.10 per share and an extra dividend of 0.16 per share.

.

17-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. Lithion, Co. has a policy of returning a minimum of 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. What combination of dividends could the company's board approve to meet their target payout percentage?

A) B)

A regular cash dividend of $0.05 A regular cash dividend of $0.05 per share and an extra dividend of 0.05 per share

C)

A regular cash dividend of $0.05 per share and an extra dividend of $0.10 per share

D)

A regular cash dividend of $0.05 per share and an extra dividend of $0.20 per share

Ans: A Feedback: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 25 percent target, the firm must distribute $0.80 × 25% = $0.20 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. The company could meet the target by distributing another $0.05 per share through a regular dividend.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following is NOT a possible result of a stock repurchase?

A) Removing a large number of shares from circulation can change the ability of certain shareholders to control the firm.

If the number of remaining shares is relatively small, the remaining shares will be less B) liquid.

The debt-to-equity ratio will be increased.

C) By repurchasing stock when it is undervalued, managers can effectively transfer value D) from stockholders who choose to sell their shares to stockholders choose to remain invested in the company.

Ans: C

.

17-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. Which type of stock repurchase often takes place at a price below the current market price of the stock?

A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) Targeted stock repurchase Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Which type of stock repurchase allows management to set the repurchase price at the lowest level necessary to repurchase the desired number of shares?

A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) All of these Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Which of these actions could by itself have an impact on the control of a firm?

A) A tender offer stock repurchase B) A special dividend payment C) A stock split D) A regular cash dividend payment Ans: A

.

17-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. Venus Co. has just announced that the board has reached a targeted stock repurchase agreement with a large stockholder. The company will repurchase all of the large investor's stock for 90 percent of the current market value. When the stock repurchase was announced, the shares of Venus Co. fell by 7 percent. Which of these explanations could reasonably explain the drop in share price?

A) The willingness of the large investor to accept the targeted stock repurchase signals that the large investor believes the company will not do well in the future.

A targeted stock repurchase essentially transfers value from the average investor to the B) targeted investor.

The investor believes that the company's management is entrenching itself by buying off C) any large block shareholders.

Both The willingness of the large investor to accept the targeted stock repurchase signals D) that the large investor believes the company will not do well in the future and The investor believes that the company's management is entrenching itself by buying off any large block shareholders.

Ans: D

.

17-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. Neonia, Co. has a policy of returning a minimum of 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.25 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 2 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage?

A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $100,000 in stock A regular cash dividend of $0.05 per share and an open-market stock repurchase of C) $400,000 in stock A regular cash dividend of $0.05 per share and an open-market stock repurchase of D) 500,000 in stock Ans: B Feedback: The company earned $0.25 × 4 quarters = $1.00 per share this year. To achieve the 25 percent target, the firm must distribute $1.00 × 25% = $0.25 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. If the company issues another regular dividend of $0.05 per share, it will still have $0.05 per share to remaining to be returned to shareholders.

The stock repurchase required to return that value would be (0.05 per share × 2 million shares) = $100,000 of stock repurchase.

.

17-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. Calciya, Co. has a policy of returning a minimum of 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 8 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage?

A) B) C) D)

A regular cash dividend of $0.05 A regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock A regular cash dividend of $0.05 per share and an extra dividend of $0.12 Both A regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock and A regular cash dividend of $0.05 per share and an extra dividend of $0.12

Ans: D Feedback: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 40 percent target, the firm must distribute $0.80 × 40% = $0.32 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share.

To meet the 40 percent target, the company must distribute another ($0.32 – $0.15) = $0.17 per share. The company could meet the target in two ways: 1. Either it could distribute another $0.17 per share through a regular dividend of $0.05 and an extra dividend of $0.12 per share, or; 2. The company could pay another $0.17 per share through a regular dividend of $0.05 and a stock repurchase of ($0.12 per share × 8 million shares) = $960,000 in stock.

.

17-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. You purchased 3,000 shares of Space Apparition Co. four years ago at $40 per share. You have just received a mail from the company announcing a fixed-price tender offer stock repurchase at $70 per share. Capital gains are taxed at 20 percent. If you participate in the repurchase, how much will you receive?

A) $31,500 B) $192,000 C) $178,000 D) $210,000 Ans: B Feedback: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($40 + ($70 − $40) × 0.80) = $192,000.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. You purchased 3,000 shares of Purple Stuff Beverage Co. four years ago at $30 per share. You have just received a mailing from the company announcing a fixed-price tender offer stock repurchase at $36 per share. Capital gains are taxed at 15 percent. If you participate in the repurchase, how much will you receive?

A) $18,000 B) $91,800 C) $105,300 D) $108,800 Ans: C Feedback: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($30 + ($36 – $30) × 0.85) = $105,300.

.

17-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. You purchased 2,500 shares of Digital Vision, Corp. several years ago for $40 per share. The company is offering a fixed-price tender offer repurchase for $54 per share. What is the amount of after-tax proceeds you would receive from taking part in the repurchase, if capital gains are taxed at 15 percent?

A) $120,000 B) $121,250 C) $129,750 D) $135,000 Ans: C Feedback: You will only be taxed on the capital gain. So you will receive 2,500 shares × ($40 + ($54 − $40) × 0.85) = $129,750.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58. Cosmic crew, Co has 3 million shares outstanding. The shares are currently selling for $40. If the firm repurchases $10 million worth of shares at market prices, approximately how much will the stock be worth after the repurchase? Ignore taxes.

A) $40 B) $38 C) $42 D) $50 Ans: A Feedback: Before the repurchase, the firm was worth $40 per share × 3 million shares = $120 million. The number of shares the firm repurchased for $10 million at the market price of $40 = $10 million / $40 = 250,000 shares. After the repurchase, the firm has $120 million − $10 million = $110 million.

The number of remaining shares = 3,000,000 – 250,000 = 2,750,000.

So each share is worth $110,000,000 / 2,750,000 = $40

.

17-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. You purchased 500 shares in Catalyst, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders in a novel way. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Catalyst, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30. Assume no new information comes out about the company. How much cash will you receive from taking part in the repurchase?

A) You will receive $14,250 by taking part in the repurchase.

B) You will receive $15,000 by taking part in the repurchase.

C) You will receive $15,750 by taking part in the repurchase.

D) You will receive $16,000 by taking part in the repurchase.

Ans: A Feedback: If you take part in the repurchase, you will have to pay taxes on your capital gains. So, the amount you will receive = 500 shares × ($20 + ($30 − $20) × 0.85 ) = $14,250

.

17-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. You purchased 500 shares in Div Choice, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders in a novel way. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Div Choice, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30.

Assume no new information comes out about the company. Approximately, how much will you receive by waiting until after the ex-dividend day and then selling the shares in the market? (Do not round intermediate calculation. Round your final answer to the nearest dollar.)

A) You will receive about $13,500 by selling after the ex-dividend day.

B) You will receive about $14,775 by selling after the ex-dividend day.

C) You will receive about $14,513 by selling after the ex-dividend day.

D) You will receive about $15,000 by selling after the ex-dividend day.

Ans: C Feedback: If you wait until the dividend payment, you will pay a 30 percent tax on the dividend, so you will receive $5 × 70% = $ 3.50 per share in dividends. However, we would expect the price of the stock to only fall by the after-tax amount of the dividend. So the stock will be worth about $30 − $3.50 = $26.50. Thus, from selling the stock you will receive = ($20 + ($26.50 − $20) × 0.85) = $25.525 per share. In total, you will receive ($25.525+ $3.50) × 500 shares = $14,512.50 or $14,513.00.

.

17-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. Which of the following explanations is NOT a possible benefit of dividends?

A) Some investors prefer dividend-paying stocks and will be willing to pay a higher price for stocks with regular dividends.

Paying out large regular dividends can force management to regularly raise more B) capital. The extra scrutiny involved in raising capital can increase the incentives of management to run the company efficiently.

Dividends can be used to manage the capital structure of a company.

C) Paying dividends reduces the probability that a firm will enter financial distress.

D) Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comrpehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. Which of the following statements about the relative advantages of stock repurchases over dividends is NOT true?

A) Since most ongoing stock repurchase programs are as visible as dividend programs, they can be used effectively to send a positive signal about a firm’s prospects to investors.

Open-market stock purchases allow management more flexibility because investors are B) less likely to react if the management cuts back or ends a stock repurchase as compared to cutting back on dividend payments.

Stock repurchases allow stockholders to choose whether or not to participate in the stock C) repurchase. This allows stockholders to have more control over their tax burden.

Historically, taxes on dividend payment have been higher than those on stock D) repurchases.

Ans: A

.

17-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. In early 2003, the U.S. government cut the tax rate on dividends to a flat 15 percent instead of treating dividend payments as other income. All else being equal, how would we expect the number of companies paying dividends to change?

A) We would expect the number of dividend-paying companies to increase.

B) We would expect the number of dividend-paying companies to decrease.

C) We would expect the number of dividend-paying companies to stay relatively constant.

D) None of these Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Suppose you are advising a retiree who holds 2,000 shares of LargeDiv Corp. The company is largely held by tax-paying institutional investors and has announced that it will shortly be issuing a large dividend. Because the shares are held in the retiree's Roth IRA, she will not incur taxes on either capital gains or dividends. The retiree has decided to sell the shares sometime this year, and use the money for living expenses. You expect the only upcoming change in the stock price will result from the dividend. Ignoring any discounting for time, what advice should you give?

A) B) C) D)

Sell the stock now—the stock price is likely to decrease more than just the dividend amount.

Sell the stock ex-dividend—the stock price is likely to decline, but by less than the dividend amount.

Sell the stock—irrespective of when the stock is sold.

Sell the stock now—it is always better to sell the stock immediately regardless of the tax consequences.

Ans: B

.

17-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. You purchased 2,000 shares of Crimson Treat Technologies several years ago at $50 per share.

The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $75. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $3,420 in cash?

A) 27 shares B) 46 shares C) 48 shares D) 51 shares Ans: C Feedback: The after-tax amount received per share = ($50 + ($75 − $50) × 0.85) = $71.25.

The number of shares to be sold = $3,420 / $71.25 = 48 shares.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. You purchased 8,000 shares of Wallflower Technologies several years ago at $20 per share.

The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $60. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $2,000 in cash? (Round your final answer to the nearest unit of shares.)

A) 30 shares B) 33 shares C) 37 shares D) 39 shares Ans: C Feedback: The after-tax amount received per share = ($20 + ($60 − $20) × 0.85) = $54.

The number of shares to be sold = $2,000 / $54 = 37 shares.

.

17-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. You purchased 4,000 shares of High-Div Co. several years ago at $50 per share. The company has decided to pay a special dividend of $2.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest in the company through the dividend reinvestment program. If the company's stock is trading at $48.20 following the dividend payment, how many additional shares can you buy through the dividend reinvestment program? (Round your final answer to the nearest unit of shares.)

A) 166 shares B) 141 shares C) 134 shares D) 125 shares Ans: B Feedback: The after-tax amount received = ($2.00 × 0.85) × 4,000 shares = $6,800. With the DRIP program, you will not have any transaction costs to reinvest. So you can buy ($6,800 / $48.20) shares = 141 shares

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. You own 7,000 shares of No-Drip Co. The company has decided to pay a special dividend of $1.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest your dividend back into the company, but the company does not have a dividend reinvestment program. To reinvest through your broker, you will have to pay a $46 commission. If the company's stock is trading at $12.43 following the dividend payment, how many additional shares will you be able to purchase? (Round your final answer to the nearest unit of shares.)

A) 563 shares B) 481 shares C) 478 shares D) 475 shares Ans: D Feedback: The after-tax amount received = ($1.00 × 0.85) × 7,000 shares = $5,950. You will also have to pay the $46 transaction fee, leaving you with $5,904 to invest. So you can buy ($5,904 / $12.43) shares = 475 shares

.

17-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. The Dimples Golf Ball, Co. has paid a regular dividend of $0.20 quarterly for the last three years. The company has 2 million shares outstanding. Over the next year the company will have to spend $800,000 to service its debt and spend $200,000 in capital expenditures. The company has $500,000 of cash and cash equivalents. Over the next year how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $500,000 in cash at the end of the year?

