Test Bank for Contemporary Financial Management 11th Edition R. Charles Moyer, James R. McGuigan, Wi

Test Bank For Contemporary Financial Management 11th Edition R. Charles Moyer, James R. McGuigan, William J. Kretlow Chapter 1—THE ROLE AND OBJECTIVE OF FINANCIAL MANAGEMENT MULTIPLE CHOICE 1. The primary objective of the firm is: a. Shareholder wealth maximization b. Social responsibility c. Long run survival d. Profit maximization ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

2. The limitations of the profit maximization goal include: a. It lacks a time dimension (i.e., it is static) b. It fails to consider risk c. The definition of profit is ambiguous d. All the above are limitations ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Maximization of shareholder wealth: Managerial strategies 3. The shareholder wealth maximization goal states that management should seek to maximize the _______ of the expected future returns to the owners of the firm. a. Future value b. Compound value c. Percentage value d. Present value ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

4. Shareholder returns can take the form of a. Periodic dividend payments b. Proceeds from the sale of the stock c. Periodic interest payments d. Periodic dividend payments and proceeds from the sale of the stock ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

5. Shareholder wealth is measured by the ________ of the shareholders' common stock holdings.

a. b. c. d.

Book value Market value Historic value Compound value

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

6. The objective of maximizing shareholder wealth, as measured by the market value of the firm's stock a. does not consider the timing of the benefits received b. provides a way to consider the risk of the returns being offered c. benefits only certain stockholders d. neither considers the timing of the benefits received nor benefits only certain stockholders ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

7. The two most important disciplines on which financial management relies are a. accounting and production b. accounting and marketing c. economics and marketing d. accounting and economics ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Financial management and other disciplines

NAT: Reflective thinking

8. The most widely accepted objective of the firm is to a. minimize risk b. maximize profits c. maximize shareholder wealth d. maximize earnings per share ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

9. The ______ the risk of receiving future cash flows, the ______ will be the present value of those cash flows. a. greater, greater b. greater, lower c. lower, lower d. lower, greater ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Risk

10. A major advantage of using the maximization of shareholder wealth as the primary goal of the firm is that this goal considers a. the timing and the risk of the expected benefits to be received b. the investor's consumption utility c. the value of closely held partnerships d. all the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

11. The primary reason for the divergence between the shareholder wealth maximization goal and the actual goals pursued by management has been attributed to a. separation of social responsibility and stakeholders' concerns b. separation of ownership and control c. separation of personal welfare and long-run profit goals d. the granting of "golden parachute" contracts ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Divergent objectives

12. Giving top management _______ is one method that ensures managers will act in the interest of shareholders in merger decisions. a. "golden parachute" contracts b. excellent pay c. executive perks d. job security ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Divergent objectives

13. _____ arise from the divergent objectives between owners and managers. a. Shareholder relationships b. Stakeholder problems c. Creditor problems d. Agency problems ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Agency problems

14. Agency costs include all of the following except: a. expenditures to monitor management's actions b. providing stock as part of management's compensation c. flotation costs d. bonding expenditures ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Stockholders and managers

15. A potential agency conflict can arise between stockholders and creditors because owners may a. increase the risk of a firm's investments b. decrease the amount of debt outstanding c. decrease the risk of a firm's investments d. increase the firm's net worth ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Stockholders and creditors

16. When KKR acquired RJR Nabisco, the ______ in the debt ratio, resulted in a(n) ______ in the value of the firm's outstanding bonds. a. decrease, increase b. increase, increase c. decrease, decline d. increase, decline ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Stockholders and creditors

17. Agency problems may give rise to costs that ______ the market value of firms. a. increase b. decrease c. do not affect d. are not important to ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Stockholders and managers

18. All of the following are problems with the microeconomic profit maximization model except: a. the absence of a time dimension b. offers financial managers insights to a wide range of problems c. does not consider the risk of alternative decisions d. the problem of defining profits ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Maximization of shareholder wealth: Managerial strategies 19. ________ are largely outside of the direct control of managers. a. investment strategies b. economic environment factors c. major policy decisions d. dividend policies ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Managerial actions to influence value

NAT: Reflective thinking

20. The success of a firm is linked to its stakeholders. This group includes: a. community neighbors b. suppliers c. employees d. all the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Social responsibility concerns

NAT: Reflective thinking

21. Techniques identified by John Casey that managers could keep in mind when addressing the ethical dimensions of a business problem include all of the following except: a. collect all the facts bearing on the problem b. clarify the parameters of the problem c. involve all parties with a financial interest in the outcome d. seek equity for those who may be affected ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Ethical issues: the practice of financial management

NAT: Reflective thinking

22. Many small business owners are _________ diversified with respect to their personal wealth. a. poorly b. highly c. well

d. 90% ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Entrepreneurial finance issues: Shareholder wealth maximization 23. __________ deals with economic decisions of individuals, households, and firms. a. Economic accounting b. Microeconomics c. Blue Chip econometrics d. Macroeconomics ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Economics

24. Financial management draws heavily on the following related disciplines: a. accounting b. macroeconomics c. microeconomics d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Financial management and other disciplines

NAT: Reflective thinking

25. The chief financial officer (CFO) normally has responsibility for all the following except: a. advertising strategy b. managing interest rate risk c. trading foreign currencies d. accounting functions ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Organization of the financial management function

NAT: Reflective thinking

26. The controller normally has responsibility for all _______ related activities, while the treasurer is normally concerned with ________. a. acquisition, data processing b. tax, cost accounting c. tax, financial accounting d. accounting, expenditure of funds ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Organization of the financial management function

NAT: Reflective thinking

27. According to the shareholder wealth maximization goal, management should seek to maximize the __________ of the __________ to owners. a. present value; expected pretax cash flows b. future value; expected pretax cash flows c. present value; expected future returns d. future value; expected future returns ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A foundation concept

28. Shareholder wealth is measured by the __________. a. book value of the shareholders' common stock holdings b. market value of the shareholders' common stock holdings c. book value of the company's assets d. market value of the company's assets ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Determinants of value

29. Among the most important agency relationships in the context of finance is (are) the relationship(s) between __________. a. stockholders and creditors b. management and workers c. stockholders and creditors, and management and workers d. management and creditors ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Agency problems

30. Protective covenants in a company's bond indentures are used in agency relationships involving __________. a. stockholders and managers b. stockholders and creditors c. management and workers d. management and creditors ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Stockholders and creditors

31. The chief financial officer (CFO) of a corporation normally reports to the _______________________ of the company. a. chairman of the board of directors b. chief operating officer c. controller d. chief executive officer ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Organization of the financial management function

NAT: Reflective thinking

32. The ___________ has a goal of serving as a bridge between academic study of finance and the application of financial principles by financial managers. a. Financial Executives Institute b. Financial Management Association c. American Finance Association d. Institution of Financial Analysts ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Professional finance affiliation

NAT: Reflective thinking

33. All of the following economic environment factors affect stock prices except: a. investment strategies b. competition c. tax rates

d. currency exchange rates ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Managerial actions to influence value

NAT: Reflective thinking

34. The major factors that determine the market value of a company's shares of stock include the __________ . a. risk of its cash flows b. timing of its cash flows c. book value of its assets d. risk of its cash flows and the timing of its cash flows ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Determinants of value

35. There is often a divergence between the shareholder wealth maximization goal and the actual goals pursued by management. The primary reason for this is __________. a. geographical dispersion of shareholders b. separation of ownership and control c. age differences between managers and shareholders d. that both have their own agendas ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Divergent objectives

36. The existence of divergent objectives between owners and managers is one example of a class of problems arising from __________. a. social responsibility concerns b. age differences between managers and owners c. agency relationships d. union-management relations ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Agency problems

37. The activities of the treasurer include all of the following except: a. financial planning b. tax preparation c. credit analysis d. pension fund management ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Organization of the financial management function

NAT: Reflective thinking

38. The most important managerial objective is to: a. make MC=MR b. maximize profits c. minimize agency costs d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A foundation concept

39. _______ are important because the financial health of a firm depends on the firm being able to generate sufficient cash to pay its creditors, employees, suppliers, and owners. a. cash sales b. cash flows c. cash profits d. net profits ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A foundation concept

40. One method of decreasing the cash outflows of a firm is to a. decrease depreciation b. increase capital expenditures c. decrease dividends d. increase debt repayment ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Cash flow

41. If a firm shows an accounting net income, then a. it will not have a cash flow problem b. it will not have a problem obtaining a bank loan c. it will be able to repay all current liabilities on time d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Cash flow

42. Cash flow concepts are _____ but generally accepted accounting principles are ______ in the determination of a firm's net income. a. unambiguous, ambiguous b. ambiguous, unambiguous c. ambiguous, also ambiguous d. unambiguous, straightforward ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Importance of cash flow

43. Accounting-based measures of performance include all the following except a. return on equity b. cash flow c. return on assets d. market share ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Cash flows and shareholder wealth

NAT: Reflective thinking

44. Accounting-based measures of performance _____ subject to short-term manipulation by managers; cash flows ______ subject to short-term manipulation. a. are, are not b. are not, are c. are, are also d. are not, also are not ANS: A

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand the role of the finance function TOP: Cash flows and shareholder wealth 45. The net present value rule provides appropriate guidance for financial decision makers when costs are incurred immediately but a. future cash flows are not known with certainty b. marginal costs are equal to marginal revenue c. result in a stream of benefits over several future time periods d. marginal costs are greater then marginal revenue ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Net present value rule

46. Corporate officers normally include all the following except: a. Secretary b. Chief operating officer c. Treasurer d. Financial analyst ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporate organization

47. The difference between a firm's annual after-tax operating profit and its total annual cost of capital is known as: a. earned income b. Economic Value Added c. Managerial Value Added d. operating income ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Divergent objectives

48. ____ equals the number of shares outstanding times the market price per share. a. Book value b. Stakeholders wealth c. Total shareholder wealth d. Economic value ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: A Foundation Concept

49. A company that requires that its top officers own common stock in the company that is at least equal to their annual salary is: a. Ford Motor Company b. Tucson Electric Power Company c. Panhandle Eastern d. Anheuser-Busch ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Divergent Objectives

50. The net present value of an investment made by a firm represents the contribution of that investment to the ____ of the firm. a. book value b. profit

c. value d. cash flow ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Net present value rule

51. A major advantage of the corporate form of business over both sole proprietorships and partnerships is the a. limited liability b. reduction in taxes c. ease of formation d. ability to maintain ownership ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporation

52. An advantage that the corporate form of business has over either the sole proprietorship or partnership is the: a. ability to raise capital b. ease of changing ownership c. limited liability d. elimination of double taxes ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporation

53. A major disadvantage of a sole proprietorship is the fact that a. it is expensive to establish b. the owner has unlimited personal liability c. it is easy to finance growth d. the owner pays taxes on all the income ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Sole proprietorship

54. In a limited partnership, the limited partners may limit their: a. tax liability b. liability c. tax write-off d. ability to attract new products ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Partnership

55. Corporate securities represent claims against the a. corporate officers of the firm b. agents of the corporation c. liabilities and net worth of the firm d. assets and future earnings of the firm ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporate securities

56. _________ is (are) referred to as a residual form of ownership in a corporation. a. Common stock b. Preferred stock

c. Bonds d. Dividends ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporate securities

57. The advantages of the corporate form of organization over both sole proprietorships and partnerships include ________. a. limited liability b. permanency c. limited liability and permanency d. lower tax rates ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporation

58. Although this type of business generates less than 6% of the total U.S. business revenue, _____ make up approximately 75% of all businesses. a. general partnerships b. corporations c. limited partnerships d. sole-proprietorships ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Sole proprietorship

59. All of the following are advantages of the corporate form of business organization EXCEPT: a. unlimited life b. unlimited liability c. flexibility in ownership change d. ability to raise capital ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporation

60. There are problems with using the “profit maximization” criterion. Which of the following is/are correct?

I. Profit maximization has an ambiguous definition of “maximizing profits”.

II. Profit maximization fails to consider risk. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Foundation concept

61. Which of the following statements is/are correct?

I. Shareholders elect the Chairman of the Board II. The board of directors has no control over whether or not dividends will be paid. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand the role of the finance function

TOP: Corporate organization

62. There are three major factors that determine the market value of a company’s share of stock. All of the following are factors EXCEPT: a. Cash flows b. Sales generated c. Timing of cash flows d. Risk taken to generate cash flows ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Determinants of value

63. An economic principle used in finance is: a. Full utilization of data processing b. Marginal analysis where marginal costs are set equal to marginal revenues. c. Accrual basis of recognizing revenues and expenses d. Target capital structure ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Financial management and other disciplines

NAT: Reflective thinking

64. The definition of the marginal analysis principle is that financial decisions are made and actions are taken a. within the global economic viewpoint. b. with regard to governmental laws and cultural effectiveness. c. when the added benefits exceed the added costs. d. based on the impact of public opinion.

ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Maximization of shareholder wealth: Managerial strategies 65. There are three forms of business organization. Which of the following has unlimited liability?

I. Corporation II. General partnership a. I only b. II only c. Both I and II d. Neither I nor II ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Partnership

66. The managerial decision that emerges from the microeconomic profit maximization model is: a. Marginal Costs < Marginal Revenues b. Marginal Costs = Profits c. Marginal Revenues > Marginal Costs d. Marginal Costs = Marginal Revenue ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Maximization of Shareholder Wealth: Managerial Strategies

67. Sole proprietorships, partnerships and corporations are the three main forms of business organization.

There are other types which are referred to as hybrids. Examples of hybrid business forms are: a. 10K & 14B Corporations b. Section 8 and Subchapter S Corporations c. Subchapter S and LLCs d. 10K Corporations and LLCs ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Other Types of Business Organization

NAT: Reflective thinking

68. The type of corporate security that pays periodic interest as well as the eventual return of principal is: a. Preferred stock b. Debt Securities c. Equity Securities d. Fixed asset loans ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Corporate Securities

69. What is the function of the CFO? a. Control of the accounting functions of the firm. b. Effective communication with the investment community about the firm’s performance. c. Oversight of the financial statements. d. Determination of effective tax reduction strategies.

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Organization of the Financial Management Function

NAT: Reflective thinking

70. According to the Small Business Administration, what percent of all businesses are considered small businesses? a. >20% b. >75% c. >95% d. >50% ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance functions TOP: Entrepreneurial Issues: Shareholder Wealth Maximization ESSAY 1. Explain the chain of command in a corporation.

ANS: The stockholders, who own a pro-rata share of the company, elect the board of directors. The board makes broad decisions affecting the direction of the company, leaving the day-to-day decisions to the corporate officers, who are elected by the board. Corporate officers are: the chairman of the board, the chief executive officer, the chief operating officer, chief financial officer, president, vice-president(s), treasurer and secretary.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Corporate organization

2. There are five competitive forces that influence an industry’s structure.

ANS: 1.

2.

3.

4.

5.

The threat of new entrants.

The threat of substitute products The bargaining power of buyers The bargaining power of suppliers The rivalry among current competitors

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Managerial actions to influence value 3. What are the shortcomings in the profit maximization objective as a managerial strategy?

ANS: 1. Profit maximization lacks a time dimension.

2. There are many definitions of profit for a firm. There is much latitude permitted in recognizing and accounting for costs and revenues.

3. There is a question as to which profit is to be maximized: total profit, rate of profit or EPS. 4. There is no direct way to consider the risk associated with alternative decisions.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Maximization of shareholder wealth: Managerial strategies 4. Preferred stock is considered priority stock. Explain this priority.

ANS: Common stock is a residual form of ownership. Preferred stock has priority over common stockholders with regard to the firm’s earnings and assets. Preferred stockholders are paid cash dividends before common stockholders. In the event of bankruptcy or liquidation, preferred stockholders are ahead of common stockholders in the distribution of the corporation’s assets.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Corporate Organization and Governance 5. What is the advantage of an LLC over an LLP business form?

ANS: An LLC (or limited liability company) has three advantages: 1. Has better access to capital to finance growth.

2. It enables broad employee ownership of the firm.

3. It enables the firm to engage in strategic acquisitions.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Other Types of Business Organizations

Chapter 2—THE DOMESTIC AND INTERNATIONAL FINANCIAL MARKETPLACE

MULTIPLE CHOICE 1. The difference between merchandise exports and imports is known as the __________. a. transaction exposure b. difference in purchasing power c. merchandise trade balance d. import/export reserve ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The global economy

2. A multinational firm __________. a. has direct investments in manufacturing facilities in more than one country b. exports finished goods for sale in another country c. imports raw materials from another country d. has a manufacturing representative in another country ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: The global economy

3. The interest rate at which banks in the Eurocurrency market lend to each other is known as the __________ . a. Eurocurrency currency rate (ECR) b. London interbank offer rate c. exchange rate d. interest rate parity ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: The Eurocurrency market

4. If Japanese yen are deposited in a bank in Paris, the deposits would be called __________ a. Eurofrancs b. European Currency Unit c. Eurobond d. Euroyen ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: The Eurocurrency market

5. An exchange rate quoted as $1.47 per British pound is known as a __________ quote. a. hedge b. direct c. futures d. indirect ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Analytic skills TOP: Direct and indirect quotes

6. If the spot rate for Swiss francs is $0.6658/franc and the 180-day forward rate is $0.6637, the market is indicating that the Swiss franc is expected to a. strengthen relative to the dollar b. weaken relative to the ECU c. lose value relative to the dollar over the next 6 months d. gain value relative to the dollar over the next 6 months

ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Forward rates

7. Which of the following is not a correct statement about foreign currency futures? a. futures contracts have a standardized maturity date b. futures contracts are an exchange-traded agreement c. futures contracts are not liquid d. futures contracts are "marked to market" daily ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Foreign currency futures

8. The most important foreign currency futures market in the United States is the __________. a. Chicago Board of Trade b. New York Mercantile Exchange c. Commodity Exchange d. Chicago Mercantile Exchange ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Foreign currency futures

9. The buyer of a foreign currency call option has the __________ a fixed amount of a foreign currency. a. right to sell b. right but not the obligation to buy c. obligation to buy, only at expiration, d. obligation to buy ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Foreign currency options

10. Eurodollars are U.S. dollars that have been deposited in a. foreign banks b. foreign branches of U.S. banks c. foreign subsidiaries d. foreign banks and foreign branches of U.S. banks ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The Eurocurrency market

11. If the exchange rate from U.S. dollars to Canadian dollars is $0.80/Canadian dollar, then the exchange rate from Canadian dollars to U.S. dollars is a. 0.80 Canadian $/US dollar b. $1.25 Canadian $/US dollar c. $1.20 Canadian $/US dollar d. $8.00 Canadian $/US dollar ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Analytic skills TOP: Direct and indirect quotes

12. If the exchange rate from U.S. dollars to Swiss francs is $0.20/franc, then the exchange rate from francs to dollars is a. 0.20 francs/dollar b. 0.80 francs/dollar c. 5.0 francs/dollar d. 2.0 francs/dollar

ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Analytic skills TOP: Foreign currencies and exchange rates

13. If the spot rate (in U.S. dollars) for Japanese Yen is 0.00703 and the 180 day forward rate is 0.00717, then the Yen is trading at a(n) ______. a. expected gain b. premium c. reciprocal d. discount ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Foreign currencies and exchange rates

14. If the forward (direct quote) exchange rate is lower than the spot rate, then the currency is said to be trading at a ______. a. forward premium b. forward gain c. forward discount d. forward loss ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Foreign currencies and exchange rates

15. Financial middlemen include a. securities brokers b. securities dealers c. investment bankers d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: An overview of the U.S. financial system

NAT: Reflective thinking

16. The following are listed security exchanges in the United Sates: a. New York Stock Exchange b. Pacific Exchange c. Cincinnati Exchange d. All the above are listed exchanges ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Listed security exchanges

17. The Standard and Poor's 500 Stock Price Index is a ____ index. a. price weighted b. market value weighted c. price average d. none of these answers is correct ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates 18. Securities not listed on exchanges are said to be traded a. on the AMEX b. as composite transactions c. over the counter

NAT: Reflective thinking TOP: Stock Market Indexes

d. on the regional exchanges ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Security exchanges and stock market indexes

NAT: Reflective thinking

19. Financial intermediaries include a. securities brokers b. commercial banks c. securities dealers d. all of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: An overview of the U.S. financial system

NAT: Reflective thinking

20. _______ markets deal in long-term securities having maturities greater than one year. a. Credit b. Money c. Commodity futures d. Capital ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Money and capital markets

21. ______ markets deal in short-term securities having maturities of one year or less. a. Credit b. Money c. Capital d. Capital and credit ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Money and capital markets

22. Which of the following (if any) are not financial intermediaries? a. commercial bank b. thrift institution c. securities broker d. all are financial intermediaries ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: An overview of the U.S. financial system

NAT: Reflective thinking

23. In the ________ market, the firm receives the proceeds from the sale of its securities. a. over-the-counter b. secondary c. fully integrated d. primary ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Primary and secondary markets

NAT: Reflective thinking

24. A savings and loan association is an example of which type of financial intermediary? a. commercial bank

b. investment company c. finance company d. thrift institution ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Thrift institutions

25. In any economy as a whole, the actual savings for a given period of time must ________ the actual investments. a. be greater than b. be unrelated to c. equal d. be less than ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: An overview of the financial system

NAT: Reflective thinking

26. Financial intermediaries a. issue secondary claims to the lender b. are compensated for their services by fixed fees c. include both brokers and dealers d. issue primary claims to the lender ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: An overview of the finance system

NAT: Reflective thinking

27. The main purpose of an economy's financial system is to facilitate the transfer of funds from a. financial middlemen to financial intermediaries b. surplus spending units to deficit spending units c. primary claimholders to secondary claimholders d. lenders to financial intermediaries ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: An overview of the financial system

NAT: Reflective thinking

28. Money markets deal in securities having maturities of ________; capital market securities have maturities ________. a. less than 18 months, greater than 18 months b. one year or less, greater than one year c. less than 9 months, greater than 9 months d. less than 6 months, greater than 6 months ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Financial markets

29. Commercial banks are an important source of a. mortgage loans b. equity loans c. real estate loans d. short-term loans and term loans ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Commercial banks

30. Finance companies obtain a significant amount of their funds by a. issuing their own equity securities b. accepting both demand and time deposits c. issuing their own debt securities d. pooling funds ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Finance companies

31. When an investor purchases shares in a no-load common stock mutual fund, she is using a(n) a. primary intermediary b. financial intermediary c. over-the-counter market d. broker ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Overview of the US financial system

NAT: Reflective thinking

32. The interest rate in the Eurodollar market is related to a. the DOW b. the stock market c. the LIBOR d. interest rates in the United States ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: The Eurocurrency Market

33. Capital markets in financially sophisticated economies are not perfectly efficient because of a. anomalous events b. the Sun Spot theory c. irrational investor behavior d. anomalous events and irrational investor behavior ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Behavioral Finance perspectives

NAT: Reflective thinking

34. Over the past decade there has been a major shift in the mix of the suppliers of funds in the U.S. capital markets with _______ now providing proportionately more funds. a. private U.S. investors b. insurance companies and pension funds c. foreign banks and investors d. insurance companies, pension funds, foreign banks, and investors ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Suppliers of capital

35. The Dow Jones Industrial Average is calculated using the a. total market value of 30 stocks b. price of 30 stocks c. a weighted index of 30 stocks d. industrial, railroad, financial, and utility stocks ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial markets and interest rates

TOP: Stock market indexes

36. Insider trading is defined as a. an individual using proper trading rules b. an individual buying or selling using non-SEC disclosure rules c. an individual buying or selling on the basis of material nonpublic information d. a zero-plus game ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Ethical issues: insider trading

NAT: Reflective thinking

37. The U.S. financial markets are said to be highly informationally efficient. This means a. they process stock trades accurately and quickly b. the market provides quick access to a firm's financial statements c. they quickly reflect information relevant to determining stock value d. accurate stock quotes are quickly available to all investors ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Information and capital market efficiency

NAT: Reflective thinking

38. Ex post returns differ from __________ returns in that they represent __________ values rather than __________ values. a. ex ante; estimated; actual b. ex post; accounting; economic c. ex ante; actual; estimated d. ex ante; economic; accounting ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Reflective thinking TOP: Holding period returns

39. The fact that no investor can expect to earn excess returns based on an investment strategy using only historical stock price or return information is an example of________ market efficiency. a. strong-form b. weak-form c. semiweak-form d. semistrong-form ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Weak-form efficiency

40. With semistrong-form market efficiency, no investor can expect to earn excess returns based on an investment strategy using any _______ information. a. past market price b. market value c. publicly available d. private ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function 41. In an efficient capital market, all security investments will have: a. a required rate of return that exceeds the cost of capital b. a positive NPV

NAT: Reflective thinking TOP: Semistrong-form efficiency

c. a required rate of return that is zero d. a NPV of zero ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: An expected NPV of zero

42. In an efficient capital market, corporate diversification is ________. a. unnecessary b. inexpensive c. of benefit to corporate managers d. of great benefit ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Expensive and unnecessary corporate diversification

NAT: Reflective thinking

43. The barriers to the free flow of capital among the major world capital markets include all of the following except: a. low transaction costs b. taxation policies c. foreign exchange risks d. legal restrictions ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Market efficiency outside of the U.S.