A) 1,000,000 B) 1,600,000 C) 2,000,000 D) 2,600,000 Ans: D Feedback: To continue the current dividend pattern, the company will need to pay ($0.20 per quarter × 4 quarter) × 2 million shares = $1,600,000. The company will also need ($800,000 debt payments + $200,000 Capital Expenditure) = $1,000,000. The company must maintain $500,000 cash and cash equivalents. The result is that to meet the dividend payments and other requirements operations must provide ($1,600,000 + $1,000,000) = $2,600,000.

.

17-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. The Wyoming Boot, Co. has paid a regular dividend of $0.25 quarterly for the last several years. The company has 1 million shares outstanding. Over the next year, the company will have to spend $600,000 to service its debt and spend $500,000 in capital expenditures. The company has $600,000 of cash and cash equivalents. Over the next year, how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $250,000 in cash at the end of the year?

A) 1,000,000 B) 1,100,000 C) 1,750,000 D) 2,100,000 Ans: C Feedback: To continue the current dividend pattern, the company will need to pay ($0.25 per quarter × 4 quarter) × 1 million shares = $1,000,000. The company will also need ($600,000 debt payments + 500,000 capital expenditures) = $1,100,000. The company can take ($600,000 − $250,000) = $350,000 from cash and cash equivalents and still have the necessary cash for next year. The result is that to meet the dividend payments and other requirements, operations must provide ($1,000,000 + $1,100,000 − $350,000) = $1,750,000.

.

17-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Suppose you own shares of ThreeFor, Inc. which has just announced a 3-for-1 stock split.

Immediately after the announcement, the price of the company's shares rose by 5 percent. You don't expect any new information about the company until after the stock split. Ignoring any discounting for time, if you intend to sell your shares soon, you should A) sell the stock now—the single share you have now is likely to be worth more than the three shares you'll have after the split. sell the stock after the split—typically, the marker reacts positively to stock splits. The B) three shares you'll have after the split will be worth more than the single share you have now. sell the stock now—the stock is likely to be more liquid before the split when there are C) fewer shares. sell the stock—irrespective of when the stock is sold. If there is no new information D) about the stock, then the value of three shares after the split should be the same as the value of the single share you hold now.

Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comrpehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Generally, management undertakes a reverse stock split to A) send a signal to investors that the company is expected to perform poorly.

B) meet the minimum requirements to be listed on one of the major stock exchanges.

C) increase the liquidity of shares by decreasing the number of share available.

D) reduce the administrative costs associated with investor relations.

Ans: B

.

17-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. Split-Gram, Inc. has announced a 4-to-1 stock split. If the company currently has 1 million shares outstanding, how many outstanding shares will it have after the split?

A) 4 million B) 3 million C) 2 million D) 1 million Ans: A Feedback: The company had 1 million shares outstanding and is issuing a 4-for-1 stock split.

The no. of outstanding shares after the split = 4 × 1 million = 4 million.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. You own 3,000 shares of Split-Holdings Co. The shares are currently selling for $48. The company has just announced a 4-for-1 stock split. How many shares will you own after the split, and approximately what will your holdings in Split-Holdings Co. be worth?

A) 12,000 shares worth about $144,000 B) 12,000 shares worth about $576,000 C) 15,000 shares worth about $144,000 D) 15,000 shares worth about $720,000 Ans: A Feedback: You own 3,000 shares of a company that is undergoing a 4-for-1 split. You will have: 4 × 3,000 = 12,000 shares After the split, each share will be worth one-fourth of the original share price, so your total holding will be worth,($48 / 4 ) × 12,000 = $144,000.

.

17-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Split-Div, Inc. has issued quarterly dividends of $0.10 per share each quarter over the last few years. This quarter the company initiated a 2-for-1 stock split. What is the minimum quarterly dividend the company’s board should approve to avoid sending a bad signal to the investors?

A) $0.02 per share B) $0.05 per share C) $0.10 per share D) $0.20 per share Ans: B Feedback: To avoid sending a bad signal to the investors, the company needs to pay out the same dividend relative to the number of outstanding shares. After a 2-for-1 split, the equivalent regular cash dividend would be $0.10 / 2 = $0.05.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. You own 1,200 shares of Harry, Co. The company has recently announced a 1-for-3 reverse stock split. How many shares will you own after the reverse split?

A) 300 shares B) 400 shares C) 3,600 shares D) 4,800 shares Ans: B Feedback: You own 1,200 shares. After a 1-for-3 reverse stock split, you would own 1,200 / 3 = 400 shares.

.

17-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. Pluto, Co. stock is currently trading for $54. Assume there is no new information about the company. If the company issues a 10 percent stock dividend, what will the approximate price of the stock be after the stock dividend is issued? (Round your final answer to two decimal places.)

A) $47.80 per share B) $48.60 per share C) $49.09 per share D) $54.00 per share Ans: C Feedback: After the stock dividend, there will be 110 percent more shares representing the same amount of assets: $54 / 110% = $49.09 per share.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. Which of the following statements describes the finding from academic studies on corporate dividend policy?

A) Managers tend to increase regular cash dividends in response to unexpectedly high earnings.

Managers tend to maintain a level dividend payment at an amount that they are relatively B) certain they can maintain in the future.

Managers tend to focus on dividends rather than stock repurchases because institutional C) investors tend to prefer regular dividends.

Dividend policy doesn't matter because investors can re-create dividends by selling a D) fraction of their shares.

Ans: B

.

17-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. Which of the following considerations should NOT be related to management's concerns when setting a stock repurchase policy?

A) Over the long term, how much does a company's level of earnings exceed its investment requirements? How certain is this level?

Is the stock currently undervalued? Can the management add value to the company by B) initiating a stock repurchase?

Does a firm have enough financial reserves to meet the short-term obligations in periods C) when earnings are down or investment requirements are up?

Can a firm quickly raise equity capital if necessary?

D) Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. GoodSignal Co. is currently trading for $10 with 1 million shares outstanding. Which of the following actions would be the most credible signal that management believes that the longterm prospects for a company have improved?

A) Pay a $0.20 extra dividend in addition to the company's $0.20 regular quarterly dividend B) Increase the company's regular quarterly dividend from $0.20 to $0.40 C) Initiate an open-market stock repurchase of 2 percent of the company's stock D) Pay a $0.20 special dividend by selling a major fixed asset Ans: C

.

17-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowlege AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 81. Describe the four general types of cash dividends and the purpose of each.

Ans: The most common form of a dividend is known as the regular cash dividend, which is paid on a regular basis. It is typically set at a level that management generally expects the company to be able to maintain in the long run, barring major changes in the fortune of the firm.

The extra dividend is generally paid when a firm has earnings that are higher than expected.

The special dividend is a one-time payment to stockholders and is used to distribute large amounts of cash. It may be used to distribute the proceeds from the sale of a major asset or business or even to alter the capital structure of the firm.

A liquidating dividend is paid to stockholders when a firm is liquidated and will no longer continue doing business. The proceeds from the liquidating dividend are available only after all creditors and priority claimants are paid.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 82. Discuss why investor perception of a stock repurchases is weaker than that of a cash dividend.

Ans: While repurchases give investors the flexibility to choose whether or not they would like to receive a dividend, the major weakness in a repurchase lies in the fact that when a company publicly announces an ongoing open-market repurchase program, investors know that management can cut back on the repurchase or end them at any time. This makes the commitment to pay out cash weaker than with a dividend, and it means that if cash flows are less certain, then managers are likely to prefer to distribute extra cash by repurchasing shares, where there is some flexibility in following through.

.

17-40

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: ComprehensionAASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 83. In the 2005 follow-up to the Lintner study, the researchers found that managers choose their firm's dividend policies in a way that enables them to continue making the investments necessary for a firm to complete in its product markets. What does this imply about a firm that operates in a low-growth industry?

Ans: Since managers appear to be sensitive to not having the ability to take on positive-NPV projects because of a lack of financing, then it appears that managers would like to create a buffer of cash, causing a low-dividend payout, in order to be able to invest in these projects.

On the other hand, if a firm does not have many growth prospects, and consequently no new positive-NPV projects, then the firm should have a higher dividend payout than a similarly successful firm in a higher growth industry.

.

17-41

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 18: Business Formation, Growth, and Valuation Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

2. The founder of a company needs to be a part of many critical decisions taken by the board but need not be a part of 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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

3. Businesses fail because of the management's inability to accurately estimate the amount of funds required to get their businesses up and running.

A) True B) False Ans: A

.

18-1

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

4. Access to capital for a sole proprietorship is excellent compared to a C-Corporation.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5. A business at the start up has a better chance to succeed if calculated risks are taken.

A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

6. A limited liability company, LLC, leads to unlimited liability for the people who make a business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership.

A) True B) False Ans: B

Page 2

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

7. Limited liability partnerships are inexpensive to form compared to sole proprietorships.

A) True B) False Ans: B Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9. The downside of being able to raise equity capital from other people is that an entrepreneur must inevitably share control with other investors.

A) True B) False Ans: A

Page 3

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

12. Corporations, which are “legal persons” under state law, automatically have a finite life.

A) True B) False Ans: B

Page 4

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 the 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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

15. A cash budget summarizes the cash flows into and out of a firm over a period of time.

A) True B) False Ans: A

Page 5

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

16. A business plan presents the results from a strategic planning process that focuses on how a business will be developed over time.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

17. A business plan includes a detailed discussion of the marketing and sales activities that will enable a 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

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Page 6

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

19. Decision makers must understand business valuation concepts in order to be able to identify the optimal capital structure and payout policy A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

20. A strategic investor is interested in buying the firm and not just its financial performance.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

21. Cost approaches include replacement cost and multiples analysis.

A) True B) False Ans: B

Page 7

Format: True/False Learning Objective: LO 3 Level of Difficulty: medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

22. The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities, but it is generally less applicable for operating businesses.

A) True B) False Ans: A Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

23. In the transaction analysis 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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Page 8

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

26. In contrast to the free cash flow to equity, FCFE, approach, which values cash flows that are available for distribution to stockholders, the dividend discount model, 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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

27. In contrast to the financial statements of publicly held firms, private company financials often include personal expenses of the owner and excess compensation expenses.

A) True B) False Ans: A

Page 9

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

28. Differences in marketability can result in premiums of 30 percent or more for shares of private companies.

A) True B) False Ans: B Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 the “key people” may not remain with the firm as long as expected.

A) True B) False Ans: A

Page 10

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

31. During the startup of a company, the founder makes several critical decisions including: A) innovating the product(s) to sell.

B) formulating the best marketing strategy for selling the products manufactured.

C) raising the funds necessary to develop the product(s).

D) formulating an efficient plan for its expansion.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

32. In which of the following forms of business organization access to capital is the least?

A) A sole proprietorship B) A general partnership C) An S-corporation D) A C-corporation Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

33. The ability to make the life of a business independent of that of the founder increases the _____ of the ownership interests, making it easier for the business to raise capital.

A) non convertibility B) liquidity C) limitation D) risk Ans: B

Page 11

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

34. A business's chances of success improve if you: A) jump into a business with capital that is just enough to set up a business.

B) overanalyze opportunities to the point where you are just convincing yourself not C) to proceed.

D) take reasonable risk. have a unique idea even if the strategy is poor.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

35. The life of an entity is flexible for: A) B)a general partnership.

C) D)a sole proprietorship.

Ans: an S-corporation. a C-corporation.

A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

36. A limited liability partnership is: A) a partnership agreement which can never be written for a fixed life.

B) less costly to form than sole proprietorships.

C) an agreement where partners face the possibility that their personal assets can be D) taken from them to satisfy claims on their businesses. less constrained than general partnerships because they can raise money from limited partners.

Ans: D

Page 12

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

37. Which of the following statements is true of limited liability company?

A) Limited liability company is 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.

The lives of limited liability company are not flexible.

C) D) Limited liability company is more constrained than general partnerships because they can raise money only from members.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

38. Which of the following statements is true of a corporation?

A) An S-corporation can have no more than 500 stockholders.

B) All profits of an S-corporation do not pass directly to the stockholders as they C) would pass to the partners in a partnership.

D) Profits earned in C-corporations are taxed only once at the corporate tax rate.

S-corporations have less limited access to capital compared to C-corporations.

Ans: D

Page 13

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

39. Which of the following statements is true of S-corporation?

A) An S-corporation can have more than 100 stockholders.

B) All profits of an S-corporation pass directly to the stockholders as they would C) pass to the partners in a partnership.

D) An S-corporation is a variation of the LLC (limited liability company).

Only foreign investors can own the shares of an S-corporation.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40. Which of the following statements is true of sole proprietorship?

A) A sole proprietorship is the most expensive type of business to start.