NAT: Reflective thinking

44. For the financial manager, taxes have important implications for a. dividend policy b. financial restructurings c. capital structure policy d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Income taxes and financial management

NAT: Reflective thinking

45. Changes in the tax code that slow down depreciation, _______ the present value of investment cash flows and, therefore, make the investment _______ desirable. a. decrease, more b. decrease, less c. increase, more d. increase, less ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Income taxes and financial management

NAT: Reflective thinking

46. In an efficient capital market a. required returns equal expected returns b. investors will have holding period returns equal to zero c. purchase of any security yields zero profit d. purchasing stocks is no better than gambling ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking

TOP: Implications of market efficiency 47. If the spot rate for the British pound is $1.5077 and the 180-day forward rate is $1.4934, what is the annualized premium (discount)? a. premium of 1.90% b. premium of 0.97% c. discount of (-)1.90% d. discount of (-)0.97% ANS: C Solution: [($1.4934 - $1.5077) / ($1.5077)](12/6)(100%) = -1.897% PTS: 1 OBJ: TYPE: E. Problem.

NAT: Analytic skills LOC: Understand derivative markets TOP: Forward rates 48. If the spot rate for the Japanese yen is $0.009204 and the 90-day forward rate is $0.009227, what is the annualized premium (discount)? a. premium of 1.00% b. premium of 0.50% c. discount of -0.99% d. premium of 0.25% ANS: A Solution: [(.009227 - .009204)/(.009204)](12/3)(100%) = 0.9996% PTS: 1 OBJ: TYPE: E. Problem.

NAT: Analytic skills LOC: Understand derivative markets TOP: Forward rates 49. Christy purchased 100 shares of Good Idea stock for $48 last year. Yesterday she sold the stock for $45. If she received $4 in dividends during the time she held the security, what is her holding period return? a. 2.08% b. 8.30% c. -6.30% d. 14.60% ANS: A Solution: ($45 - $48 + $4) / $48 = 0.0208 or 2.08% PTS: 1 OBJ: TYPE: E. Problem.

NAT: Analytic skills LOC: Understand derivative markets TOP: Holding period returns 50. If an investor purchased 100 shares of Biggee stock for $30 per share, 6 months ago, and then sold the stock today for $33 per share, what was the investor's holding period return if a total of $1 per share in dividends was received over the 6 month period? a. 10% b. 27.1% c. 17.1% d. 13.3% ANS: D Solution:

HPR = ($33 - $30 + $1) / $30 = 13.3% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Holding period returns 51. What is the holding period return to an investor who bought 100 shares of Oil Slick stock nine months ago for $36 per share, received two $50 dividend checks, and sold the stock today at $38 a share. a. 5.56% b. 8.33% c. 11.11% d. 6.94% ANS: B Solution: ($38 + $1 - $36)/ $36= 0.0833 or 8.33% PTS: 1 OBJ: TYPE: E. Problem.

NAT: Analytic skills LOC: Understand derivative markets TOP: Holding period returns 52. If a treasury bond can be purchased for $9,450 today and the bond holder will receive $850 in interest and the $10,000 face value at maturity, what is the percentage holding period return? a. 14.8% b. 5.8% c. 6.7% d. 12.6% ANS: A Solution: ($10,000 - $9,450 + $850)/$9,450 = 0.148 or 14.8% PTS: 1 OBJ: TYPE: E. Problem.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Holding period returns

53. You bought 100 shares of Risky Venture stock six months ago for $14 per share and sold it yesterday for $12. The company paid a total of $0.24 per share in dividends to you during the time you held the stock. What was your holding period return? a. -25.14% b. -16.67% c. -12.57% d. 16.00% ANS: C Solution: HPR = ($12 - $14 + $0.24)/$14 = -0.1257 or -12.57% PTS: 1 OBJ: TYPE: E. Problem.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Holding period returns

54. Maher purchased 100 shares of Chill Pill Pharmaceuticals at $30 per share last spring and sold them in six months for $36 per share. The stock paid no dividend. What was Maher's holding period return? a. 40% b. 20% c. 10% d. 5%

ANS: B Solution: HPR = (3600 - 3000)/3000 x 100% = 20% PTS: 1 OBJ: TYPE: E. Problem.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Holding period returns

55. Two years ago you bought 100 shares of Big Bubba convertible preferred stock at $25 per share. The preferred stock had an annual dividend of $2.125 per share, and a total of $3.19 in dividends per share have been paid so far. Today the company announced that the stock is redeemable for $26.70 plus accrued and unpaid dividends, for a total of $27.76. Alternatively, holders may convert their shares of preferred stock at a conversion rate of 1.6393 shares of Big Bubba common stock for each share of preferred stock. If the closing price of Big Bubba common stock is $27.50, what is your holding period return? a. 93.08% b. 23.80% c. 80.32% d. 64.60% ANS: A Solution: Ending price = $27.50(1.6393) = $45.08 HPR = ($45.08 - $25 + $3.19)/$25 = 0.9308 or 93.08% PTS: 1 OBJ: TYPE: C. Problem.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Holding period return

56. If the spot rate (in U.S. dollars) for Japanese Yen is 0.00703 and the 180 day forward rate is 0.00717, then the Yen is trading at an annualized a. premium of 4.04% b. premium of 3.98% c. premium of 3.91% d. discount of 3.89% ANS: B Solution: Premium = [(0.00717 - 0.00703)/0.00703](12/6) = 0.0398 PTS: 1 OBJ: TYPE: C. Problem.

NAT: Analytic skills LOC: Understand derivative skills TOP: Foreign currency value over time 57. Lear purchased 100 shares of Quitcha Twitchin Anti-inch Cream stock at $30 per share last year and sold them eleven months later for $24 per share. The shares split 2 for 1 shortly after Lear purchased the stock. If the stock paid $0.25 per share in dividends last year, what is Lear's holding period return? a. 61.67% b. -19.17% c. 21.67% d. 6.17% ANS: A Solution: HPR = [2400 - 1500 + .25(100)]/1500 x 100% = 61.67% PTS: 1

OBJ: TYPE: C. Problem.

NAT: Analytic skills

LOC: Understand derivative markets

TOP: Holding period returns

58. All of the following reflect the implications of income taxes for financial managers EXCEPT: a. Interest payments on debt made by the firm are not tax deductible. b. Preferred stock and common stock dividends are not tax deductible. c. Dividends are taxed on the corporate level as profits and are taxed on the stockholders’ tax return as income. d. Depreciation provides a tax deduction for the corporation.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Income taxes and financial management

NAT: Reflective thinking

59. All of the following are financial intermediaries EXCEPT: a. commercial banks b. investment companies c. thrift institutions d. loan sharks ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Overview of the US financial system

NAT: Reflective thinking

60. Which of the following is correct regarding the forms of market efficiency?

I. In an efficient capital market stock prices provide an unbiased estimate of the true value of an enterprise.

II. In an efficient capital market, stock prices reflect the present value of the firm’s expected cash flows. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Market efficiency

61. There are three forms of market efficiency. All of the following statements are correct EXCEPT: a. The weak form efficiency states that no investor can earn excess returns based on historical price information. b. The strong form of efficiency states that no investor can consistently earn excess returns since all public and private information is reflected in stock prices. c. The semi-strong form of efficiency states that no investor can earn excess returns based on an investment strategy using public information. d. Market efficiency is a hard and fast rule that has been verified in real-world situations.

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Market efficiency

62. Which of the following statements is/are correct about financial intermediaries?

I. Financial intermediaries primarily operate within the secondary market.

II. Examples of financial intermediaries are: commercial banks, thrift companies and the internal revenue service. a. I only b. II only c. Both I and II

d. Neither I nor II ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Overview of the US financial system Financial markets

NAT: Reflective e thinking

63. There are highly publicized hedge fund problems, for example Julian Robertson’s Tiger fund or Long Term Capital Management. The impact that this has had on hedge funds is: a. minimal. They have continued to grow in size and number. b. huge. Hedge funds are being discontinued. c. being felt in the overall reallocation of hedge funds into bonds. d. inconsequential and irrelevant. Investors may rely on the due diligence of the fund managers.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function.

TOP: Introduction: Finance Challenge

NAT: Reflective thinking

64. All of the following are considered financial middlemen EXCEPT: a. brokers b. dealers c. investment bankers d. thrift institutions ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: An Overview of the U.S. Financial System

NAT: Reflective thinking

65. An example of an organized exchange is: a. OTC b. NYSE c. NASDAQ d. Automated quotations ANS: B PTS: 1 OBJ: TYPE: FACT NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Security Exchanges and Stock Market Indexes ESSAY 1. What are the differences between the primary and secondary markets?

ANS: The primary market allows the investor to purchase new securities. Net proceeds from such sales go to the issuing corporation.

The secondary market allows the investor to purchase securities that are already in circulation. These are purchased through an organized security exchange, for example NYSE, or in the over-the-counter market, and none of the proceeds go to the issuing corporation.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Financial markets 2. What is the purpose and importance of the stock market indexes?

ANS: Stock market indexes give a broad indication of how the stock market or a segment of it performed during a particular day. The most known index is the Dow Jones Industrial Average (DJIA), which is composed of 30 stocks. The index gives an overview of how well stocks are doing, the overall health of the economy, and the anticipated marketability of securities.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Stock market indexes 3. Explain the degrees of market efficiency and their applicability to the stock market.

ANS: 1. Weak form market efficiency: No investor can earn excess returns based on historical price information or past return information.

2. Semi-strong market efficiency: No investor can earn excess returns based on an investment strategy using any public information. Stock prices consistently incorporate any new information about the stock or the issuing company.

3. Strong market efficiency: No investor can consistently earn excess returns based on any public or private information. Stock prices reflect all information, both public and private.

The number of investors who have traded with insider knowledge provides graphic evidence that the strong form efficiency does not hold.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Market Efficiency 4. Define the differences between the capital market and the money market. Give examples of the kinds of securities found in each category.

ANS: Money market securities are short-term and liquid with maturities under one year. There is minimal risk in the money market and money market securities generally pay interest that is guaranteed.

Types of money market securities are: cash and cash equivalents, commercial paper, treasury bills, government securities, and certificates of deposit.

Capital market securities are long-term and illiquid with maturities greater than one year. There is significant risk involved and capital market securities earn a rate of return that is not guaranteed.

Types of capital market securities are: preferred stocks, common stocks and bonds.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function TOP: Financial markets

Chapter 3—EVALUATION OF FINANCIAL PERFORMANCE MULTIPLE CHOICE 1. Which of the following financial ratios are market-based ratios? a. debt-to-equity b. price-to-earnings c. return on investment d. gross profit margin ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: Market-based ratios

2. The appropriate standard for comparison of financial ratios probably should be the a. best firm in the industry b. worst firm in the industry c. industry average d. better performing firms in the industry ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: A word of caution about financial ratio analysis

NAT: Reflective thinking

3. ________ indicate the ability of the firm to meet its short-term financial obligations a. Activity ratios b. Liquidity ratios c. Leverage ratios d. Profitability ratios ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Liquidity ratios

4. ________ indicate the firm's capacity to meet its debt obligations, both short-term and long-term. a. Liquidity ratios b. Activity ratios c. Financial leverage ratios d. Profitability ratios ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Financial leverage management ratios

NAT: Reflective thinking

5. The primary weakness of the current ratio is a. it is difficult to calculate b. it includes some items, such as inventory, that may not be readily liquid c. it requires many years of past data d. it includes many non-current items in its calculation ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Current ratio

6. The quick ratio is the same as current ratio except it does not consider a. cash b. accounts receivable c. prepaid items d. inventories ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Quick ratio

7. The fixed asset turnover ratio is influenced by a. the age of the assets employed b. the depreciation method used by the firm c. the firm's choice of a production technology d. all of the above ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: Asset management ratios

8. The greater the amount of financial leverage used by a firm, the greater its ___________, all other things being equal. a. profitability b. liquidity c. risk d. size ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Financial leverage management ratios

NAT: Reflective thinking

9. The best accounting-based measure of a firm's profitability is a. gross profit margin b. net profit margin c. return on fixed assets d. return on total assets ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Profitability ratios

10. Financial ratio analysis is most often performed as a a. comparative analysis b. trend analysis c. point in time analysis d. comparative analysis and a trend analysis ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Trend analysis

11. A firm's return on equity is a function of its net profit margin, ______ and equity multiplier. a. current ratio b. cost of goods c. total asset turnover d. fixed asset turnover ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: A foundation concept

12. Primary sources of comparative financial data include a. Dun and Bradstreet b. New York Times c. Richard Moore, Inc. d. Framingham Financial Library ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Sources of comparative financial data

NAT: Reflective thinking

13. The data from ______ is especially useful when analyzing small firms. a. Prentice-Hall b. Robert Morris Associates c. Dan Bradbury Ltd. d. Securities and Exchange Commission

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Sources of comparative financial data

NAT: Reflective thinking

14. In an inflationary period, a firm is likely to show temporary profit increases because a. accounts receivable collections increase b. cash balances decline c. inventory profits are realized d. all of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Inflation and financial statement analysis

NAT: Reflective thinking

15. If a firm wanted to report high profits, it would choose which method of inventory accounting in inflationary times? a. FIFO b. LIFO c. FILO d. GIGO ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Inflation and financial statement analysis

NAT: Reflective thinking

16. Financial ratios can be used to analyze a firm's performance from a. day to day b. period to period c. purchase to purchase d. sale to sale ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Trend analysis

17. The earnings per share figure a. is a comparative ratio b. is the best measure of a firm's profitability c. can only be computed if a firm has no debt d. is only one measure of a firm’s profitability ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Market-based ratios

18. The retained earnings figure represents a. a pool of cash readily available to the firm and its stockholders b. an accounting of that portion of a firm's assets that were financed from past earnings c. a permanent part of the firm's equity base d. a deferred liability owed to preferred stockholders ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Earnings quality

19. Which ratio is frequently used in conjunction with the analysis of a bond's quality? a. times interest earned b. deferred liability ratio

c. receivables turnover d. dividend coverage ratio ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial leverage ratios

20. The current ratio would normally be increased by a. paying off some current liabilities with cash b. selling bonds and investing the proceeds in marketable securities c. buying treasury stock d. paying off some current liabilities with cash and selling bonds and investing the proceeds in marketable securities ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Current ratio

21. The following policy that is consistent with an increase in a firm's return on total assets is: a. costs increase more than revenues b. the firm's net working capital (current assets minus current liabilities) position declines c. the firm sells off some unused assets and pays the proceeds to existing stockholders in the form of an extra dividend d. the firm's net working capital (current assets minus current liabilities) position declines, and the firm sells off some unused assets and pays the proceeds to existing stockholders in the form of an extra dividend ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Profitability ratios

22. If a firm wishes to retain the same return on equity when its net profit margin and total asset turnover has declined, it must a. decrease its equity multiplier b. increase its equity multiplier c. increase sales and increase assets d. reduce sales and increase assets ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Return on stockholders' equity

NAT: Reflective thinking

23. A fresh fruit wholesaler would normally be expected to have a. high profit margin and high asset turnover b. low profit margin and low asset turnover c. low profit margin and high asset turnover d. high profit margin and low asset turnover ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Return on investment

24. The ratio group most likely to be used to indicate a firm's ability to meet short-term financial obligations would be a. liquidity ratios b. financial leverage ratios c. activity ratios d. profitability ratios ANS: A

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows 25.

TOP: Liquidity ratios

The following ratio(s) that would probably not be used to assess the profitability of a firm is: a. return on stockholders' equity b. return on total assets c. times interest earned d. both return on stockholders' equity and return on total assets ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Financial leverage management ratios

NAT: Reflective thinking

26. In general, firm's with _______ risk and _______ earnings growth prospects will have higher P/E multiples. a. low, low b. high, low c. low, high d. high, high ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Price to Earnings ratio

27. The analysis of financial statements is affected by inflation because a. the value of long-term debt will increase b. the value of fixed assets may be understated c. the life of long-term assets are decreased d. inventory increases ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Inflation and financial statement analysis

NAT: Reflective thinking

28. An increase in the average collection period may suggest all of the following except a. easing of credit terms b. customers are not paying their bills on time c. sales have decreased d. firm could have a liquidity problem in the future ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Asset management ratios

29. Asset management ratios indicate a. how well a firm is using its assets to support sales b. how efficiently a firm is allocating its liabilities c. the return on assets d. the profitability of the firm ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Asset management ratios

30. Christy would like to improve the current ratio of her firm, which is now 0.5, so that she will have a better chance of obtaining a working capital loan. Which of the following options would improve her current ratio? a. use cash to pay off notes payable b. collect some of her accounts receivables

c. purchase additional inventory on credit d. borrow short-term funds to pay off some payables ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Liquidity ratios

31. The major types of financial ratios include all of the following except a. market-based b. liquidity c. financial leverage d. equity ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Basic classifications of financial ratios

NAT: Reflective thinking

32. Financial leverage ratios measure the a. amount of interest paid by the firm b. firm's use of fixed-charge financing c. amount of equity funds retired by the firm d. static ratio ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Financial leverage management ratios

NAT: Reflective thinking

33. __________ ratios indicate how efficiently a firm is using its assets to generate sales. a. Liquidity b. Asset management c. Financial leverage d. Equity ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Basic classifications of financial ratios

NAT: Reflective thinking

34. A common-size balance sheet shows the firm's assets and liabilities as a percentage of : a. stockholders' equity b. industry averages c. total assets d. net sales ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Key financial statements

35. A common-size income statement shows the firm's income and expense items as a percentage of __________. a. stockholders' equity b. net sales c. industry averages d. total assets ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Key financial statements

36. The __________ ratio, sometimes called the "acid test," is a more stringent measure of __________ than the current ratio. a. quick; liquidity b. fixed-asset turnover; activity c. net profit margin; gross profit margin d. equity, activity ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Quick ratio

37. Return on stockholders' equity is equal to __________ times __________ times __________. a. net profit margin; fixed asset turnover; equity multiplier ratio b. gross profit margin; total asset turnover; equity multiplier ratio c. net profit margin; total asset turnover; equity multiplier ratio d. net profit margin; total asset turnover; debt-to-equity ratio ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Return on stockholders' equity

NAT: Reflective thinking

38. When considering the quality of a firm's earnings, high quality earnings tend to be ____________________ a. cash earnings b. earnings derived from regularly recurring transactions c. cash earnings and earnings derived from regularly recurring transactions d. earnings per share ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Earnings quality

39. The fixed charge coverage ratio includes all of the following except _______ in the denominator. a. lease payments b. preferred dividends before tax c. before tax sinking fund d. common stock dividends ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Fixed charge coverage ratio

40. The _______ ratio is a more severe measure of a firm's ability to meet fixed financial obligations than is the times interest earned ratio. a. acid test b. debt c. fixed charge coverage d. debt to equity ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Fixed charge coverage ratio

41. If a firm's current ratio is 1.5, a. its current liabilities exceed its current assets b. it is possible for its quick ratio to be 2.0 c. it is possible for its quick ratio to be 1.0 d. its current assets equal its current liabilities ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Liquidity ratios 42. If a firm's total asset turnover ratio is 2.0, a. its annual sales are less than its total assets b. it is possible that its fixed asset turnover ratio is 1.5 c. its total assets are two times its annual sales d. its annual sales are two times its total assets ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Total asset turnover ratio 43. If a firm's return on investment, i.e., earnings after taxes divided by total assets, is 7%, and the firm has no preferred stock financing, it is a. possible that its return on stockholders' equity is 10%. b. possible that its return on stockholders' equity is 5%. c. not possible for its debt-to-equity ratio to be 1.0. d. not possible for its net profit margin to be 7%.

ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Return on investment ratio 44. If a firm's price to earnings (P/E) ratio is 10, a. it is not possible for it to be paying dividends also b. its market to book ratio has to be at least 2.0 c. its net profit margin is positive d. its return on stockholders' equity is negative ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Price to earnings ratio 45. The analysis of the financial performance and condition of a firm with sizable international operations is generally more complicated than analyzing a firm whose operations are largely domestic for all of the following reasons except: a. problems with the translation of foreign operating results b. problems with definition of capital c. fluctuating exchange rates d. all of the above are correct reasons ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Int'l issues: Financial analysis of multinational...

46. The work of the external independent auditor includes a letter that states that the financial information represents fairly the financial position of the company and that these statements were: a. an accurate picture of the company's market position b. based on the company's accounting information system (AIS) c. constructed in conformity with generally accepted accounting principles d. developed using management's choice of accounting enhancement techniques ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Ethical understanding and reasoning LOC: Understand the role of the finance function

TOP: Ethical issues: Accuracy of financial statements 47. The Market Value Added (MVA) is the _______. a. indicator of how successful a firm has been at increasing its financing its assets b. return on total capital minus cost of capital c. indication of an increase in operating efficiency d. positively related to the present value of all expected future EVA. ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: The market value added concept

NAT: Reflective thinking

48. Economic value added (EVA) is a measure of operating performance that indicates how successful a firm has been at: a. increasing the growth in earnings b. increasing the MVA of the enterprise in any given year c. increasing the rate of return on investment d. all of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Economic value added

49. Firms with a positive economic value added (EVA): a. have increasing growth in earnings b. have an increasing rate of return on investment c. have a return on capital greater than their cost of capital d. have a high return on book value ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Economic value added

50. Deferred taxes may occur due to the use of a. different tax schedules b. different depreciation methods for taxes and financial reporting c. long-term equipment d. different cash flow methods ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Deferred taxes

51. The _____ ratio indicates the percentage of a firm's earnings that are distributed as dividends. a. dividend yield b. payout c. return on earnings d. earnings ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Payout ratio

52. Firms with _____ growth rates would be expected to have _____ payout ratios. a. high, low b. high, high c. low, low d. low, high ANS: A

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand the role of the finance function

TOP: Payout ratio

53. Stocks with _____ dividend yield often indicate _____ expected future growth. a. high, high b. low, low c. low, high d. high, low ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Dividend Yield

54. To increase the return on stockholders' equity, management could increase the _____. a. current ratio b. price-to-earnings ratio c. dividend yield d. equity multiplier ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Analyzing profitability

55. Although ratios can provide valuable information, they can also be misleading for the following reason(s): a. ratios are only as reliable as the accounting data on which they are based. b. compilation of industry norms often do not report information about the distribution of values. c. comparative analysis depends on the availability of data for appropriately defined industries. d. all of the above are correct.

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: A word of caution about financial ratio analysis

NAT: Reflective thinking

56. A component of earnings that recognizes the return that the firm is expected to earn on assets that have not been placed in services is called _____. a. earnings allowance b. allowance for funds used during construction c. capital budgeted d. budgeted earnings ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Earnings quality

57. Companies can avoid paying income taxes on inventory profits by using the _____ inventory valuation method. a. LIFO b. FIFO c. Priced out d. Priced in ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Inflation and financial statement analysis

NAT: Reflective thinking

58. Nuking Gnats Pest Service, Inc. has a debt ratio of 50% and an equity multiplier of 2. What is Nuking Gnats' stockholders' equity if total debt is $100,000? a. $100,000 b. $150,000 c. $200,000 d. $50,000 ANS: A Solution: Debt/T.A = 0.5; T.A = $100,000/0.5 = $200,000 Equity = T.A - Debt = $200,000 - $100,000 = $100,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 59. Given the following information, calculate the inventory for Big Show Videos: Quick ratio = 1.2; Current assets = $12,000; Current ratio = 2.5 a. $4,800 b. $6,240 c. $7,200 d. $5,660 ANS: B Solution: C.L. = $12,000/2.5 = $4,800 Inv = $12,000 - 1.2($4,800) = $6,240 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 60. A firm with an equity multiplier of 4.0, will have a debt ratio of a. 0.25 b. 1.00 c. 0.75 d. 4.00 ANS: C Solution: T.A/Equity = 4, so T.A = (4)Equity Debt = T.A - Equity = 4E - E = 3E T.D./T.A = 3E/4E = 0.75 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 61. A firm with a debt ratio of 0.75, will have an equity multiplier of a. 0.25 b. 1.00 c. 0.75 d. 4.00 ANS: D

Solution: T.D/T.A = 0.75, so T.D = 0.75 T.A. Equity = T.A - T.D = T.A - 0.75 T.A = 0.25 T.A Equity multiplier. = T.A./0.25 T.A. = 4 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 62. What is the market price of a share of stock for a firm that pays dividends of $1.20 per share, has a P/E of 14, and a dividend payout ratio of 0.4? a. $16.80 b. $42 c. $3 d. $28 ANS: B Solution: EPS = DPS/payout = $1.20/0.4 = $3.0 Price = P/E (EPS) = 14($3) = $42 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 63. What is the return on investment for a firm that has a debt ratio of 0.65, a net profit margin of 6.5%, sales of $740,000, and a total asset turnover of 4? a. 26.0% b. 16.9% c. 6.5% d. 4.6% ANS: A Solution: Return on investment = Total asset turnover times net profit margin = 4(6.5%) = 26% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Return on investment 64. What is the return on stockholders' equity for a firm with a net profit margin of 5.2 percent, sales of $620,000, an equity multiplier of 1.8, and total assets of $380,000? a. 8.48% b. 5.74% c. 15.27% d. 9.36% ANS: C Solution: ROE = 5.2%($620,000/$380,000) 1.8 = 15.27% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Return on equity