B) The life of a sole proprietorship is limited.

C) Sole proprietorships must rely on equity contributions from the public.

D) The liability of owners of a sole proprietorship is limited.

Ans: B

Page 14

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

41. Which of the following statements is true of cash flow break-even analysis?

A) It is useful in understanding the cash requirements of a business and in estimating B) how much financing a new business will require.

C) As per the cash flow break-even analysis, the cash flow break-even point D) calculation usually focuses on the computation of EAT break-even.

It summarizes the cash flows into and out of a firm, usually on monthly basis.

It helps an entrepreneur in understanding where the money is coming from and where it is going.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

42. Which of the following statements is true about a cash budget?

A) Cash budget helps an entrepreneur understand the concept of EBITDA breakB) even and how to calculate this point for each product a business’s produce.

C) Cash budget focuses on the importance of maximizing a product’s per unit contribution.

Cash budget provides a means of estimating how long it will take for a product to reach the break-even point and, therefore, how much money will be needed to launch a new product.

D) Cash budget summarizes the cash flows into and out of a firm over a period of time.

Ans: D

Page 15

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

43. Which of the following statements is true about business plans?

A) A well-prepared business plan always avoids contingent liabilities as the plan B) helps to predict and change the occurrence of a contingent liability.

C) A business plan is useful only in case of exigency in the business environment D) otherwise a business plan is not important.

A business plan is a trivial part in the overall strategy formulation and its impact on business operations in the long run is miniscule.

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.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

44. _____ is a road map for a business.

A) A cash budget B) A cash flow break-even analysis C) A business plan D) A transaction analysis Ans: C

Page 16

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

45. Which of the following mathematical expressions is used while calculating the value of a firm using the income approach?

A) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years + The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm The present value of the free cash flows (FCF) that a business is expected to B) produce over the next T years – The present value of all free cash flows after year T – The value of all of the nonoperating assets in the firm The present value of the free cash flows (FCF) that a business is expected to C) produce over the next T years + The present value of all free cash flows after year T – The value of all of the nonoperating assets in the firm D) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years – The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm Ans: A Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

46. Decision makers must understand business valuation concepts in order to be able to: A) prepare the financial statements of the business.

B) identify the optimal capital structure and the payout policy.

C) identify the break-even point and the payout policy.

D) calculate the deferred tax assets.

Ans: B

Page 17

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

47. Which of the following statements is true about business valuation?

A) The valuation of business is solely about how much return a business provides to B) its stockholders.

C) There is a single value for any business.

D) There is no such thing as the value for a business.

The value of a business is solely affected by investment managers’ decision.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

48. The value of a business changes over time because: A) the impact of the business valuation is minimized when timed properly.

B) the risk involved in operations do not change.

C) the estimates reflects the timing of what economic, industry, and firm conditions D) are at the time of valuation. the factors influencing the valuation can be controlled.

Ans: C

Page 18

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

Note: Wording changed to match text 49. Which of the following statements is true of business valuation principle?

A) As per first valuation principle, the value of business does not change over time.

B) The value of a business is solely affected by managers’ financing decisions.

C) The fair market value of a business is the value of that business to a hypothetical D) person who is knowledgeable about the business.

Estimating the fair market value of a business includes the value of synergies or the effects of any investor-specific management style.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

50. Which of the following statements is true of replacement cost approach?

A) Replacement cost is an income-based valuation approach.

B) This approach should include only tangible assets, whether they are actually C) included on the accounting balance sheet or not.

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 the whole of assets within a business when they are being insured.

Ans: C

Page 19

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

51. The adjusted book value approach involves: A) restating the value of the individual assets in a business to reflect their historical B) costs.

C) valuing individual assets within a business when they are being insured, but it is D) rarely used to value an entire business. the cost of duplicating the assets of the business in their present form as of the valuation date. valuing all tangible and intangible assets.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

52. When using the multiples analysis approach to valuing a business, one must be aware: A) of the presence of a marketability premium that can be sizable.

B) of the adjusted book value of a business which is the cost of duplicating the assets C) of the business in their present form as of the valuation date.

D) of the stock value of similar companies whose shares are not publicly traded. of the presence of a marketability discount that can be sizable.

Ans: D

Page 20

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

53. The transaction approach is difficult to use because: A) transactions data are 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 frequently and hence the amount of data is immense. the terms of the transactions can be easy to assess. the terms of the transactions can be difficult to assess.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

54. Which of the following statements about the free cash flow from the firm (FCFF) approach is true?

A) The present value of these cash flows exceeds the total value of the firm, or its B) enterprise value.

We 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.

The costs associated with noninterest-bearing current liabilities, which are C) included in the firm's cost of sales and other operating expenses, are added 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 weighted average cost of capital, WACC. Ans: D

Page 21

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) are added to the value of equity claims.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) discounted by the inflation rate prevailing in the economy.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) for distribution to board of directors.

Ans: C

Page 22

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

58. The three specific cash flows associated that are included in the free 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. the interest expense on existing debt, the repayment of debt principal, and the payment of dividends.

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

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) the stream of cash flows that stockholders expect to receive through bonus issue. the stream of cash flows that stockholders expect to receive through stock repurchase.

Ans: B

Page 23

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

60. Important issues that one must consider in valuing young 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. the difficulty in valuing young, rapidly growing companies in contrast to mature, B) 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. the difficulty in valuing young, rapidly growing companies in contrast to mature, C) stable companies, whether key people remain in the firm, and whether a controlling ownership interest or a minority interest is being valued.

D) whether the key people remain in the firm, the pretax operating cash flows generated by the firm in the coming years, and whether a controlling ownership interest or a minority interest is being valued.

Ans: C

Page 24

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

61. Sonicmony Soft, makes designer gold bracelets. Its annual costs include shop rent of $15,000, salaries for two jewelers of $125,000, design software costs of $12,000, and other overhead costs of $15,000. An average bracelet is priced at $6,500. It costs $2,200 in raw material, $1,500 in labor, and $400 in other expenses. What is the minimum number of bracelets that need to be sold to earn a profit? (Round to nearest whole unit.)

A) 18 B) bracelets C) 47 D) bracelets Ans: C70 bracelets Feedback: Fixed14 costs = $15,000 + $125,000 + $12,000 + $15,000 = $167,000 bracelets Unit variable costs = $2,200 + $1,500 + $400 = $4,100 Unit selling price = $6,500 Therefore,

$167,000 = 69.58 bracelets $6,500 – $4,100 The firm needs to sell at least 70 braceletsannually before it can make a profit. =

Page 25

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

62. Atamony makes circuit boards and markets them to electronic goods manufacturers.

The firm has nonsalary fixed costs of $112,000 and salary costs of $64,250. Each circuit board is sold at a price of $69 and involves variable costs of $46 per unit. What is the break-even point for Atamony? (Round to nearest whole unit.)

A) 5,105 circuit B) boards 7,663 C) circuit boards D) 6,237 circuit 2,714 Ans: Bboards circuit boards Feedback: Fixed costs = $112,000 + $64,250 = $176,250 Unit variable costs = $46 Unit selling price = $69 Therefore,

$176,250 7,663.04 circuit boards = $69 – $46 The firm needs to sell at least 7,663circuit boards annually before it can make a profit. =

Page 26

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63. Warren Soft makes period pieces. The firm has total fixed costs of $500,000. The average piece is sold at a price of $2,500 and involves variable costs of $1,800 per unit.

What is the break-even point for this firm? (Round to nearest whole unit.)

A) 714 B) pieces C) 928 D) pieces Ans: A617 pieces Feedback: Fixed738 costs = $500,000 pieces Unit variable costs = $1,800 Unit selling price = $2,500 Therefore,

$500,000 = = 714.29 pieces $2,500 – $1,800 The firm needs to sell at least 714 pieces of furniture annually before it can make a profit.

Page 27

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

64. Neucon company needs to sell 6,000 circuit breakers to break even. Its unit variable cost is $441, and its unit selling price is $800. What is the fixed cost of this company?

A) $1,497,25 B) 0 C) $2,154,00 D) 0 Ans: B$2,855,25 0 Feedback: $4,652,50 Break-even point = 6,000 units 0 Unit variable costs = $441 Unit selling price = $800

The firm has fixed costs $2,154,000 of .

Page 28

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

65. FifeSiete Corp. wants to break even at 15,000 units on its only product. Its unit variable cost is $55, and its fixed cost is $750,000. What should be the company's unit selling price?

A) $85 B) $92 C) $105 D) $78 Ans: C Feedback: Break-even point = 15,000 units Unit variable costs = $55 Fixed costs = $750,000

$750,000 Price – $55 $750,000 Unit selling price = + $55 15,000 The firm has to sell its product at $105 15,000 =

Page 29

= $105

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

66. Settetocol, Inc., has cash of $12,000, receivables of $35,000, and inventory of $28,000.

In addition, the firm has fixed assets of $120,000. Management has also told you that you can reasonably expect to collect 93 percent of the receivables, that the inventory could be sold to realize 84 percent of its book value, and that the sale of the property, plant, and equipment would yield $94,000. What is the liquidation value of this company? (Round to the nearest dollar.)

A) $162,07 B) 0 C) $139,69 D) 5 Ans: A$174,86 6 Feedback: $138,69 value is The liquidation Cash 5 $12,000 ×100% = $12,000.00 Accounts receivable $35,000 × 93% = $32,550.00 Inventory $28,000 × 84% = $23,520.00 Net PP&E $120,000 $94,000.00 Total assets $162,070.00 $195,000

Page 30

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

67. Foursonic Labs has cash of $26,000, receivables of $85,000, and inventory of $118,000. In addition, the firm has property, plant, and equipment of $165,000.

Management has also told you that you can reasonably expect to collect 89 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 $125,000. What is the liquidation value of this company? (Round to the nearest dollar.)

A) $201,95 B) 0 C) $229,00 D) 0 Ans: D$394,00 0 Feedback: $326,95 value is The liquidation Cash 0 $26,000 × 100%= $ 26,000 Accounts Receivable $85,000 × 89%= $ 75,650 Inventory $118,00 × 85%= $ Net PP&E 0 100,300 Total assets $165,00 $ 0 125,000 $394,00 $ 0

326,950

Page 31

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

68. FifeSiete. 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 Neuncon, 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 FifeSiete? (Round to the nearest million dollars.)

A) $1,421 B) million C) $1,651 D) million Ans: B$1,191 million Feedback: $1,715 The P/E multiple for Neuncon Inc. is: million ($14.25150,000,000) P/E = Total equity= =11.74 Net income $182,000,000 Implied equity value for FifeSiete: VE = P/E  Net income= 11.74$121,000,000 = $1,420,540,000 Value of FifeSiete's debt = VD = $230 million Therefore, the implied total value of FifeSiete is: VF = VE + VD = $1,420.54 + $230.00 $1,650.54 = million

Page 32

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

69. Cervil 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 Cervil has an enterprise value/EBITDA multiple of 5.40. What is the enterprise value of Cervil? (Round to the nearest million dollars.)

A) $1,334 B) million $453 C) million D) $1,787 Ans: Cmillion $1,315 Feedback: million value/EBITDA multiple for Cervil's competitor = 5.40 The enterprise Cervil's EBITDA = EBIT + D&A = $247 million + $84 million = $331 million Cervil's enterprise value is: VF = MultipleEBITDA = 5.40 $331million = $1,787.4 million

Page 33

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

70. Cervil 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 Cervil has an enterprise value/EBITDA multiple of 5.40. What is the value of Cervil's debt?

(Round to the nearest million dollars.)

A) $121 B) million C) $165 D) million $97 Ans: Dmillion $59 million Feedback: No. of shares outstanding = 135 million Share price = $12.80 Value of Cervil's equity = VE = $12.80 × 135 million = $1,728 million Cervil's enterprise value = $1,787.4 million Cervil's debt value = VD = VF – VE = $1,787.4 – $1,728 = $59.4 million

Page 34

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

71. Factrack 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 value of the cash flows in the first three years is: The present $342.5 $512.3 $750.0 + + (1.1125)3 PV(FCFF 3 ) = (1.1125) (1.1125)2 = $307.87 + $413.93 + 544.70 =$1,266.50 million Free cash flows in year 4 = $750 million × (1.08) = $810 million $810 TV3 = = $24,923.08 0.1125 – 0.08 Terminal value = The present value of the terminal value is: TV3 24,923.08 PV (TV3) = = =$18,100.96 millions 3 3 (1+WACC ) (1.1125) Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,266.5 + $18,100.96 + $0 =$19,367.46 million

Page 35

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

72. ProtoSeis 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? (Do not round intermediate computations. Round final answer to the nearest million.)