65. What is the cost of sales for a firm with a gross profit margin of 30 percent, a net profit margin of 4 percent, and earnings after taxes of $20,000? a. $200,000 b. $350,000 c. $150,000 d. $125,000 ANS: B Solution: Sales = EAT/0.04 = $20,000/0.04 = $500,000 Cost of sales = (1 - 0.3)$500,000 = $350,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 66. If a firm has a total asset turnover of 8 times and a return on total assets of 15%, its net profit margin must be a. 1.875% b. 1.95% c. 2.05% d. 2.25% ANS: A Solution: NPM = 15% / 8 = 1.875% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 67. A firm's current ratio is 1.5 and its quick ratio is 1.0. If its current liabilities are $10,000, what are its inventories? a. $ 5,000 b. $10,000 c. $15,000 d. $20,000 ANS: A Solution: 1.5 = current assets / $10,000 Current assets = $15,000 1.0 = ($15,000 - inventories) / $10,000 Inventories = $5,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Liquidity ratio calculation 68. A firm's price to earnings ratio is 8 and its market to book ratio is 2. If its earnings per share are $4.00, what is the book value per share? a. $ 8.00 b. $32.00 c. $64.00 d. $16.00

ANS: D Solution: P = 8 x $4 = $32; BV = $32/2 = $16.00 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Market-based ratio calculation 69. Flash In The Pan Cooking School is considering the issuance of additional long-term debt to finance expansion. At the present time the company has $160 million of 10% debentures outstanding. Its after-tax net income is $48 million, and the company's (marginal) income tax rate is 40%. The company is required by the debenture holders to maintain its coverage ratio at 4.0 or greater.

Determine Flash’s present coverage ratio. a. 3.33 b. 2.78 c. 5.00 d. 6.00 ANS: D Solution: EBT = $48 million / (1 - 0.40) = $80 million EBIT = EBT + I = $80 million + ($160 million x 0.10) = $96 million Coverage Ratio = EBIT/I = $96 million/$16 million = 6.0 times PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Coverage ratio calculation 70. Stepping Out Shoe Mfg. has inventory purchases of $2,200 during the month of June. If the June 1 accounts payables were $1,700 and June 30 accounts payables were $1,900, what was the cash payment? a. $3,900 b. $2,000 c. $1,900 d. $1,700 ANS: B Solution: Cash payment = $1,700 + $2,200 - $1,900 = $2,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills; technology LOC: Knowledge of financial analysis; spreadsheet applications TOP: Cash flow calculation 71. Last year, Monroe Bro Products had $25,000 net cash provided by its operating activities. Its investing activities used $30,000, and its financing activities provided $10,000. Its cash and cash equivalents balance at the beginning of the year was $15,000. By how much did Monroe's cash and cash equivalents increase? a. -$10,000 b. $0 c. $5,000 d. $15,000 ANS: C

Solution: Cash increase = $25,000 - $30,000 + $10,000 = $5,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Statement of cash flows 72. Newfangled Dangle Systems had earnings after tax of $1,000,000 last year. Included in its expenses were $50,000 of interest, $100,000 of deferred taxes, and $150,000 of depreciation. In addition, the company paid dividends of $200,000 to its stockholders last year. What was Newfangled’s after-tax cash flow last year? a. $1,500,000 b. $1,300,000 c. $1,150,000 d. $1,250,000 ANS: D Solution: ATCF = $1,000,000 + $150,000 + $100,000 = $1,250,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Cash flow analysis 73. If a firm has interest expenses of $10,000 per year, sales of $700,000, a tax rate of 40%, and a net profit margin of 7%, what is the firm's times interest earned ratio? a. 8.17 b. 4.90 c. 13.25 d. 9.17 ANS: D Solution: EAT = $700,000(0.07) = $49,000; EBT = $49,000/0.6 = $81,667 EBIT = $81,667 + $10,000 = $91,667; TIE = $91,667/$10,000 = 9.17 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Times interest earned calculation 74. How much cash and marketable securities does Gray Day Computer Co. have if the firm has a current ratio of 2.5, a quick ratio of 1.2, and current liabilities of $12,000. Gray's credit sales are $98,000 and its average collection period is 40 days? (Assume 365 days per year.) a. $3,660 b. $14,440 c. $10,740 d. $12,660 ANS: A Solution: C.A = 2.5 (C.L.) = 2.5 ($12,000) = $30,000 C.A. - Inv = 1.2 (C.L.) = 1.2 ($12,000) = $14,400 Inv = $30,000 - $14,400 = $15,600 A.R. = 40 ($98,000/365) = $10,740 Cash = $30,000 - $15,600 - $10,740 = $3,660

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 75. What is the market price per share of Big Whoop, Inc. if the firm had net income of $200,000, earnings per share of $2.70, total equity of $800,000, and a market to book ratio of 1.5? a. $16.20 b. $10.80 c. $7.20 d. $12.40 ANS: A Solution: Number of shares = $200,000/$2.70 = 74,074 Book value = $800,000/74,074 = $10.80 Market value = 1.5($10.80) = $16.20 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 76. If Power-On Inc. has a total asset turnover of 1.8, a fixed asset turnover of 3.2, a debt ratio of 0.5 and a total debt of $200,000, then fixed assets are a. $56,250 b. $711,111 c. $225,000 d. $62,250 ANS: C Solution: T.A = $200,000/0.5 = $400,000 Sales = 1.8(T.A) = 1.8($400,000) = $720,000 F.A. = Sales/3.2 = $720,000/3.2 = $225,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 77. What would be the times interest earned of a company, if its total interest charges are $20,000, sales are $220,000, and its net profit margin is 6 percent? Assume a tax rate of 40 percent. a. 2.65 b. 1.1 c. 2.1 d. 1.2 ANS: C Solution: EAT = Sales (0.06) = $220,000(0.06) = $13,200 EBT = EAT/(l - T) = $13,200/0.6 = $22,000 EBIT = EBT + I = $22,000 + $20,000 = $42,000 TIE = EBIT/I = $42,000/$20,000 = 2.1 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets

TOP: Ratio manipulation 78. Determine the cost of sales for a firm with the following financial ratios and data: Current ratio = 3.0; Quick ratio = 2.0; Current liabilities $1,000,000; Inventory turnover 6 times a. $2,000,000 b. $6,000,000 c. $3,000,000 d. $1,000,000 ANS: B Solution: C.A. = 3($1,000,000) = $3,000,000 ($3,000,000 - Inven.)/$1,000,000 = 2.0 Inven. = $1,000,000 Cost of Sales = $1,000,000 x 6 = $6,000,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 79. AK, Inc. is considering issuing additional long-term debt to finance an expansion. The company currently has $20 million in 5% debt outstanding. Its earnings after-tax (EAT) are $3.0 million, and its marginal and average tax rate is 40 percent. The company is required by the debt holders to maintain its times interest earned ratio at 3.0 or greater. How much additional 10 percent debt can the company issue now and maintain its times interest earned ratio at 3.0? Assume for this calculation that earnings before interest and taxes remains at its present level. a. $10 million b. $ 6 million c. $ 1 million d. $5 million ANS: A Solution: EBT = $3.0 / (1 - 0.40) = $5.0 EBIT = $5.0 + $1.0 = $6.0 Interest permitted = EBIT / T.I.E. = $6.0 / 3.0 = $2.0 Additional interest = $2.0 - $1.0 = $1.0 Additional debt = $1.0 / 0.1 = $10, or $10 million PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Times interest earned calculation 80. Given the following information, determine Salem Company's fixed assets.

Sales = $10,000,000 Total asset turnover = 4 times Current ratio = 2.40 Current liabilities = $500,000 Total assets = current assets + fixed assets a. $1,200,000 b. $4,800,000 c. $1,300,000

d. Cannot be determined ANS: C Solution: Total assets = $10,000,000/4 = $ 2,500,000 Current assets = 2.40 x $500,000 = $1,200,000 Fixed assets = $2,500,000 - $1,200,000 = $1,300,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 81. Given the following information, determine Taylor Company's cash balance.

Sales = $10,000,000 (all on credit) Current ratio = 3.0 Current liabilities = $800,000 Average collection period = 36.5 days (Assume 365 days/year) Quick ratio = 1.50 Current assets = cash + accounts receivable + inventory a. $200,000 b. $1,400,000 c. $2,400,000 d. $500,000 ANS: A Solution: Current assets = 3.0 x $800,000 = $2,400,000 Accounts receivables = ($10,000,000/365) x 36.5 = $1,000,000 ($2,400,000 - Inventory)/$800,000 = 1.50 $2,400,000 - Inventory = $1,200,000 Inventory = $1,200,000 Cash = $2,400,000 - $1,000,000 - $1,200,000 = $200,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 82. What is the net profit margin for TJX Inc. if the current ratio = 2; total asset turnover =1.5; total assets = $100,000; and EBIT = $30,000? Assume the marginal tax rate for TJX is 40% and that interest expenses are $10,000. a. 20% b. 8% c. 12% d. 6% ANS: B Solution: Sales = 1.5(100,000) = $150,000 EAT = (30,000 - 10,000)(1-.4) = $12,000 NPM= 12,000/150,000 = .08 or 8% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation

83. Your current assets consist of cash, accounts receivable, and inventory. Total current liabilities equal $200,000. The average collection period is 20 days on average daily credit sales of $2,500. The current ratio is 1.3 and the quick ratio is 0.625. What is the balance in the cash account? a. $ 75,000 b. $ 65,000 c. $135,000 d. $ 50,000 ANS: A Solution: ACP = Rec./2500 = 20, so Rec = 20(2500) = 50,000 CR = CA/CL = 1.3, so CA = 1.3(200,000) =260,000 QR = (CA - Inv)/CL = 0.625, so Inv = $135,000 Cash = 260,000 - 50,000 - 135,000 = $75,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 84. Wall Mart Pictures and Decor Company has a net profit margin of 10% and its inventory turnover is 9, what is its annual cost of sales? You also know the Wall Mart’s average inventory is $96,700 and its annual sales are $1,000,000. a. $870,000 b. $850,000 c. $870,300 d. $790,000 ANS: C Solution: Inventory turnover = COS/Avg. Inventory = 9 so COS = 9($96,700) = $870,300 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 85. Greg is interested in investing in a small company, and he thinks Good Buy Co. might be a good investment. He has been given the following information and would like to know the return on stockholder's equity. Assume Good Buy’s marginal tax rate is 40%.

Earning before taxes Net profit margin Total liabilities Total stockholder's equity a. b. c. d.

12% 20% 15% 18%

ANS: D Solution: EAT = 3,000,000(1-.4) = $1,800,000 NPM = EAT/sales = 0.036

$3 million 3.6% $15.0 million $10.0 million

so Sales = 1,800,000/.036 = $50,000,000 E.M. = TA/ Equity = 25/10 = 2.5 R.O.E. = NPM x Total asset turnover x Equity multiplier R.O.E. = 0.036 x 50/25 x 2.5 = 0.18 or 18% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Ratio manipulation 86. Given the following information, calculate the return on equity for Regrets Only Dating Services, Inc.: Net Profit margin = 5% Total asset turnover = 2 Debt ratio = 0.73 a. 14% b. 7.3% c. 37% d. 21% ANS: C Solution: Debt ratio = TD/TA = 0.73 so TD = 0.73TA Equity = TA - TD = TA - 0.73TA = 0.27TA Equity multiplier = TA/Equity = TA/0.27TA = 3.7 R.O.E. = NPM x TAT x EM = 0.05 x 2 x 3.7 = 0.37 or 37% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; finance applications in spreadsheets TOP: Return on stockholder's equity 87. All of the following are users of financial information EXCEPT: a. customers b. bankers c. analysts d. unions ANS: A PTS: 1 OBJ: Type: fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Uses of Financial Analysis

88. Successful financial ratio analysis requires all of the following EXCEPT: a. Some industries use special ratios that are unique to each company. b. A single ratio is all that is needed to indicate specific areas of weakness that must be addressed. c. Ratios are meaningful only when it is compared to a standard. d. Ratios must be used in conjunction with other data to obtain meaningful information.