A) $628 B) million C) $864 D) million Ans: B$811 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 TV= = $920 million 0.10−0.00 Terminal value = The present value of the terminal value is:

Nonoperating assets = NOA = $23.4 million Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $212.54 + $628.37 + $23.4 =$864.31 million

Page 36

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

73. Symbyrec Phonic, 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? (Do not round intermediate computations.

Round final answer 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 $262.5+ $262.5(1.3) $262.5(1.3)2 $262.5(1.3)3 $262.5(1.3)4 = + + PV(FCFF 5) (1.09)2 + (1.09)3 (1.09)4 (1.09)5 (1.09) = $1,766.44 million Free cash flows in year 6 = $749.73 million × (1.06) = $794.71 million $794.71 TV5= =$26,490.33 million 0.09 – 0.06 Terminal value = The present value of the terminal value is: TV 5 $26,490.33 PV (TV5) = =$17,216.90 million 5 5 = (1+WACC ) (1.09) Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,766.44 + $17, 216.90 + $31.00 = $19,014.34 million

Page 37

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

74. Simpltar 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 final answer 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) (1.12)3 = $29.81 million Free cash flows in year 4 = $17.7 million Terminal value = The present value of the terminal value is: TV3 = $147.5 = $104.99 millions PVTV ( 3)= 3 (1+ WACC )3 (1.12) Nonoperating assets = NOA = $0 Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $29.81 + $104.99 + $0 = $134.8 million Value of debt = VD = $44.5 million Value of equity = VE = $134.8 – $44.5 = $90.3 million

Page 38

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

75. 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? (Round final answer to the nearest million.)

A) $301 B) million C) $354 D) million Ans: A$241 million Feedback: $144 Value of the FCFF for the first five years using the growing annuity formula = million FCFF for year 1 = $13.6 million Cost of capital = WACC = 8.0%

$13.6 × 1 = 0.08 – 0.06

= $60.67 million

–

1.0 6 1.0 8

5

g4× (1+g normal) 1 × (1+) Free cash flows in year 6 = FCFF = $13.6 × (1.06)4 × (1.03) = $17.68 million Terminal Value =

TV5 =

$17.68 0.08 – 0.03

=

$353.70 million

The present value of the terminal value is:

and the value of the firm is therefore: million VF = $60.67 million + $240.72 million$301.39 =

Page 39

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

76. Phosfranc Inc. is valuing the equity of a company using the free cash flow from equity, FCFE, approach and has estimated that the FCFE in the next three years will be $6.25, $7.70, and $8.36 million respectively. Beginning in year 4, the company expects the cash flows to increase at a rate of 4 percent per year for the indefinite future. It is estimated that the cost of equity is 12 percent. What is the value of equity in this company? (Do not round intermediate computations. Round final answer to the nearest million.)

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 PV(FCFF 3)= (1.12)2 (1.12)3 (1.12) = $17.67 million FCFF3 = FCFE3 as there is no debt component.

The terminal value is: FCFE 3  (1+ g ) $8.36 (1.04) = =$108.68 million TV3 = kE − g 0.12 − 0.04 The present value of the terminal value is: TV3 $108.68 = = $77.36 millions PVTV ( 3)= 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

Page 40

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

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

77. You are valuing the equity of NewNil Corp. using the FCFE approach and have estimated that the FCFE in the next three years will grow at 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? (Round final answer to the nearest million dollars.)

A) $42 B) million C) $56 D) million Ans: C$48 million $6 Feedback: million FCFE for year 1 = $2.1 million × (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) (1.10)3 = $6.07 million The terminal value is: FCFE 3  (1+ g ) $2.65 (1.05) = =$55.55 million TV3 = kE − g 0.10 − 0.05 The present value of the terminal value is: TV3 $55.55 = = $41.74 millions PVTV ( 3)= (1+ kE)3 (1.10)3 Therefore, if there are no nonoperating assets, the value of the equity is VF = $6.07 + $41.74 = $47.81 million

Page 41

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

78. 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?

(Round final answer A) $14.92 perto two decimal places.)

B) share $16.65 C) per share D) $11.80 per Ans: Dshare $10.88 per share Feedback: Value per share = Share value × [(1 + Control premium) × (1 – Marketability discount) × (1 – Key person discount) = $13.44 × (1 + 12%) × (1 – 15%) × (1 – 15%) = $10.88

Page 42

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

79. Shuman Wolf 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 $20 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 9 percent. Shuman estimates the marketability discount for such a firm to be 11 percent. The discount for the key person, one of the founders who may leave the firm upon Shuman's control of the firm, is 19 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.)

A) $16.47 per B) share $31.45 C) per share D) $15.72 per Ans: Cshare $32.94 per share Feedback: Value per share = Share value × [(1 + Control premium)×(1 – Marketability discount) × (1 – Key person discount) = $20 × (1 + 9%) × (1 – 11%) × (1 – 19%) = $15.72

Page 43

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

80. Alfred Sautin wants to invest in Dieciring, Inc., a private company. Based on earnings multiples of similar publicly traded firms, Alfred estimates the value of the private company's stock to be $19 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 11 percent. He estimates the marketability discount for such a firm to be 14 percent. The discount for the key person, one of the founders who may leave the firm upon Alfred's control of the firm, is 16 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.)

A) $15.24 per B) share $18.10 C) per share D) $14.05 per Ans: Ashare $20.70 per share Feedback: Value per share = Share value × [(1 + Control premium) × (1 – Marketability discount) × (1 – Key person discount) = $19 × (1 + 11%) × (1 – 14%) × (1 – 16%) = $15.24

Page 44

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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.

Page 45

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 are 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.

Page 46

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 should be 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 differences 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 ratio you are using are consistent with each other.

The data used to compute the multiple for the comparable company should include the stock price as of the valuation date and accounting data from the same period for which you have accounting data for the company of interest.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

84. Why does the value of a business change over time?

Ans: The value of a business changes over time because of: • 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.

Page 47

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 19: Financial Planning and Managing Growth Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. The investment plan of a firm addresses the issue of what capital resources the management needs to get to achieve its goals.

A) True B) False Ans: A

.

19-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. The financing plan deals with how a firm is going to secure the funds needed to pay for the capital resources required.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. The financing plan documents a firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities that 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 Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. The strategic plan identifies major areas for investments in productive assets, and also identifies mergers, alliances, and divestitures to strengthen a firm’s business portfolio.

A) True B) False Ans: A

.

19-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. The strategic plan of a firm addresses the issue of what capital resources the management needs to achieve its goals.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Once capital investments are made, they are almost impossible to be reversed.

A) True B) False Ans: A

.

19-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. In the financing plan of a firm, 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 Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. The financial plan focuses only on strategic planning and investment planning.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. The cash budget identifying the time line for cash inflows and outflows included in divisional business plans is a part of the financial plan.

A) True B) False Ans: A

.

19-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. Financial planning helps management to establish financial and operating goals for a firm and to communicate those goals throughout the firm.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Financial planning models are not considered an integral part of financial planning.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. Financial models provide management with the ability to prepare projected financial statements.

A) True B) False Ans: A

.

19-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. Sales are often correlated to the regional or national economy, and hence economic forecasts are incorporated into the financial planning model.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. 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 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Investment and financing policy decisions are not considered inputs in financial planning models.

A) True B) False Ans: B

.

19-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. 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 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 20. 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 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 21. 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

.

19-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. Sales are often correlated to the regional or national economy, so it is not necessary to incorporate economic forecasts into the model.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. The percent of sales model is a complex financial planning model.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. In the percent of sales model, all income statement and balance sheet accounts vary directly with sales.

A) True B) False Ans: B

.

19-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 25. 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 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 26. Fixed assets vary directly with sales when firms are operating at less than full capacity.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 27. Firms that are not highly capital intensive tend to be more risky than similar firms that use less fixed assets.

A) True B) False Ans: B

.

19-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 28. In cases where fixed assets are added as large discrete units, and much of a firm’s capacity may not be utilized for some period of time. These types of assets are called lumpy assets.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 30. Holding the growth rate constant, the higher a firm's dividend payout ratio, the larger the amount of external debt or equity financing needed.

A) True B) False Ans: A

.

19-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 31. The sustainable growth rate is the rate of growth that a firm can sustain without selling additional debt.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 32. The sustainable growth rate is the rate of growth that a firm can sustain without selling additional equity while maintaining the same capital structure.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 33. The higher a firm's dividend payout ratio, the higher is the firm's internal growth rate.

A) True B) False Ans: B

.

19-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 34. The higher a firm's plowback ratio, the higher is its sustainable growth rate.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 35. The lower a firm's ROE, the lower is the firm's sustainable growth rate.

A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 these Ans: D

.

19-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Which of the following issues is addressed in a financial plan?

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 these Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. Which of the following issues is NOT addressed in a firm’s financial plan?

A) What is the growth rate for the firm's main competitor?

B) Where is the firm headed?

C) What capital resources does the management need to get there?

D) How is the firm going to pay for the resources needed?

Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. The strategic plan identifies A) the lines of business in which a firm will compete.

B) major areas of investment in productive assets.

C) capital expenditures, acquisitions, and new lines of business.

D) All of these Ans: D

.

19-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. The strategic plan does NOT identify A) major areas of investment in productive assets.

B) future mergers, alliances, and divestitures.

C) working capital strategies.

D) the lines of business a firm will compete.

Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Which of the following is true of capital expenditures?

A) It is part of a firm's investment plan.

B) Once a capital investment is made, it is almost always impossible to be reversed.

C) Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations.

All of these D) Ans: D

.

19-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. 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. the dollar amount of funds that has to be raised externally and the sources of funds B) available to the firm, the desired capital structure for the firm, and the firm's working capital policy. the dollar amount of funds that has to be raised externally and the sources of funds C) available to the firm, the firm's dividend policy, and the firm's working capital policy. the firm's dividend policy, the desired capital structure for the firm, and the firm's D) working capital policy.

Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Which of the following is a part of a financing plan?

A) The dollar amount of funds that has to be raised externally and the sources of funds available to a firm The desired capital structure for a firm B) A firm's dividend policy C) All of these D) Ans: D

.

19-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. A 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 these Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. The financial planning model 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 these Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Financial planning models A) help management make investment decisions.

B) help management make financing decisions.

C) make the analysis faster and accurate.

D) All of these Ans: D

.

19-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. 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 these Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following statements is NOT true?

A) Sales forecasts models are typically very basic and use no complicated analysis.

B) Sales forecasts are generated within a firm.

C) Sales forecasts utilize economic variables as input.

D) All of these Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. The inputs used in building financial planning models include A) financial statements, sales forecasts, and a firm's investment and financial policy decisions. pro forma statements, sales forecasts, and macroeconomic variables.

B) pro forma statements, sales forecasts, and financing decisions.

C) None of these D) Ans: A

.

19-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Which 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 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Which 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 compare the projected financial statements.

Economic forecasts and their impact on the firm's sales are also included in financial B) planning models.

Investment and financing decisions are not considered as inputs in financial planning C) models.

Changes in a firm's balance sheet and income statement items as a result of the growth in D) sales are also used in these models.

Ans: C

.

19-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. 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 payables vary directly with sales. fixed assets that do not always vary directly with sales.

C) All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. Which of the following statements is NOT true about more sophisticated financial planning model?

A) Only fixed costs change directly with sales.

B) Working capital accounts like inventory, accounts receivables, and accounts payables vary directly with sales.

Fixed assets do not always vary directly with sales.

C) All of these D) Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. As sales increase, a firm needs to _____ proportionately to support the _____.

A) increase the level of fixed assets; increase the level of inventory B) increase the level of inventory; higher sales level C) increase the level of inventory; increase the level of fixed assets D) None of these Ans: B

.

19-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 55. Which of the following statements is NOT true for a firm that operates below full capacity?

A) Fixed assets can vary directly with sales.

B) Fixed assets will not vary directly with sales.

C) Fixed assets per unit can be incrementally changed.

D) All of these Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 56. Which 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 equity is called the capital intensity ratio.

C) The higher the capital intensity ratio, the more capital a firm needs to generate sales.

D) Firms that have high capital intensive ratios are riskier than similar firms that use less fixed assets.

Ans B :

.

19-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 57. A firm paid out $163,961.60 as dividends on net income of $298,112. What is the firm's retention ratio?