ANS: B PTS: 1 OBJ: Type: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Interpreting Financial Ratios

89. If a firm’s common size income statement shows that the earnings after tax percentage is too low, the firm may have spent too much money: a. on total assets as a percentage of long-term liabilities. b. on expenses as a percentage of current assets. c. on cost of goods sold as a percentage of sales.

d. on taxes paid as a percentage of stockholders’ equity.

ANS: C PTS: 1 OBJ: Type: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Key Financial Statements

90. The sales-to-inventory ratio: a. is superior to the inventory turnover ratio. b. as a determination of financial performance, is good comparison tool. c. is technically inferior to other commonly used ratios. d. was developed by the Dupont Corporation and is satisfactory when used to make comparisons between the firm and the industry as a whole.

ANS: C PTS: 1 OBJ: Type: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Asset Management Ratios

91. The type of ratio that indicates the firm’s ability to provide adequate returns in the form of dividends and share price appreciation is: a. Profitability ratios b. Asset management ratios c. Liquidity ratios d. Financial leverage management ratios ANS: A PTS: 1 OBJ: Type: Fact LOC: Knowledge of financial analysis and cash flows TOP: Basic Classifications of Financial Ratios

NAT: Reflective thinking

92. A firm has revenue of $60,000, its total operating costs including depreciation and cost of goods sold are $50,620, depreciation is $4,620 and its interest expense on outstanding loans is $2,000. What is the firm’s EBIT? a. $55,380 b. $2,760 c. $9,380 d. $12,000 ANS: C PTS: 1 NAT: Analytic skills TOP: Key Financial Statements

OBJ: Type: E. Prob LOC: Knowledge of financial analysis and cash flows

93. Market based ratios can be which of the following: I. Price-to-earnings ratio II. Dividend yield a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: Type: Fact LOC: Knowledge of financial analysis and cash flows TOP: Basic Classifications of Ratios

NAT: Reflective thinking

ESSAY 1. What are the main purposes of financial analysis and what does it identify?

ANS:

Financial analysis identifies the major strengths and weaknesses of a business. It indicates whether a firm has enough cash to meet obligations; a reasonable accounts receivable collection period; an efficient inventory management policy sufficient plant, property and equipment; and an adequate capital structure. These are necessary in determining whether or not the firm is maximizing shareholder wealth.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Uses of financial analysis 2. List the major financial ratio groups and briefly indicate what they analyze.

ANS: 1. Liquidity ratios - they indicate the firm’s ability to meet short-term financial obligations. Whether or not the company can pay its day-to-day bills.

2. Asset management ratios - they indicated how efficiently a firm is using its assets to generate sales.

3. Financial leverage ratios - they indicate a firm’s capacity to meet its short-term and long-term debt obligations.

4. Profitability ratios - they measure how effectively a firm’s management generates profits on sales, assets, and stockholder’s investments.

5. Market-based ratios - they measure the financial market evaluation of the firm’s performance.

6. Dividend policy ratios - they indicate the dividend practices of the firm.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Basic classifications of financial ratios 3. What information can be determined by common size financial statements?

ANS: Common size financial statements can: 1. identify trends in financial performance. Negative trends can be identified and monitored.

2. can indicate the percentage of sales invested in each item on the balance sheet and income statement. These percentages can be compared with like percentages of larger or smaller companies and can be used as a comparison tool.

PTS: 1 OBJ: Type: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Key Financial Statement 4. What information can Asset Management Ratios provide?

ANS: Asset Management Ratios indicate: 1. how much a firm has invested in a particular type of asset relative to the revenue being produced by the asset.

2. how efficiently the firm is allocating its resources.

3. whether or not the firm has achieved an effective asset structure in generating sales revenue.

4. whether or not the firm has achieved the best mix of cash, receivables, inventories, plant, property and equipment (total assets).

PTS: 1 OBJ: Type: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Asset Management Ratios

5. What factors make it possible for firms with virtually identical plants to have significantly different fixed-asset turnover ratios?

ANS: The following factors make is possible for identical firms to have different fixed-asset turnover ratios: 1. the cost of the assets when acquired.

2. the length of time since acquisition.

3. the depreciation policies adopted by the firm. r. the extent to which fixed assets are leased rather than owned.

PTS: 1 OBJ: Type: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Asset Management Ratios

Chapter 4 - FINANCIAL PLANNING AND FORECASTING MULTIPLE CHOICE 1. In the percent-of-sales forecasting method, all of the following balance sheet and income statement items are assumed to increase proportionately with sales EXCEPT: a. dividends b. accounts payable c. long-term debt d. a and c ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

2. In the percent-of-sales forecasting method, which of the following is (are) assumed to increase proportionately with sales? a. cash b. accounts receivable c. accounts payable d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

3. Which of the following is a financial model that attempts to maximize or minimize the value of a criterion function (e.g., profits, costs)? a. static b. dynamic c. probabilistic d. optimization ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Finance applications in spreadsheets TOP: Computerized financial forecasting and planning models 4. Pro forma financial statements are used to: a. find the contribution margin b. show the results of some assumed event c. predict the sensitivity of different output variables

NAT: Reflective thinking

d. show the results of an actual event ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial forecasting

5. The percentage of sales forecasting method is used by management to forecast the amount of... a. profit expected for a given percentage increase in sales b. capital financing needed to promote marketing efforts c. cash needed to finance future sales growth d. debt financing needed ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

6. In using the percentage of sales forecasting method the assumption is that a. there is a direct relationship between long-term debt and sales b. inventories will increase proportionately with sales c. there is a direct relationship between notes payable and sales d. retained earnings will increase proportionately with sales ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

7. To decrease the additional financing needed to support an increase in sales, management can a. decrease notes payable b. retire common stock c. increase the dividend payout d. cut dividends ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

8. Cash budgeting can be employed effectively by management to a. identify potential cash flow problems in advance b. aid them in capital budgeting c. control retained earnings d. coordinate cash and deferred expenses ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash budgeting

9. The first step in cash budget preparation is the a. estimation of credit sales b. estimation of the expected cash disbursements c. scheduling of disbursements d. determination of estimated receipts ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash budgets

10. Computerized financial planning models may be classified as any of the following except: a. deterministic b. optimistic

c. probabilistic d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Computerized financial forecasting and planning models

NAT: Reflective thinking

11. The main advantage of deterministic models is that they a. provide the user with more useful information than other models b. allow the user to maximize some objective function c. allow the user to perform sensitivity analyses quickly d. allow the user to maximize or minimize some objective function ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Computerized financial forecasting and planning models

NAT: Reflective thinking

12. All the following current liabilities normally vary directly with the sales except: a. accounts payable b. notes payable c. accrued wages d. accrued taxes ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method

NAT: Reflective thinking

13. Pro forma financial statements show the results of some __________ event rather than a (an) __________ event. a. actual; assumed b. assumed; actual c. deterministic; probabilistic d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial forecasting

14. The __________ is (are) used to forecast the amount of additional financing (i.e., cash) a company will need in some future period. a. percentage of sales forecasting method b. pro forma statement of cash flows c. a and b d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting method & Pro Forma...

NAT: Reflective thinking

15. __________ financial planning models seek to maximize (or minimize) the value of some objective function, such as profits (or costs). a. Deterministic b. Optimization c. Probabilistic d. none of the above ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows TOP: Computerized financial forecasting and planning models 16. In 1998, Hepler Company's sales were $26 million and its total assets were $10 million. Current liabilities were $4 million and total equity was $2 million. Hepler Company's sales for 1999 are forecasted to be $34 million, earnings after taxes are expected to be 5 percent of sales and dividends of $800,000 are expected to be paid. Assuming that the ratios "assets to sales" and "current liabilities to sales" in 1998 remain the same in 1999, determine the amount of additional financing required. a. $1,746,154 b. $1,446,154 c. $6,946,154 d. $ 946,154 ANS: D Solution: AFN =[(A/S)S - (CL/S)S] - [EAT - D] =[(10,000,000/26,000,000)(8,000,000) - (4,000,000/26,000,000)(8,000,000)] -[34,000,000 x .05 - 800,000] = $946,154 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

17. Peerless believes that its sales next year will increase 20 percent from the current level of $800,000.

Management calculates that assets must increase $110,000 to support the new sales level, and current liabilities will increase $70,000. What total financing will be needed? a. $40,000 b. $1,600 c. $33,600 d. $8,000 ANS: A Solution: TFN = $110,000 -$70,000 = $40,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Calculation of cash financing needs

NAT: Analytic skills

18. ECG Monitors is forecasting that sales next year will be $8,640,000, a 20 percent increase over current sales. ECG has total assets of $3,840,000 and all assets will increase proportionately with sales. Of the current liabilities, only accounts payable (now $740,000) will increase with sales. What total financing will be needed by ECG to support the expected sales increase? a. $317,600 b. $620,000 c. $465,600 d. $840,400 ANS: B Solution: S = $8,640,000/1.2 = $7,200,000 TFN = (3,840,000/$7,200,000) ($1,440,000) -($740,000/$7,200,000)($1,440,000) = $620,000 PTS: 1

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Knowledge of financial analysis and cash flows

TOP: Percent of sales forecasting

19. ICU has current assets of $800,000 and net fixed assets of $1,400,000. The firm expects its sales to climb 25 percent next year from its current level of $3,500,000. ICU's only current liability is accounts payable of $1,200,000. If both current assets and current liabilities will increase proportionately with sales, what additional financing will be needed by ICU next year? Assume ICU has a net profit margin of 6 percent. An increase in net fixed assets of $500,000 will be required. The firm pays out 50 percent of its earnings as dividends. a. $400,000 b. $358,750 c. $178,750 d. $268,750 ANS: D Solution: AFN = $500,000 + $800,000(0.25) - $1,200,000(0.25) - $3,500,000 (1.25)(0.06)(0.5) = $268,750 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

20. CU Tech expects sales next year will be $4.8 million, a 25% increase over current sales. CU has total assets of $2.24 million and all assets will increase proportionately with sales. CU has $1.49 million in current liabilities and a current ratio of 1.60 to 1. What total financing will CU need to support the expected sales increase? a. No financing needed, surplus of $139,700 b. $ 187,500 c. $ 48.800 d. $234,400 ANS: B Solution: Current sales = $4.8/1.25 = $3.84 million TFN = (2.24/3.84)(.96) - (1.49/3.84)(.96) = $.1875 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

21. Getrag expects its sales to increase 20% next year from its current level of $4.7 million. Getrag has current assets of $660,000, net fixed assets of $1.5 million, and current liabilities of $462,000. All assets are expected to grow proportionately with sales. If Getrag has a net profit margin of 10%, what additional financing will be needed to support the increase in sales? Getrag does not pay dividends. a. $339,600 b. $283,200 c. No financing needed, surplus of $224,400 d. No financing needed, surplus of $524,400 ANS: C Solution: AFN = (2.16/4.7)(.94) - (.462/4.7)(.94) - 5.64(.10) = 432,000 - 92,400 - 564,000 = - $224,400 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

22. Great Subs believes it can increase sales by 50 percent without any increase in net fixed assets.

Earnings after tax are expected to be $2,000. The company pays no dividends. What additional financing will Subs need to finance this growth? Subs balance sheet currently is as follows: Cash Accounts Rec. Inventory Fixed assets, net

a. b. c. d.

$ 2,500 4,400 6,000 47,700 $60,600

Accounts payable Notes payable Long-term debt Stockholder's equity

$ 5,600 10,000 15,000 30,000 $60,600

$3,350 surplus--no additional financing needed $1,650 $3,650 None of the above are correct

ANS: B Solution: AFN = ($12,900 / S )(.5S) - ( $5,600 / S)(.5S) - $2,000 = 6,450 - 2,800 - 2000 = $1,650 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

23. Calculate United's total assets if the firm expects sales to grow 15 percent this year and the earnings after tax will be $50,000. United paid $20,000 in dividends last year and expects to increase dividends 10 percent this year. The firm will need additional financing of $25,000 to finance the expected growth. United started the year with $40,000 in accounts payable; $30,000 in notes payable; and $100,000 in long-term debt. The company is operating at full capacity. a. $393,333 b. $590,000 c. $226,667 d. $616,000 ANS: A Solution: $25,000 = (A/S)(.15S) - ($40,000/S)(.15S) - ($50,000 - $22,000) A = $393,333 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

24. Lane Manufacturing needs to determine the amount of growth the firm could experience without having to obtain external financing. The current sales level is $800,000, the net profit margin is 6 percent, and the dividend payout ratio is 40 percent. Assume the firm is currently operating at full capacity and all assets will increase proportionately with sales. Lane's current balance sheet follows: Cash Accounts receivable Inventories Net fixed assets

a. 6.53%

$ 30,000 90,000 110,000 380,000 $610,000

Accounts payable Notes payable Long-term debt Common stock Retained earnings

$140,000 50,000 280,000 40,000 100,000 $610,000

b. 1.09% c. 11.97% d. 13.50% ANS: A Solution: AFN = (610/800)(800g) - (140/800)(800g) - [800(1+g)(0.06)(1- 0.4)] 0 = 610g - 140g - 28.8 - 28.8g g = 0.0653 or 6.53% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

25. The Hudson River Line Company has a balance sheet as of the end of the year as follows: Cash Accounts receivable Inventories Total current assets Fixed assets, net Total assets

$

5,000 20,000 40,000 $ 65,000 50,000 $115,000

Accounts payable Notes payable Total current liab.

Long-term debt Stockholders' equity Total liabilities and equity

$15,000 10,000 30,000 60,000 $115,000

Last year, the firm had sales of $148,750. This year the company expects sales to increase 25 percent, to generate earnings after tax of $16,000, and to pay a dividend of $5,000. Hudson operated its fixed assets at 85 percent capacity last year. What additional financing will be needed to support the sales increase? a. $2,125 b. $4,625 c. $1,500 d. $375 surplus ANS: B Solution: Full capacity sales = $148,750/0.85 = $175,000 New Sales = $148,750(1.25) = $185,938 $50,000 net fixed assets will support $175,000 in sales. Hence net fixed assets must increase by 50/175, or 0.2857 times sales in excess of capacity, or 0.2857 ($185,938 - $175,000) = $3,125 AFN = $65,000(0.25) + $3,125 - $15,000(0.25) - ($16,000 - $5,000) = $16,250 + $3,125 - $3,750 - $11,000 = $4,625 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

26. Jones Company sales last year were $25 million and its total assets were $8 million. Accounts payable were $2 million and common stock and retained earnings were $5 million. Jones sales are forecasted to be $30 million this year, earnings after tax are expected to be 3% of sales, and dividends of $250,000 are expected to be paid. Assuming that the ratio of assets to sales and current liabilities to sales remain the same this year as last year, determine the amount of additional financing required. a. $550,000 b. $1,200,000 c. $300,000 d. none of the above ANS: A Solution:

AFN = [(A/S) S - (CL/S) S] - [CF - D] = [($8,000,000/$25,000,000) ($5,000,000) - ($2,000,000/$25,000,000)($5,000,000)] - [0.03 x $30,000,000 - $250,000] = $550,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Percentage of sales forecasting

NAT: Analytic skills

27. In 20X3, the Fillmore Company's sales were $12.0 million. Its balance sheet at year end 20X3 is shown below. Fillmore's 20X4 sales are expected to be $15 million and its 20X5 sales are expected to be $18 million. Earnings after tax in both years is expected to be 5.0% of sales, and annual dividends of $250,000 are expected to be paid in both 20X4 and 20X5. The company presently has excess plant and equipment capacity. As a result, assume that the net fixed asset figure on the balance sheet will remain constant for both 20X4 and 20X5. Assuming that the ratios of assets (except fixed assets, net) to sales and accounts payable to sales in 20X3 remain the same in 20X4 and 20X5, calculate the total amount, i.e., one number, of external financing required during the 2 year period from 20X4 through 20X5, using the percentage of sales method.

Current assets: Cash Accts. Rec. Inventory Fixed assets, net

Fillmore Co. Balance Sheet (December 31, 20X3) ($ millions) Current liabilities: $0.2 Accts. payable 1.2 Notes payable 2.0 Long-term debt 2.6 Stockholders' equity $6.0

a. b. c. d.

$0.6 0.7 1.5 2.2 $6.0

$ 750,000 $ 250,000 $1,000,000 None of the above

ANS: B Solution: Assets that are expected to vary proportionately with sales = $6.0 - $2.6 = $3.4 million External financing needed = [($3.4/$12)($6) - ($0.6/$12)($6)] - [0.05($15 + $18) - 2($0.25)] = $0.25 million, or $250,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial skills and cash flows

NAT: Analytic skills TOP: Percentage of sales method

28. The Danville Company is considering a $50 million expansion (capital expenditure) program next year. The company wants to determine approximately how much additional financing will be needed if the expansion program is undertaken. Next year the company expects to earn $25 million after interest and taxes. The company also plans to increase its dividends from $5 million to $7 million. If the expansion program is accepted, the company expects working capital requirements to increase by approximately $8 million next year. Long-term debt retirement obligations total $3 million next year and depreciation is expected to be $13 million. No fixed assets are expected to be sold next year. a. $30 million b. $43 million c. $32 million

d. $22 million ANS: A Solution: Financing needed = $50 million capital expenditure - $25 million EAT + $7 million dividends + $8 million working capital increase + $3 million debt retirement - $13 million depreciation = $30 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Cash Flow Calculation

29. Ship-to-Shore earned $280,000 after taxes last year. Its expenses included depreciation of $55,000, interest expenses of $40,000 and deferred taxes of $20,000. The company also purchased two new fresh water fishing boats for $40,000 ($20,000) each. What is Ship-to-Shore’s after-tax cash flow for last year? a. $395,000 b. $355,000 c. $315,000 d. $280,000 ANS: B PTS: 1 NAT: Analytic skills TOP: Cash Flow Analysis

OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

30. Scorch & Burn Fire Extinguishers, Inc. had an operating income (EBIT) of $260,00 last year. The firm had $18,000 in depreciation expenses, $15,000 in interest expenses and $60,000 in selling, general, and administrative expenses. If Scorch & Burn has a marginal tax rate of 40%, what was its after-tax cash flow for last year? a. $165,000 b. $129,000 c. $174,000 d. $147,000 ANS: A Solution: EBIT = $260,000 - $15,000 = $245,000 EAT = $245,000(1 - 0.40) = $147,000 ATCF = $147,000 + $18,000 = $165,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flow

NAT: Analytic skills TOP: Cash Flow Analysis

31. Last year Curative Technologies Inc. reported earnings after-tax of $23 million. Included in the expenses were depreciation of $3.7 million and interest expenses of $2.9 million. The year-end balance sheets shows an increase in deferred taxes of $2.6 million to a total of $14.2 million. What is Curative Technologies’ after-tax cash flow for last year? Assume a marginal tax rate of 40%. a. $20.1 million b. $32.2 million c. $29.3 million d. $26.4 million ANS: C Solution: ATCF = $23 + $3.7 +$2.6 = $29.3 million PTS: 1

OBJ: TYPE: C. Prob.

NAT: Analytic skills

LOC: Knowledge of financial analysis and cash flows

TOP: After-tax cash flows

32. Last year Molex’s net cash provided by operating activities was $14.1 million and its net cash used by investing activities was $20.7 million. If net cash provided by financing activities was $9.8 million, what was the net increase (or decrease) in cash and cash equivalents during the year? Molex started the year with $2.1 million in cash. a. $44.6 million b. $3.2 million c. $25.0 million d. $5.3 million ANS: B Solution: Cash = $14.1 - $20.7 + $9.8 = $3.2 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Statement of cash flows

33. The financial statement that shows the effects of a company’s operating, investing, and financing activities on its cash balance is known as the: a. cash budget statement b. pro forma financial statement c. statement of cash flows d. breakeven analysis ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The statement of cash flows

34. The Financial Accounting Standard Board (FASB) requires companies to prepare their statement of cash flows using the: a. indirect method b. direct method c. reconciliation method d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The statement of cash flows

35. Generally, which of the following non-cash charges is/are added to earnings after tax to calculate the after-tax cash flow?

I. Depreciation II. Deferred taxes a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The cash flow concept

36. Which of the following shows the effects of a company’s operating, investing, and financing activities on its cash flows? a. income statement b. balance sheet c. statement of cash flows

d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The statement of cash flows

37. In preparing a statement of cash flows, the ___________ method involves adjusting net income to reconcile it to net cash flows from operating activities. a. direct b. indirect c. accrual d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The statement of cash flows

38. After-tax cash flow equals: a. earnings after tax plus non-cash charges b. net earnings plus deferred expenses c. net earnings plus depreciation d. earnings after tax ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash Flow Analysis

39. Which of the following is defined as the systematic allocation of the cost of an asset over more than one period? a. Deferral b. Expensing c. Optimization d. Depreciation ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Depreciation

40. Getrag expects its sales to increase 20% next year from its current level of $4.7 million. Getrag has current assets of $660,000, net fixed assets of $1.5 million, and current liabilities of $462,000. All assets are expected to grow proportionately with sales. If Getrag has a net profit margin of 10%, what additional financing will be needed to support the increase in sales? Getrag does not pay dividends. a. $339,600 b. $283,200 c. No financing needed, surplus of $224,400 d. No financing needed, surplus of $524,400 ANS: C Solution: AFN = (2.16/4.7)(.94) - (.46/4.7)(.94) - 5.64(.10) = 432,000-92,400-564,000 = -$224,400 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Percent of sales forecasting

41. Calculate United’s total assets if the firm expects sales to grow by 15% this year and the earnings after tax will be $50,000. United paid $20,000 in dividends last year and expects to increase dividends 10% this year. The firm will need additional financing of $25,000 to finance the expected growth. a. $393,333

b. $590,000 c. $226,667 d. $616,000 ANS: A Solution: $25,000 = (A/S)(.15S) - ($40,000/S)(.15S) - ($50,000 - $22,000) A = $393,333 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

42. Great Subs believes it can increase sales by 50% without any increase in net fixed assets. Earnings after tax are expected to be $2,000. The company pays no dividends. What additional financing will Subs need to finance this growth? Subs’ balance sheet currently is as follows: Cash $ 2,500 Accounts Payable $ 5,600 Accounts Rec. 4,400 Notes Payable 10,000 Inventory 6,000 Long-term Debt 15,000 Fixed Assets, net 47,700 Stockholder’s Equity 30,000 $60,600 $60,600 a. b. c. d.

$3,350 surplus -- no additional financing needed $1,650 $3,650 None of the above are correct.

ANS: B Solution: AFN = (12,900/S)(.5S) - ($5,600/S)(.5S) - $2,000 = 6,450 - 2,800 - 2,000 = $1,650 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

43. Lullaby Lane Bedding, Inc. needs to determine the amount of growth the firm could experience without having to obtain external financing. The current sales level is $800,000, the net profit margin is 6%, and the dividend payout ratio is 40%. Assume the firm is currently operating at full capacity and all assets will increase proportionately with sales. Lane’s current balance sheet follows: Cash $ 30,000 Accounts Payable $140,000 Accounts Receivable 90,000 Notes Payable 50,000 Inventories 110,000 Long-term Debt 280,000 Net Fixed Assets 380,000 Common Stock 40,000 $610,000 Retained Earnings 100,000 $610,000 a. b. c. d.

6.53% 1.09% 11.97% 13.50%

ANS: A Solution: AFN = (610/800g)(800g) - (140/800)(800g) - {800(1+g)(0.06)(1-0.4)] 0 = 610g - 140g - 28.8 - 28.8g

g = 0.0653 or 6.53% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

44. The Hudson River Line Company has a balance sheet as of the end of the year as follows: Cash $ 5,000 Accounts Payable $ 15,000 Accounts Receivable 20,000 Notes Payable 10,000 Inventories 40,000 Total Current Liab.

25,000 Total Current Assets $ 65,000 Long-term Debt 30,000 Fixed Assets, net 50,000 Stockholder’s Equity 60,000 Total Assets $115,000 Total Liabilities & Equity $115,000 Last year, the firm had sales of $148,750. This year the company expects sales to increase 25%, to generate earnings after tax of $16,000, and to pay a dividend of $5,000. Hudson operated its fixed assets at 85% capacity last year. What additional financing will be needed to support the sales increase? a. $2,125 b. $4,625 c. $1,500 d. $375 surplus -- no financing needed.

ANS: B Solution: Full capacity sales = $148,750/0.85 = $175,000 New Sales = $148,750(1.25) = $185,938 $50,000 net fixed assets will support $175,000 in sales. Hence net fixed assets must increase by 50/175, or 0.2857 times sales in excess of capacity, or 0.2857($185,938 - $175,000) = $3,125 AFN = $65,000(0.25) + $3,125 - $15,000(0.25) - ($16,000 - $5,000) = $16,250 + $3,125 - $3,750 - $11,000 = $4,625 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

45. Jones Company sales last year were $25 million and its total assets were $8 million. Accounts payable were $2 million and common stock and retained earnings were $5 million. Jones sales are forecasted to be $30 million this year, earnings after tax are expected to be 3% of sales, and dividends of $250,000 are expected to be paid. Assuming that the ratio of assets to sales and current liabilities to sales remain the same this year as last year, determine the amount of additional financing required. a. $550,000 b. $1,200,000 c. $300,000 d. None of the above ANS: A Solution: AFN = {(A/S) S - (CL/S) S} - [CF - D] = [($8,000,000/$25,000,000)($5,000,000) - ($2,000,000/$25,000,000)($5,000,000] - [0.03 x $30,000,000 - $250,000] = $550,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Percent of sales forecasting

46. Operational plans are generally conducted at two levels. Which length of time is considered long-term?

a. b. c. d.