A) 55% B) 45% C) 50% D) None of these Ans: B Feedback: Dividends = $163,961.60 Net income = $298,112.

Dividends = $163,961.6 = Net =55% Dividend payout ratio income 0 $298,112.0 0

.

19-21

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 58. 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. (Round your percentage answers to nearest whole number.)

A) 85%, 15% B) 45%, 55% C) 55%, 45% D) 15%, 85% Ans: A Feedback: Revenues $312,766.00 Costs 220,222.00 EBIT $92,544.00 Interest 31,477.00 EBT $61,067.00 Taxes (34%) 20,762.78 Net income $40,304.22 Dividends paid = $34,125

Dividend payout ratio =

Dividends Net Income

.

=

34,125.00

=

85%

40,304.22

19-22

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 59. Comacho Traders has total assets of $513,480 and sales of $723,062. What is the firm's capital intensity ratio? (Round to two decimal places.)

A) 1.41 B) 0.71 C) 1.23 D) None of these Ans: B Feedback: Total assets = $513,480 Sales = $723,062

Capital intensity ratio= =

Total assets Net sales $513, 480 = 71.01% $723, 062

=0.71

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 60. Michael Holdings, Inc. has total assets of $1,480,072 and sales of $2,236,625. What is the firm's capital intensity ratio? (Round to two decimal places.)

A) 66.17% B) 53.73% C) 151.14% D) None of these 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%

.

19-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level Of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 61. Dennis Compton, Inc. has total assets of $5,335,901 and a capital intensity of 53.9%. What is the firm's sales? (Round to nearest whole dollar.)

A) $5,335,901 B) $2,828,028 C) $9,899,631 D) None of these Ans: C Feedback: Total assets = $5,335,901 Capital intensity ratio = 53.9%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. Which of the following statements in using more sophisticated planning models 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 decisions.

Retained earnings will vary directly as sales changes.

C) All of these D) Ans: C

.

19-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. Which of the following statements in using more sophisticated planning models is 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 decisions.

Retained earnings will vary as sales changes but not directly as it is affected by the firm's C) dividend payout policy.

All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Which of the following includes weaknesses in financial planning models?

A) Interest expense is not accounted.

B) All working capital accounts do not necessarily vary directly with sales, especially cash and inventory.

The way fixed assets are handled as lumpy assets, leaving the company with excess C) capacity.

All of these D) Ans: D

.

19-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 65. Which of the following statements in accounting for changes in fixed assets is NOT true?

A) When a firm is not operating at full capacity, sales may be increased without adding any new fixed assets.

Since it requires time to get new assets operational, they are added in small discrete B) quantities.

Fixed assets are added in large discrete units called lumpy assets.

C) All of these D) Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 66. Which of the following statements in accounting for changes in fixed assets is NOT true?

A) When a firm is not operating at full capacity, sales may be decreased without adding any new fixed assets.

Since it requires time to get new assets operational, they are added as the firm nears full B) capacity.

Fixed assets are added in large discrete units called lumpy assets.

C) All of these D) Ans: D

.

19-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. Which of the following is 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) Rapid growth is considered a desirable achievement in capital budgeting decisions.

C) The cost of the projects should comply with the firm's budget constraints.

D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. Which 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.

Rapid growth is considered a desirable achievement in capital budgeting decisions.

B) Once the list is made, no management review can change it.

C) All of these D) Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. External funding needed (EFN) is A) the additional debt or equity a firm needs to issue so that it can purchase additional assets to support an increase in sales. the additional funds raised by a firm to pay off existing short-term debt.

B) the additional funds raised by a firm to pay off existing long-term debt.

C) None of these D) Ans: A

.

19-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 70. Which of the following statements is NOT true?

A) The internal growth rate (IGR) is defined as the maximum growth rate that a firm can achieve without external financing.

The higher the retained earnings generated by a firm, the higher the growth possible B) without using external funding.

Given the same level of retained earnings, a firm that has the higher amount of total C) assets has a higher growth possibility without using external funding.

All of these D) Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Firms that achieve higher growth rates without seeking external financing A) have a high plowback ratio.

B) have less equity and/or are able to generate high net income leading to a high ROE. C) are not highly leveraged.

D) All of these Ans: D

.

19-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. 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 ROE. C) are highly leveraged.

D) None of these Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 73. The sustainable growth rate (SGR) A) is a function of the plowback ratio and the ROE. B) the rate of growth that a firm can sustain without selling additional shares of equity.

C) helps management to determine whether they can avoid issuing new equity.

D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 74. Which of the following statements about the sustainable growth rate (SGR) is NOT true?

A) The SGR is a function of the plowback ratio and the ROE. B) The SGR determines the rate of growth that a firm can sustain without selling additional shares of equity.

The SGR helps management to determine whether they can avoid issuing new debt.

C) All of these D) Ans: C

.

19-29

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 75. Which of the following statements about the sustainable growth rate (SGR) is true?

A) The higher a firm's ROE, the higher the SGR. B) 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 statements.

C) None of these are true D) Ans: C

Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 76. Hilton Corp. has revenues of $1,214,800, 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 these Ans: A Feedback: Revenue = $1,214,800 Tax rate = 32%

Costs = $816,355; Payout ratio = 50%

Retained earnings = $270,942.60 (1 0.50) = $135,471.30

.

19-30

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 77. Tangent Inc. has revenues of $4,375,233, 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? (Round final answer to two decimal places.)

A) $171,254.18 B) $755,533.15 C) $503,688.77 D) None of these Ans: C Feedback: Revenue = $4,375,233 Tax rate = 34%

Costs = $2,467,321; Payout ratio = 60%

Retained earnings = $1,259,221.92 (1 − 0.60) = $503,688.77

.

19-31

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 78. 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.(Round the percentage answer to nearest whole number.)

A) 66%, 34% B) 25%, 75% C) 69%, 31% D) 34%, 66% Ans: C Feedback:

Revenues Costs EBIT Interest EBT Taxes (34%) Net income Dividends paid = $1,384,125

$9,651,220.00 6,080,412.00 $3,570,808.00 511,233.00 $3,059,575.00 1,040,255.50 $2,019,319.50

Dividends = $1,384,125.00 = Net = 68.5% Dividend payout ratio income $2, 019, 319.50 =69%

.

19-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 79. 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? (Do not round intermediate calculations. Round final answer to one decimal place.)

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%

= Plowback ratio  ROE  Equity ratio Internal growth rate (IGR) Equity = Plowback ratio Net income Equity Total assets Net income = Plowback ratio  Total assets $1,212,335 522, 788 $12,  = 0.70 6.8% =

.

19-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 80. Mercantile Co. 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? (Do not round intermediate calculations. Round final answer to two decimal places.)

A) 21.21% B) 8.62% C) 11.65% D) 9.43% Ans: C Feedback: Net income = $3,413,500 Total assets = $16,109,445 Plowback ratio = 55%

= Plowback ratio  ROE  Equity ratio Internal growth rate (IGR) Equity = Plowback ratio Net income Equity Total assets Net income = Plowback ratio  Total assets = 0.55 $3, 413, 500 $16,109, 445 = 11.65%

.

19-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 81. Mandolin Bottlers Co. 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? (Round your answer to the nearest dollar.)

A) $32,290,904 B) $238,824 C) $30,388,235 D) None of these Ans: A Feedback: Net income = $4,272,335 Total assets =?

Plowback ratio = 65% IGR = 8.6%

= Plowback ratio  ROE Equity ratio Internal growth rate (IGR) 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 Total assets= 0.65 =$32,290,904 0.086

.

19-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 82. 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? (Round to two decimal places) A) 8.32% B) 3.55% C) 6.43% D) 4.84% 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%

.

19-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 83. Sterling Resorts Co. 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, it expects a net income of $3,475,321 and will pay out 45 percent as dividends. What is the external financing needed by the firm to meet its growth expectations?

A) $1,796,849.30 B) $1,449,317.20 C) No external funding is needed.

D) None of these Ans: B Feedback: Total assets = $13,442,975 Expected net income = $ 3,475,321 Addition to retained earnings = $3,475,321 × (1 − 0.45) = $1,911,426.55

.

19-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 84. 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 these Ans: A Feedback: Total assets = $9,751,223 Net income = $2,213,564 Addition to retained earnings = $2,213,564 × (1 − 0.65) = $774,747.40

.

19-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 85. 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? (Round your final answer to one decimal place.)

A) 32.9% B) 6.4% C) 30.3% D) 26.5% Ans: C Feedback: Total assets = $6,413,228 Net income = $3,145,778 EFN = $1,000,000 Addition to retained earnings = $3,145,778 × (1 − 0.70) = $943,733.40

.

19-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 86. 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? (Round your final answer to one decimal place) A) 32.9% B) 25.1% C) 30.3% D) 27.3% Ans: B Feedback: Total assets = $4,417,665 Net income = $2,771,342 EFN = $0 Addition to retained earnings = $2,771,342 × (1 – 0.60) = $1,108,536.80

.

19-40

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 87. 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) 7.44% B) 2.15% C) 0.47% D) 8.2% Ans: A Feedback: ROE = 18.6% Payout Ratio = 60%

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 88. 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? (Round to nearest whole number.)

A) 34% B) 30% C) 24% D) 28% Ans: B Feedback: ROE = 23.4% Plowback ratio =?

Sustainable growth rate = 7%

=30%

.

19-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 89. 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? (In your interim computations, round your ROE percentage to one decimal place.)

A) 12.74% B) 23.72% C) 18.96% D) 20.10% Ans: A Feedback: Sales = $4,512,644 Net income = $736,253 Debt ratio = 47% Dividend payout ratio = 65% Total assets = $3,812,832

Equity = 0.53 × $3,812,832 = $2,020,800.96

SGR = Plowback ratioROE = 0.350.364=12.74%

.

19-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 90. Courtney Bike, Co. 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? (Do not round intermediate calculations. Round final answer to one decimal place.)

A) 17.2% B) 15.6% C) 11.5% D) 18.9% Ans: C Feedback: Net profit margin = 7.8% Debt ratio = 45% Total assets = $2,112,370 Sales = $4,276,990 Dividend payout ratio = 60%

Net income  Plowbackratio Equity $333,605.22 =  0.40 $1,161,803.50 = 11.49%

SGR =

.

19-43

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 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 a 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 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 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.

.

19-44

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 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 at which a firm can grow without needing any external equity financing and holding the level of debt constant.

Growing a firm at the sustainable growth rate allows management to avoid costly equity issues, thus reducing the dilution of earnings. Whenever a firm grows 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.

.

19-45

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 20: Options and Corporate Finance

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) B) True Ans: False A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

3. A call option can sometimes be priced higher than the underlying asset.

A) True B) False Ans: B

.

1-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

4. Neither a call nor a put option can have a negative price.

A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

.

1-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9. When using the binomial pricing model to price an option, the volatility of the value 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

.

1-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Feedback: Call option will not be exercised as the stock price is lower than the strike price.

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Feedback: Put option will be exercised as the stock price is lower than the strike price.

Payoff = $60 – $50 Payoff = $10

.

1-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

12. Suppose you have sold a put option on a stock with a strike price of $25 and assume the current price of the stock is $25. If the stock price at expiration is $30, your payoff will be –$5.

A) True B) False Ans: B Feedback: The value of put option to the owner is $0 when the value of underlying asset is greater than or equal to the strike price. Since the stock price at expiration is $30 which is greater than the strike price of $25. The payoff value would be equal to $0.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

13. A portfolio consisting of one put option and one call option, both with the same exercise price 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 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

14. If a firm adds financial options to its debt securities, it will increase the interest expense to the firm.

A) True B) False Ans: B

.

1-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

15. 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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

16. 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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

17. The management’s ability to choose to terminate a project is like a put option.

A) True B) False Ans: A

.

1-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

18. 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

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

19. 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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

20. The option to abandon a project can decrease its value.

A) True B) False Ans: B

.

1-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

21. Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of smart thermostats. The discounted cash flows from smart 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 Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

22. 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

.

1-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

23. 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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

24. 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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

25. 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

.

1-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

26. 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

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

27. 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 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 Feedback: Put option will guarantee $20,000 minus the put option premium of $1,000 She will get $19,000 for 1,000 bushels or $19 per bushel

.

1-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

28. 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 corn with a strike price of $15 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

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

29. 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 Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

30. Harmostrax 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 .

1-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

31. 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. Assume 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 Feedback: Call option premium earned = $0.50 Put option premium paid = $0.35 Net premium earned= $0.15 If price of crop at expiry falls below $11, the farmer would exercise put option.

If price of crop at expiry exceeds $14, the farmer is obligated to sell the crop at $14.

Range = (Minimum price + Net premium earned) to (Maximum price + Net premium earned) Range = ($11 + $0.15) to ($14 + $0.15) Range = $11.15 to $14.15

.

1-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 sell the underlying asset and the seller has the right to buy it. the buyer has the right to sell the underlying asset and the seller has the right to buy it.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

33. An investor (the buyer) purchases a put option from a seller. On the expiration date of a put 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. the buyer has the right to buy the underlying asset and the seller has the right to sell it.

Ans: C

.

1-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

34. Which of the following statements is true of a call option?

A) The value of a call option can never be positive.

B) The value of a call option can be more than the value of the underlying asset.

C) The value of a call option can never be worth less than the current value of the D) asset minus present value of the strike price.

The value of a call option can be worth more than the strike price.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

35. Which of the following statements is true of a put option?

A) The value of a put option can be negative.

B) The value of a put option can be worth more than the underlying asset.

C) The value of a put option can be less than the present value of the strike price D) minus the current value of the underlying asset.

The value of a put option increases when the stock price increases.

Ans: B

.

1-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Feedback: –$5= Payoff for call option = Stock price – Strike price = $15 – $20 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 Feedback: Payoff for put option = Strike price – Stock price = $35 – $25 $10=

.

1-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

39. Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which 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 C) American call option. Both European call and American call option D) should always have the same value. The American option can be exercised only on specific dates during the life of the option.

Ans: A

.

1-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40. The option payoff function is the relationship: A) between the value of an option and the value of a firm.

B) between the value of an option and the price of the underlying asset.

C) between the call premium and the value of an option.

D) between the call premium and the price of underlying asset.

Ans: B Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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) The option is nearing its expiration date.

Ans: C

.

1-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 B) worth less. Put options will be worth less, call options C) will be worth more. Both call and put options will be D) worth more. Both call and put options will be worth less.

Ans: D Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 B) worth less. Put options will be worth less, call options C) will be worth more. Both call and put options will be D) worth more. Both call and put options will be worth less.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 D) more. Both call and put options will be worth less.

Ans: D .

1-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

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 B) worth less. Call options will be worth less, put options C) will be worth more. Both call and put options will be D) worth less. Both call and put options will be worth more.

Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

47. The management at PhoneUn 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 its new line of cars is poorly received, its 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

.

1-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

48. Frost1 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.

Thisproblem. is a good example of: A) the dividend payout B) the underinvestment problem.

C) the asset substitution problem.

D) the agency cost of equity.

Ans: C Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

49. Why would the managers of a firm bundle options with stock in an IPO? A) B) To increase the supply of outstanding shares in order to attract more investors C) D) To promote the dilution of common stockholders’ control on assets Ans: To reduce the number of common shares that must be sold at the IPO price in order to raise the amount of money that the firm needs To bring down the earnings per share of common stockholders C

.

1-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

50. When a company issues convertible bonds with a $1,000 par value that can be converted to 20 shares of common stock, each bond includes: A) B) a put option with an exercise price of $200 per share.

C) D) a call option with an exercise price of $50 per share.

Ans: a put option with an exercise price of $20 per share. a call option with an exercise price of $20 per share B Feedback: The bond includes call option Exercise price = Par value of convertible bonds / Number of shares offered for conversion Exercise price = $1,000 / 20 shares = $50 per share.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

51. 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) B) stockholders.

C) D) lenders.

Ans: owners of a call option on the firm. holders of a risk-free bond with coupon payments equal to her salary.

B

.

1-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

52. When the value of the firm is above the face value of the debt: A) B) the stockholders repay the debt and the equity is worth less than $0.

C) D) the stockholders repay the debt and the equity is worth the difference between Ans: the firm value and the face value of the debt. the stockholders default and the lenders receive the value of the firm. the stockholders default and the equity is worth $0.

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

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

53. Which of the following is a valid reason for managers selecting projects with negative NPV? A) The NPV analysis includes a valuable real option to expand the project if things B) go well.

C) If a firm has debt, managers may create value for shareholders by taking on D) some risky negative NPV projects.

An Managers' payoff functions represent the payoffs of lenders. By taking negative s: NPV projects, the managers can create value for lenders.

Projects having negative NPV can have high internal rate of return.

B

.

1-22

Fundamentals of Corporate Finance 3e

Test Bank

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

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

54. 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 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

.

1-23

Fundamentals of Corporate Finance 3e

Test Bank

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

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

55. Arctic Inc. has built a highly interactive operating system for mobile and other electronic gadgets. The development cost to the company was high but the system was inexpensive to sustain and market. The NPV of this project was negative. However, in the coming years the company plans to launch mobile phones, portable audio and video devices. The decision of launching the operating system for mobile and other devices is an example of: A) option to defer investment.

B) option to abandon a project.

C) option to change operations.

D) option to make follow-on investments.

Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

56. 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 of 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) B) C) D) the option to defer investment. the option to make follow-on investments. the option to change operations. the option to abandon projects.

Ans: D

.

1-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

57. Adosonic Reality 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, Adosonic Reality 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 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

58. 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 selected 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.

If development is successful, it allows managers to reach wide range of consumers.

Ans: B

.

1-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

59. 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 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

60. 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. option fee isinvestment. best described as: A) theThis option 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

.

1-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 61. The management at Sevenglobe 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 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

62. Anonxy 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 than 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

.

1-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63. Bifive 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 Bifive Homes will evaluate population and real estate trends in Austin.

Its plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more than 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

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

64. 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) a put option on the firm's liabilities.

Ans: A

.

1-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

65. Which of the following statements is 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.

ABC Co. has no debt but very few investment opportunities. The board of B) directors decides not to pay out a large special dividend. Lenders collect 100 percent of the face value of the debt.

ABC Co. is financially sound. The company has a negative-NPV investment C) opportunity. Investors refuse to invest the additional funds necessary to pursue the project, as it has negative 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: A Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

66. 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

.

1-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 67. 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) public.

Ans: A Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

68. What is the payoff for a call option with a strike price of $50 if the underlying stock price at expiration is $85?

A) $35 B) $50 C) $45 D) $140 Ans: A Feedback: (Call) Payoff = Stock price – Strike price = $85 – $50 = $35 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

69. What is the payoff for the owner of a call option with a strike price of $35 if the underlying stock price at expiration is $30?

A) $10 B) $20 C) $5 D) $0 Ans: D Feedback: The payoff for the owner of a call option is zero as the value of the underlying asset, .

1-30

Fundamentals of Corporate Finance 3e

Test Bank

$30 is below the exercise price of $35.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

70. What is the payoff for the owner of a put option with a strike price of $63 if the underlying stock price at expiration is $43?

A) $126 B) $43 C) $20 D) $63 Ans: C Feedback: Payoff for the owner of a put option = Strike price – Stock price = $63 – $43 = $20 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

71. You own a put option on Phosfranc Inc. stock with a strike price of $50. The current stock price is $50. In which of the following cases your benefit will increase?

A) If the stock price goes up B) If the stock price goes down C) If the stock price stays the same D) Benefit is indifferent to the changes in the stock price.

Ans: B

.

1-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

72. You have sold a call option on Ausia Co. stock with a strike price of $50. You do not intend to make any other transactions before the options expiration date. The current stock price is $30. Which of the following statements best describes your hopes for the stock?

A) You want the stock price to fall below $30. You want the B) stock price to rise above $50. You are indifferent, as long C) as the stock price stays under $50. It doesn't matter; you D) are indifferent to changes in the stock price.

Ans: C Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

73. What is the payoff for a put option with a strike price of $22 if the price of the underlying stock at expiration is $19?

A) $1 B) $3 C) $20 D) $22 Ans: B Feedback: Payoff for the owner of a put option = Strike price – Stock price = $22 – $19 = $3

.

1-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

74. Consider a call option with a strike price of $20, which expires in one year. The riskfree 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? (Round intermediate computations to two decimal places.)

A) $0 B) $8 C) $15 D) $1 Ans: C Feedback: Without arbitrage, the value of the option must fall between $10.95 and $30. Out of the given choices, only $15 is a possible price for the option.

.

1-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

75. Consider a call option with a strike price of $10, which expires in one year. The riskfree 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? (Round intermediate computations to two decimal places.)

A) $0 B) $19.5 C) 0 D) $21.0 Ans: C0 $19.0 Feedback: 0 arbitrage, the value of the option must fall between $20.91 and $30. Out of the Without given choices, only $21 is a possible price for the option.

.

1-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

76. Consider a put option with a strike price of $40, which expires in one year. The riskfree 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? (Round intermediate computations to two decimal places.)

A) $0.50 B) $16.2 C) 0 D) $25.0 Ans: C0 $10.2 Feedback: 0 arbitrage, the value of the put option must fall between $17.04 and $19.04.

Without 37.04 Out of the given choices, only $25 is a possible price for the option.

.

1-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

77. Pitchgent, Inc., stock is currently trading at $22 per share. There are two types of options available on the stock. Call options with a strike price of $16, which expire next month, are currently trading at $7.00. Put options with a strike price of $16 which expire next month are currently trading at $1.10. Larry invests $132 in common stock.

Keaty invests $132 in the call options. Marek invests $132 in the put options. At the end of one month, the price of Pitchgent, Inc., is $25. Who made the most money off of their investment?

A) Larry B) Keaty C) Marek D) Larry and Keaty tied Ans: B Feedback: Larry holds ($132) / ($22) per share = 6 shares of stock. His gain is (6 shares) × ($25 per share) – $132 = $18 Keaty holds ($132) / ($7 per call option) = 18.857 call options. The final price of the stock is above the $16 strike price, so her options are in the money. Her gain is ($25 – $16) × (18.857 call options) – $132 = $37.714 Marek holds ($132) / ($1.1 per put option) = 120 put options. The final price of the stock is above the $16 strike price, so his options are out of the money. He received no payoff. His loss is –$132.

Keaty made the most money.

.

1-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

78. Tunerecord Unit Co. stock is currently trading at $24. There are two types of options available on the stock. Call options with a strike price of $24, which expire next year, are currently trading at $9.6. Put options with a strike price of $24, which expire next year, are currently trading for $2.4. Berniss invests $144 in common stock. Jewel invests $144 in the call options. Reynardo invests $144 in the put options. At the end of one year the price of Tunerecord Unit stock is $21.6. Who made the least losses off of their investment?

A) Berniss B) Jewel C) Reynardo D) Berniss and Jewel tied Ans: C Feedback: Berniss holds ($144) / ($24) per share = 6 shares of stock. The stock went down, so Berniss lost money. His loss is (6 shares) × ($21.6 per share) – $144 = –$14.4.

Jewel holds ($144) / ($9.6 per call option) = 15 call options. The final price of the stock is below the $21.6 strike price, so her options are out of the money. There is no payoff from her call options. Her loss is –$144.

Reynardo holds ($144) / ($2.4 per put option) = 60 put options. The final price of the stock is below the $24 strike price, so his options are in the money. His gain is ($24 – $21.6) × (60) – $144 = 0.

Reynardo broke even, the others lost money.

.

1-37

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

79. Assume that the stock of Alitor Craft, Inc,. is currently trading for $19 and will either rise to $21 or fall to $15 in one year. The risk-free rate for one year is 12 percent. What is the value of a call option with a strike price of $16? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $4.67 B) $2.33 C) $1.04 D) $6.83 Ans: A Feedback: 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 = ($21 × x) + (1.12 × y) $0 = ($15 × x) + (1.12 × y) The first equation can be written in terms of x as follows:

$5 – (1.12 y) $21 Now, substituting into the second equation gives us: x=

$0 =$15 ×

$5 – (1.12 y) $21

+ 1.12 y

1.12y = –$12.5 y = –$11.16 Finally, substituting this value back into the first equation gives us the value of x: $5 = ($21× x) + (1.12 × –$11.16) x = 0.833 The value of the option is the value of the replicating portfolio: (0.833 × $19) + (1 × (–$11.16)) = $4.67

.

1-38

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

80. Assume that the stock of Tencheck, Inc., is currently trading for $45 and will either rise to $57 or fall to $19 in one year. The risk-free rate for one year is 9 percent. What is the value of a call option with a strike price of $47? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $3.40 B) $6.84 C) $8.84 D) $7.25 Ans: D Feedback: The payoff from the call option is $10 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: $10 = ($57 × x) + (1.09 × y) $0 = ($19 × x) + (1.09 × y) the first equation can be written in terms of x as follows: $10 - (1.09 y) x= $57 Now, substituting into the second equation gives us:

$0 =$19 ×

$10 - (1.09 y) $57

+ 1.09 y

1.09 y = – $5 y = –$4.59 Finally, substituting this value back into the first equation gives us the value of x: $10 = ($57 × x) + (1.09 × –$4.59) x = 0.263 The value of the option is the value of the replicating portfolio: (0.263 × $45) + (1 × (–$4.59)) = $7.25

.

1-39

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

81. XYZ, Inc., stock is currently trading for $47 and will either rise to $49 or fall to $44 in one year. The risk-free rate for one year is 6 percent. You own a call option with a strike price of $32, which expires in one year. What is the value of your call option?

(Do not round intermediate computations. Round final answer to two decimal places.)

A) $0 B) $5.27 C) $10.0 D) 5 Ans: D$16.8 1 Feedback: The payoff from the call option is $17 if the stock price rises and $12 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $17 =$49 x + 1.06 y $12 =$44 x + 1.06 y $17 - (1.06 y) x= $49 Now, substituting into the second equation gives us:

$12 =$44 ×

$17 - (1.06 y) $49

+ 1.06 y

1.06 y = –$32.00 y = –30.19 Finally, substituting this value back into the first equation gives us the value of x: $17 = $49 x + 1.06 × (–$30.19) x=1 The value of the option is the value of the replicating portfolio: (1 × $47) + (1 × (–$30.19)) = $16.81

.

1-40

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

82. Assume that the stock of XYZ, Inc., is currently trading for $18 and will either rise to $24 or fall to $13 in one year. The risk-free rate for one year is 11 percent. What is the value of a call option with a strike price of $26?

A) $0 B) $5.23 C) $7.72 D) $2.00 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.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective

83. The standard deviation of the return on a stock is 25% per year. Compute the standard deviation over two years. (Round your intermediate answer to 3 decimal places.)

A) 30.35% B) 35.35% C) 12.25% D) 25.00% Ans: B Feedback: n σ2years = σ × ()1/2 = 25 × (2 years) 1/2 = 25 × 1.414 = 35.35%

.

1-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

84. Phocuscorp’s stock is currently worth $60. The replicating portfolio consists of one-half share and $24.50 risk-free loan. Compute the value of call option.

A) B) $5.5 C) D) $4.5 Ans: $5.0 $6.0 A Feedback: Value of the call option today = C = ($60 × x) + (1 × y) = ($60 × 0.5) + (1 × – $24.5) = $5.5 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

85. Assume that the stock of Unmix, Inc., is currently trading for $22 and will either rise to $31 or fall to $18 in one year. Assume the risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $25? (Round the final answer to two decimal places.)

A) $0 B) $1.85 C) $3.00 D) $4.85 Ans: D Feedback: 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 = ($31 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = –0.538 shares of stock y = $16.69 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.538 × $22) + ($16.69) = $4.85 .

1-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

86. Assume that the stock of AllSiete, Inc., is currently trading for $44 and will either rise to $50 or fall to $29 in 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? (Round the final answer to two decimal places.)

A) $0 B) $2.20 C) $3.14 D) $5.54 Ans: B Feedback: 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

.

1-43

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

87. Assume that the stock of Phoneeffect, 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? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $0 B) $2.75 C) $4.23 D) $5.73 Ans: C Feedback: 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 = –0.621 shares of stock y = $14.16 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.621 × $16) + ($14.16) = $4.23

.

1-44

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

88. Assume that the stock of TuneSeis, 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? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $0 B) $0.41 C) $1.78 D) $2.20 Ans: D Feedback: The payoff from the put option is $0 if the stock price rises and $25 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($32 × x) + (1.02 × y) $25 = ($5 × x) + (1.02 × y) x = –0.926 shares of stock y = $29.05 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.926 × $29) + ($29.05) = $2.20

.

1-45

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

89. Assume that the stock of Mixtoss, Inc., is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent.

What is the value of a put option with a strike price of $15? (Do not round intermediate computations.)

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 riskfree bonds The value of the option is the value of the replicating portfolio: (–0.167 × $18) + ($5) = $2 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

90. If the value of the underlying asset is well above the exercise price of put option then: A) it is likely that the option will be exercised by the buyer.

B) the exercise price remains constant irrespective of the change in the value of the underlying asset.

C) the value of the option is directly proportional to the value of the underlying asset.

D) the seller of the option will most likely make a profit.

Ans: D

.

1-46

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

91. Assume that the stock of Statrec, 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? (Do not round intermediate computations. Round final answer to two decimal places.)

A) B) $0 C) D) $2.35 Ans: $3.65 $3.80 C Feedback: 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

.

1-47

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

92. You own a share of common stock in Vibrapower, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume 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? (Do not round intermediate computations. Round final answer to two decimal places.)

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 Ans: C Feedback: First,$6 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 = –0.444 shares of stock y = $13.33 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.444 × $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

.

1-48

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

93. You are fortunate enough to own a put option with a strike price of $40 on the stock of Osmerc, Inc. The current stock price is $3. When the option expires, you expect the stock price to be either $2 or $5. Assume the risk-free rate of interest is zero. What is the value of your option?

A) $0 B) $35 C) $37 D) $46 Ans: C Feedback: The payoff from the put option is $35 if the stock price rises and $38 if the stock price falls. When the put option pays off in either state, the value of the option is strike price minus the current stock price. $40 – $3 = $37 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

94. Assume that the stock of EffeUn, 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) $2.00 C) $2.33 D) $5.00 Ans: A Feedback: 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.

.

1-49

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

95. 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. Assume 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?

(Do not round intermediate computations. Round final answer to one decimal place.)

A) $4.5 B) $25.0 C) $6.0 D) $6.5 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 portfolio is $1.25 + $5.25 = $6.5

.

1-50

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

96. Assume that the stock of DiezEight, 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? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $0 B) $15.6 C) 4 D) $21.4 0 Feedback: To calculate the value of this portfolio, we can use the Ans: D $18.5 binomial pricing model to calculate that value of the call and the put. Then 2 add the values together. The payoff from the call option is $35 if the we can 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) = $10.31 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) = $8.21 The total value of the portfolio is $10.31 + $8.21 = $18.52

.

1-51

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

97. 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 HearFour, Inc., whose current stock price is $16. One year from now, shares of HearFour will either rise to $18 or fall to $14. The second option is written on EsoOne, Inc., whose current stock price is also $16. One year from now shares of EsoOne 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) B) The call option on HearFour, is worth more.

C) D) The call option on EsoOne is worth more.

Ans: They are both worth the same amount.

There is not enough information to make a comparison.

B Feedback: First we can price the HearFour call option. The payoff from the HearFour 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 EsoOne call option. The payoff from the EsoOne 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 risk-free bonds The value of the option is the value of the replicating portfolio: (0.32 × $16) + ($0) = $5.09 The EsoOne call option is worth more.

.

1-52

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

98. Consider a call option and a put option both written on Neunlay, Inc. stock. Both options have a strike price of $20 and expire in one year. The stock of Neunlay, Inc., is currently selling for $20. In one month the stock will be at either $24 or $18. Assume 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 × $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.

.

1-53

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

99. The value of call option can never be less than _____ A) $0 $1 strike price value B) of under lying asset C) D) Ans: A Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

100. When we consider the value of a call option at some time prior to expiration, we must: A) compare the current value of the underlying asset with the present value of the B) cash flow by underlying asset, discounted at the risk-free rate.

C) compare the current value of the underlying asset with the present value of the D) exercise price, discounted at the risk-free rate. compare the current value of the underlying asset with the present value of the cash flow by underlying asset, discounted at the nominal rate. compare the current value of the underlying asset with the present value of the exercise price, compounded at the nominal rate.

Ans: B Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 101. Which of the following is true of a call option?

A) The value of a call option must be less than or equal to $0.

B) The value of a call option cannot be lower than the value of the underlying asset.

C) The value of a call option prior to expiration will never be less than the value of D) the option if it were exercised immediately.

A call option protects the seller from price volatility.

Ans: C

.

1-54

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

102. Calculate the value of put option with the given information. Value of the call option is $6.2, Exercise price is $58, risk-free rate of interest is 5.5%, time before the option expires is one year and the current value of underlying assets is $52. Consider the value for ‘e’ as 2.71828.

A) B) $9.10 C) D) $12.2 Ans: 0 $6.20 $8.92 A Feedback: The value of put option can be computed using the equation of put-call parity.

P = C + Xe–rt – V P = $6.2 + $58 × (2.71828)–(0.055)(1) – $52 P = $9.10

.

1-55

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

103. Trerec Co. is a privately owned oil drilling and refinery company with a significant amount of debt. Most of the company's cash flows come from the financially stable refinery 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 drilling project, determined to have a positive NPV. Because of the nature of oil prices, the project is very risky. At any oil price above $115, the project would add value to the company. However, if oil prices were to fall below $95 the losses could push the entire business into financial distress. Assume the risk-free interest rate is 0 percent. Which of the following strategies would allow the firm to pursue the positive NPV project while hedging the oil risk?

A)price The firm purchases call options with a strike price of $130 for each barrel of oil it B) expects to produce. Each option costs $6.

C) The firm sells call options with a strike price of $130 on each barrel of oil it D) expects to produce. Each option costs $6.

The firm purchases put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6.

The firm sells put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6.

Ans: C

.

1-56

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

104. Consider a corn farmer who expects to produce 55,000 bushels of corn at the end of this season. To hedge the risk associated with corn prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $8.50 per bushel and a premium of $0.40 per bushel. He also sells an equal amount of call options with a strike price of $8.50 per bushel and a premium of $0.53 a bushel. Which of the following statements is correct?

A) From this transaction the farmer can pocket $7,500 immediately.

B) If corn prices go up substantially, the farmer will earn more money.

C) The put options guarantee that the farmer will receive at least $7.63 per bushel at D) the end of the season.

The farmer has guaranteed that he will sell his corn for $8.50 a bushel.

Ans: D Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

105. Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for 4 years in exchange for payments of $650 per month. At the end of the lease, the customer can choose to purchase the SUV for $18,000. What sort of option does this resemble?

A) A put option on the SUV with a strike price of $18,000 B) A call option on the SUV with a strike price of $18,000 C) A put option on the SUV with a strike price of $17,800 D) A call option on the SUV with a strike price of $17,800 Ans: B

.

1-57

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

106. Neunlay 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 than $6,100 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 $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

The company purchases a call option for the necessary amount of copper with a B) strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

The company sells a put option for the necessary amount of copper with a strike C) price of $6,000 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 $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now.

Ans: B

.

1-58

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Hard

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

107. 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.

.

1-59

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 2 Level of Difficulty: Hard

Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

108. 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 riskfree 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.

.

1-60

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

109. You're brought in to consult on a project for Sanpharm 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 than 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.

.

1-61

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 4 Level of Difficulty: Hard

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

110. 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.

.

1-62

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 21: International Financial Management Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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 Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 2. While the production of goods and services has become globalized, American consumers only purchase domestic goods.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 3. The production of goods and services has become highly globalized due to emergence of large multinational companies.

A) True B) False Ans: A

.

21-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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 Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 6. Royal Dutch Shell is a transnational corporation.

A) True B) False Ans: A

.

21-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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 Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 9. English is the world's social language.

A) True B) False Ans: B

.

21-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 10. English is the language for international business, but not the world's social language.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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 Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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

.

21-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 13. Country risk has no effect on a firm's cash flows.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 15. The European manager's goal is to earn as much wealth as possible for a firm while considering the overall welfare of both the stockholders and stakeholders.

A) True B) False Ans: A

.

21-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 16. European firms focus on maximizing market share rather than stockholder wealth.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 17. Japanese managers focus on maximizing market share rather than stockholder wealth.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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

.

21-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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

.

21-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 22. The bid quote is the rate at which the dealer will sell foreign currency.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 23. The decision to accept international projects with a positive NPV increases the value of a firm, and it should be consistent with maximizing stockholder wealth.

A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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

.

21-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 25. To convert a 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: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 26. To convert a project's future cash flows into another currency, we need to use today's spot exchange rates.

A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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

.

21-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 30. Eurodollar and other Eurocurrency bonds have all characteristics identical to similar U.S corporate bonds.

A) True B) False Ans: B

.

21-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 31. Evidence of globalization include A) consumers in many countries buy goods that are purchased from a number of countries, other than just their own. goods and services are produced around the world.

B) the financial system has also become highly integrated.

C) All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 32. Which of the following statements about multinational firms is NOT true?

A) A multinational corporation is a business firm that operates in more than one country but is headquartered or based in its home country.

Multinational corporations are owned by domestic stockholders only.

B) Multinational corporations may purchase raw materials from one country, obtain C) financing from a capital market in another country, and produce finished goods with labor and capital equipment from a third country.

All of these D) Ans: B

.

21-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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) Time value of money,expected returns procedures, and size of market.

D) economic systems, cultural factors, and country risk Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 34. Which of the following statements about the goal of a 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 a Japanese business manager is to increase the wealth and growth of the keiretsu.

All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 35. Which of the following statements about the goal of a 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 a Japanese business manager is to increase the wealth and growth of the keiretsu.

Private-sector firms in China focus on providing full employment in the economy.

D) Ans: C

.

21-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic4 IMA: Global Business AICPA: Industry/Global Perspective 36. Economic benefits provided by the foreign exchange markets include A) a mechanism to transfer purchasing power from individuals who deal in one currency to people who deal in a different currency. a way for corporations to pass the risk associated with foreign exchange price B) fluctuations to professional risk-takers. a channel for importers and exporters to acquire credit for international business C) transactions.

All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 37. In 2010, 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: D

.

21-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 38. The major participants in the foreign exchange markets are A) multinational commercial banks, large investment banking firms, and domestic firms.

B) multinational commercial banks, local banks and domestic firms.

C) multinational commercial banks, large investment banking firms, and small currency boutiques.

None of these D) Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 39. Which of the following statements is true?

A) Equilibrium occurs at the price at which the quantity of the currency demanded exactly equals the quantity supplied.

When pounds become less expensive in relation to dollars, British products become less B) expensive for Americans to buy.

According to a British buyer, the lower the dollar price of pounds, the greater the C) number of pounds that must be given up to obtain dollars to buy foreign goods.

All of these D) Ans: D

.

21-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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 Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 41. A European quote is the same as A) an American quote.

B) an indirect quote.

C) a bidding quote.

D) a cross quote.

Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 42. Which of the following is an indirect quote from an American perspective?

A) £0.5125/$ B) $0.006900/¥ C) $1.5637/€ D) ¥115.23/€ Ans: A

.

21-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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) the dealer will buy domestic currency from you.

D) the dealer will sell domestic currency to the exchange.

Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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) the dealer will buy domestic currency from the exchange.

D) the dealer will sell domestic currency to you.

Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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) direct quote.

Ans: B

.

21-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 46. 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? (Round your final answer to two decimal places.)

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

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 47. Starling, Corp. 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 your final answer to the nearest dollar.)

A) $110,000,000 B) $10,623,913 C) $11,110,235 D) $1,138,940,000 Ans: B Feedback: Cost of payables = MP 110,000,000 Spot rate = MP 10.3540/$ Dollar cost of payables = MP 110,000,000 / MP 10.3540/$ = $10,623,913.46 or $10,623,913

.

21-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 48. 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) $42.3850/Rs. C) Rs.42.3850/$ D) Rs.4.2385/$ Ans: C Feedback: Inventory cost to firm = Rs.5,325,000 Dollar 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.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 49. 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.

.

21-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 50. If the spot rate is quoted as $0.009369/¥, what is the exchange rate in terms of yen per dollar?

(Round your final answer to the four decimal places.)

A) ¥0.009369/$ B) ¥0.936900/$ C) ¥106.7350/$ D) ¥16.7350/$ Ans: C Feedback: Spot rate = ¥0.009369/$ Direct quote = 1/ $0.009369/¥ = ¥106.7350/$

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 51. 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.

.

21-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 52. 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. B) the Yen is at a forward premium against the U.S. dollar.

C) the Yen is at a forward discount against the U.S. dollar.

D) the U.S. dollar is 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.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 53. Celio, Inc. sold equipment to a 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? (Round your final answer to the nearest dollar.)

A) $1,249,425 B) $805,457 C) $1,938,108 D) $1,312,224 Ans: C Feedback: Expected euro revenue = €1,249,425 30-day forward rate = $1.5512/€ Dollar revenue received = €1,249,425 × $1.5512/€= $1,938,108

.

21-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 54. 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? (Round your final answer to the nearest dollar.)

A) $2,640,338 B) $2,784,500 C) $2,936,534 D) $2,714,300 Ans: A Feedback: Cost of machinery = ¥278.45 million Forward rate = ¥105.46/$ Cost of equipment in dollars = ¥278,450,000 / ¥105.46/$ = $2,640,337.57 or $2,640,338

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 55. 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) THB33.0749/$ C) $0.0242/THB D) $1.2471/THB Ans: B Feedback: Cost of trip = THB 41,250 Cost of trip based on forward rate = $1,247.17 30-day forward quote = THB 41,250 / $1,247.17 = THB 33.0749/$

.

21-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 56. 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? (Round your final percentage answer to one decimal place.)

A) 1.2% B) 2.1% C) 0.9% D) 0.65% Ans: C Feedback:

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 57. 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? (Round your final percentage answer to two decimal place places.)

A) 0.26% B) 2.13% C) 0.96% D) 1.21% Ans: D Feedback:

.

21-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 58. 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? (Do not round your intermediate calculation. Round your final answer to four decimal places.)

A) MP10.3619/$ B) MP10.4192/$ C) MP10.4249/$ D) MP10.2165/$ Ans: A Feedback:

The ask rate will have to be MP10.3619/$ to provide a 0.55 percent bid-ask spread.

.

21-23

Test Bank

Fundamentals of Corporate Finance 3e

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 59. Bartman, Corp. 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? (Round your final answer to four decimal places.)

A) SK0.3214/SF B) SK3.1116/SF C) SK0.4183/SF D) SK2.1467/SF Ans: B Feedback: To find the SK/SF cross rate, divide the Swiss franc quote by the Swedish krona quote.

Cross rate = $0.6164/SF / $0.1981/SK = SK3.1116/SF

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 60. Xecor Pharma just received revenues of A$2,372,300 in Australian dollars (A$). The only quotes management received are A$2.0651/£ and $1.8538/£. What is the U.S. dollar value of the company's revenues? (Do not round your intermediate calculation. Round your final answer to the nearest dollar.)

A) $4,397,770 B) $4,899,037 C) $2,129,567 D) $9,081,834 Ans: C Feedback: Revenues received by Xecor Pharma = $2,372,300 To determine the A$ /$ cross rate, you divide the A$ to £ quote by the $/£ quote.

Cross rate = A$2.0651/£ ÷ $1.8538/£ = A$1.1139820 U.S. dollar value of its revenue

.

= A$2,372,300 / A$1.1140/$ = $2,129,567

21-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 61. 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? (Do not round your intermediate calculations. Round your final answer to the nearest dollar.)

A) $2,531,890 B) $2,305,350 C) $2,139,735 D) $1,987,325 Ans: C Feedback: Foreign currency payables = MP 23.5 million To find the MP/$ quote, divide the C$/MP quote by the C$/$ quote.

Cross rate = C$0.0981/MP / C$1.0774/$ = $0.091052534/MP Dollar cost of payables = MP23,500,000 × $0.0910525/MP = $2,139,735

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 62. Dresdner Bank has offered the following exchange rate quotes on Indian rupees (Rs) Rs.83.7612/£ and $1.8654/£. What is the cross rate between the Indian rupees and the U.S. dollar?(Round your final answer to four decimal places) A) Rs.44.9025/$ B) Rs.49.9375/$ C) Rs.51.2134/$ D) Rs.36,7122/$ Ans: A Feedback: To find the Rs./$ cross rate, divide the Rs/£ quote by the $/£ quote.

Cross rate = Rs.83.7612/£/ $1.8654/£= Rs.44.9025/$

.

21-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 63. 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 your final answer to one decimal place.)

A) 1.6% premium B) 6.3% premium C) 6.3% discount D) 1.6% discount Ans: B Feedback:

or 6.30% The British pound is at a forward discount of 6.3 percent against the U.S. dollar as it takes more pounds to buy a dollar at the forward rate. Or we can say that the U.S dollar is at a 90-day forward premium of 6.3 percent against the British pound.

.

21-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 64. 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 your final answer to the nearest percentage.)

A) 7% premium B) 7% discount C) 5% premium D) 5% discount Ans: C Feedback:

or 5.00% The Japanese yen is at a 5 percent forward premium against the dollar.

.

21-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 65. 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 discount of 7.65 percent against the dollar. What is the 30-day forward quote?

A) Rs.43.5622/$ B) Rs.41.5687/$ C) Rs.45.1226/$ D) Rs.42.7407/$ Ans: D Feedback: Spot rate = Rs.42.47/$ 30-day forward premium on the dollar = 7.65%

The 30-day forward rate is Rs.42.7407/$.

.

21-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 66. 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/BR. 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 your final answer to the nearest dollar.)

A) $24,687 B) $803,838 C) $779,152 D) $31,278 Ans: A Feedback: Foreign currency payables = BR1,272,500 Spot rate on payment date = $0.6317/BR Dollar cost of payables = BR1,272,500 × $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 or $24,687.00

.

21-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 67. 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 your final answer to the nearest dollar.)

A) $687 B) $338 C) $152 D) $286 Ans: D Feedback: Foreign currency payables = 11,500,000 Korean won 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 or $286.00

.

21-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 68. 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 your final answer to the nearest dollar.)

A) $24,687 B) $83,838 C) $59,023 D) $31,278 Ans: C Feedback: Foreign currency receivables = MP 41,275,000 Spot rate on payment date = $0.09596/peso Dollar revenues from receivables = MP 41,275,000 × $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 or $59,023

.

21-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 69. 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 your final answer to the nearest dollar.)

A) $124,687 B) $118,418 C) $159,023 D) $131,278 Ans: B Feedback: Foreign currency receivables = €4,275,000 Spot rate on payment date = $1.5645/€ 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 or $118,418.00

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 70. 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 activities.

D) All of these Ans: D

.

21-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 71. 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 those applicable for domestic firms. disallow any remittance of funds from the subsidiary to the parent firm for either a C) limited period of time or the duration of the project.

All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 72. 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 those applicable for domestic firms. remove tariffs and quotas on any imports.

C) disallow any remittance of funds from the subsidiary to the parent firm for either a D) limited period of time or the duration of the project.

Ans: C

.

21-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 73. 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) including the country risk premium to sunk costs.

D) None of these Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 74. The Euromarkets are A) vast, largely unregulated money and capital markets existing in Tokyo, Hong Kong, and Singapore. vast, regulated money and capital markets with major financial centers in the United B) Kingdom. vast, regulated money and capital markets with major financial centers in the euro zone.

C) None of these D) Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 75. 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 these Ans: B

.

21-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 76. Which 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.

Eurocredits are denominated in all major Eurocurrencies, although the dollar is the B) overwhelming favorite.

Eurocredits are short- to medium-term loans made to multinational corporations and C) governments of medium to high credit quality.

All of these D) Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 77. 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

.

21-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 78. Long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated are called _____.

A) Samurai bonds B) Eurobonds C) foreign bonds D) currency bonds Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 79. Which of the following statements about Eurobonds is NOT true?

A) Multinational firms can use Eurobonds to finance international or domestic projects.

B) Eurobonds are bearer bonds.

C) Eurobonds are bonds that have to be registered.

D) Eurobonds also pay interest annually.

Ans: C

.

21-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 80. 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? (Round your final answer to two decimal places.)

A) $63,107.45 B) $126,214.90 C) $39,143.76 D) $56,357.99 Ans: A Feedback: Amount Zylex plans to borrow = €4.5 million Term of loan = 90 days Interest cost = LIBOR + 0.5% = 4.175 % + 0.5% = 4.675% Interest cost in euros = €4,500,000 × 0.04675 × (90/360) = €52,593.75 Spot rate on payoff date = €0.8334/$ Dollar interest cost = €52,593.75 / €0.8334/$ = $63,107.45

.

21-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level Of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 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.

.

21-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 82. How does the goal of a 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 a 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 a Japanese business manager is to increase the wealth and growth of the keiretsu. As a result, he 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 privatesector firms fully embrace the Western standard of stockholder wealth maximization.

.

21-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 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 yendenominated 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.

.

21-40