2 years 12 - 18 months 5 years 10 years

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Introduction

47. Which of the following statements is/are correct about deferred taxes?

I. Deferred taxes can occur because of geographical problems with the location of corporate headquarters.

II. Deferred taxes can occur because some companies use the straight-line depreciation method to calculate income reported to stockholders and accelerated depreciation to calculate taxable income.

This practice reduces taxes owed. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Deferred Taxes

48. In those industries where capacity can be added only in discrete or “lumpy” increments, fixed assets are increased in a _______________ manner as sales increase. a. b. c. d.

proportional stepwise direct relationship discriminant

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Percentage of sales method

49. Which of the following is an example of a deterministic model? a. profit optimization model b. budget simulator c. probabilistic set d. discriminant model ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Computerized financial forecasting and planning models

NAT: Reflective thinking

50. _____________ is the statistical technique that helps the analyst classify observations (firms) into two or more predetermined groups based on certain characteristics of the observation. a. Deterministic analysis b. Sensitivity analysis c. Discriminant analysis d. Optimization ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Using financial ratios to forecast future financial performance

51. In considering financial planning, the type of planning that focuses more on the overall direction of the business and the industry is: a. Deterministic b. Strategic c. Operational d. Probabilistic ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial Planning

52. Short-term operational plans are generally conducted over what time frame? a. 3 - 6 months b. 8 - 12 months c. 12 - 18 months d. 2 - 5 years ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial Planning

53. The value of debt and equity securities is based upon: a. The type of investment vehicle b. The growth potential of the asset c. The accounting method used for recording the asset d. The present value of the cash flows that the securities are expected to provide.

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Importance of Cash Flows

54. Using a cash budget is more useful than the percentage of sales method because: I. It can more precisely estimate the amount of financing needed.

II. It can better estimate the time of financing need. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash Budgeting

55. The first step in the preparation of a cash budget is: a. Estimation of future spending b. Estimation of asset value c. Estimation of cash receipts d. Estimation of future stock sales ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash Budgeting

56. An example of an investing activity is: a. Issuing new corporate stock b. Paying corporate income taxes c. Buying new computers d. Taking out a new loan.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking

TOP: The Statement of Cash Flows 57. Cash and cash equivalents include: I. Money market accounts II. Currency on hand. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: The Statement of Cash Flows

NAT: Reflective thinking

58. The category “Cash and Cash Equivalents” includes short term investments. The time frame for short-term is: a. 30 days b. 6 months c. under 5 years d. less than three months ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: The Statement of Cash Flows

NAT: Reflective thinking

ESSAY 1. An operational plan is necessary to determine what the firm wants to be at some future point in time.

What does an operational plan consist of?

ANS: 1. a marketing plan 2. a production plan 3. a human resource plan 4. a financial plan PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Introduction 2. What information does a long-term financial plan offer?

ANS: The financial plan lays out the financial resources that are needed to achieve the operational (including the financial) objectives of the firm. It also includes financial forecasts.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Introduction 3. Financial planning models have two classifications. What are they and how do they differ from each other?

ANS: The two models are deterministic and probabilistic.

Deterministic give a single-number forecast of a financial variable or variables without stating anything about the probability of occurrence.

Probabilistic models provide output in the form of a probability distribution which gives the company planners more useful information than a deterministic model. However, more input is needed for a probabilistic model.

PTS: 1 OBJ: Type: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Computerized Financial Forecasting and Planning Models 4. Explain the cash flow generation process: ANS: Financial managers are concerned with raising funds that can be used by the firm and investing those funds into assets that can be converted into a stream of cash flows that can accrue for the firm and its owners. If the stream of cash flows generated by the assets is greater than the cost of those assets, the investments of the firm will add value to the firm. In the process of acquiring funds and directing those funds, the financial manager must balance the risk and timing of the expected cash flow stream against the magnitude of the expected returns.

PTS: 1 OBJ: Topic: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: The Cash Flow Generation Process 5. Why would a firm experience cash flow difficulties immediately after a good sales period?

ANS: Inventory has been sold and must be replenished. However, many sales have been conducted on an accounts receivable basis and collections have not yet been received. In addition, accounts payable may become due before cash is actually received. All of this leads to cash flow difficulties.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Cash Budgeting

Chapter 5—THE TIME VALUE OF MONEY MULTIPLE CHOICE 1. The amount of simple interest is equal to the product of the principal times_________ times _________. a. (1 + rate per time period), the number of time periods b. (1 + rate per time period), (the number of time periods -1) c. rate per time period, the number of time periods d. rate per time period, (the number of time periods - 1) ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Simple interest

2. The present value of a single amount can be represented as a. PV0 = FVn(PVIFi,n) b. PV0 = FVn(PVIFAi,n) c. PV0 = FVn[1/(1 + i)n] d. a and c

ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value

3. The basic future value equation is given by a. FVn = PV0(PVIFi,n) b. FVn = PV0(FVIFAi,n) c. FVn = PV0(1/(1+ i)n) d. FVn = PV0(FVIFi,n) ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Compound interest and future value

4. The process of finding present values is frequently called a. annualizing b. compounding c. discounting d. leasing ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value

5. The values shown in ordinary annuity tables (either present value or compound value) can be adjusted to the annuity due form by _________ the ordinary annuity interest factor by ______. a. dividing, (1 + i) b. dividing, (1 + i)n c. multiplying, (1 + i) d. multiplying, (1 + i)n ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Future value of an annuity due

6. A(n) __________ is a financial instrument that agrees to pay an equal amount of money per period into the indefinite future (i.e. forever) a. annuity b. annuity due c. sinking fund d. perpetuity ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Perpetuities

NAT: Reflective thinking

7. Finding the discounted current value of $1,000 to be received at the end of each of the next 5 years requires calculating the a. future value of an annuity b. future value of an annuity due c. present value of an annuity d. present value of an annuity due ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of an ordinary annuity

8. Finding the compound sum of $1,000 to be received at the beginning of each of the next 5 years requires calculating the a. future value of an annuity b. present value of an annuity

c. future value of an annuity due d. present value of an annuity due ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Future value of an annuity due

9. When using a present value of an annuity table(e.g.,Table IV at the back of the book), a. payments are assumed to be made at the beginning of each period b. PVIFA factors decrease with an increase in the interest rate c. PVIFA factors increase with an increase in the number of periods d. b and c only ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of an ordinary annuity

10. When using a future value of an annuity table (e.g., Table III at the back of the book), a. payments are assumed to be made at the end of each period b. FVIFA factors increase with an increase in the interest rate c. FVIFA factors increase with an increase in the number of periods d. all of the above ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Future value of an ordinary annuity

11. An annuity due is one in which a. payments or receipts occur at the end of each period. b. payments or receipts occur at the beginning of each period. c. payments or receipts occur forever. d. cash flows occur continuously.

ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Annuities

NAT: Reflective thinking

12. You have just won a $5 million lottery to be received in twenty annual equal payments of $250,000.

What will happen to the present value of your winnings if the interest rate increases during the next 20 years. a. it will be worth less b. it will be worth more c. it will not change d. it will increase during the first ten years ANS: A PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value

13. You have just calculated the present value of the expected cash flows of a potential investment.

Management thinks your figures are too low. Which of the following actions would improve the present value of your cash flows? a. extend the cash flows over a longer period of time b. increase the discount rate c. decrease the discount rate d. extend the cash flows over a longer period of time, and decrease the discount rate ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value

14. If the present value of a given sum is equal to its future value, then

a. b. c. d.

the discount rate must be very high there is no inflation the discount rate must be zero none of the answers is correct

ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value

15. Using the "Rule of 72," about how long will it take a sum of money to double in value if the annual interest rate is 9 percent? a. 9 years b. 7 years c. 8 years d. 10 years ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Analytic skills TOP: Solving for the interest rate

16. The present value of an ordinary annuity is the a. sum of the present value of a series of equal periodic payments b. future value of an equal series of payments c. receipt of equal cash flows for a specified amount of time d. sum of the future value of an equal series of payments ANS: A PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of an ordinary annuity

17. When a loan is amortized over a five year term, the a. rate of interest is reduced each year b. amount of interest paid is reduced each year c. payment is reduced each year d. balance is paid as a balloon payment in the fifth year ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of an ordinary annuity

18. Annuity due calculations are especially important when dealing with a. term loans b. lease contracts c. capital investments d. capital recovery problems ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of an annuity due

19. The more frequent the compounding the a. greater the present value b. greater the amount deposited c. greater the effective interest rate d. lesser the future value ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Compounding periods and effective interest rates

20. The effective rate of interest will always be _______ the nominal rate. a. greater than

b. equal to c. less than d. equal to or greater than ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Effective rate calculations

21. __________ is interest that is paid not only on the principal, but also on any interest earned but not withdrawn during earlier periods. a. basic interest b. simple interest c. future interest d. compound interest ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Compound interest and future value

22. Which of the following is worth more? a. Future value of an ordinary annuity of PMT dollars per year for n years discounted at i percent. b. Future value of an annuity due of PMT dollars per year for n years discounted at i percent. c. Both are worth the same amount. d. Cannot be determined from the information given.

ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Future value of an annuity due

23. The annual effective rate of interest (ieff ) is a function of: a. the annual nominal rate of interest (inom) b. the number of compounding intervals per year (m) c. the number of years (n) d. a and b ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Effective rate calculations

24. More frequent compounding results in _________ future values and __________ present values than less frequent compounding at the same interest rate. a. higher, higher b. lower, higher c. higher, lower d. lower, lower ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand time value of money TOP: Effect of compounding periods on present and future values 25. The present value of a(n) __________ is determined by dividing the annual cash flow by the interest rate. a. annuity b. annuity due c. perpetuity d. lease ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Perpetuities

NAT: Reflective thinking

26. An annuity that begins more than 1 year in the future is referred to as a(n)__________. a. perpetuity b. annuity due c. uneven annuity d. deferred annuity ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Present value of deferred annuities

27. The __________ of a perpetual stream of equal, annual returns (PMT) discounted at i% per year is equal to __________ . a. present value; PMT/i b. present value; PMT x i c. future value; PMT/i d. future value; PMT x i ANS: A PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Perpetuities

NAT: Reflective thinking

28. Annuity due calculations are most common when dealing with: a. cash dividends b. loan repayments c. lease contracts d. interest payments ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Annuities

NAT: Reflective thinking

29. The payment or receipt of a series of equal cash flows per period, at the end of each period, for a specified amount of time is called a(n): a. annuity due b. perpetuity c. ordinary annuity d. simple interest ANS: C PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Annuities

NAT: Reflective thinking

30. The difference between an ordinary annuity and an annuity due is: a. the interest rate b. the timing of the payments c. the amount of the payments d. the number of periods ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Annuities

NAT: Reflective thinking

31. __________ is the return earned by someone who has forgone current consumption. a. the present value b. principle c. an annuity d. interest ANS: D PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact TOP: Interest

NAT: Reflective thinking

32. Determine how much $1,000 deposited in a savings account paying 8% (compounded annually) will be worth after 5 years. a. $5,526 b. $ 784 c. $1,400 d. $1,469 ANS: D All problems use Tables I - IV in the back of the book unless otherwise stated.

Solution: FV5 = PV0(FVIF.08,5) = 1,000(1.469) = $1,469 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value 33. The earnings of Omega Supply Company have grown from $2.00 per share to $4.00 per share over a nine year time period. Determine the compound annual growth rate. a. 11.1% b. 8% c. 22.2% d. 100% ANS: B Solution: PVIFi,9 = $2.00/$4.00 = 0.500. i = 8% from Table II. PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Calculation of compound growth rate 34. Comet Powder Company has purchased a piece of equipment costing $100,000. It is expected to generate a ten-year stream of benefits amounting to $16,273 per year. Determine the rate of return Comet expects to earn from this equipment. a. 16.3% b. 62.7% c. 10% d. 20% ANS: C Solution: $100,000 = $16,273(PVIFAi,10) PVIFAi,10 = 6.145 Therefore, i = 10% from Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 35. Mr. Moore is 35 years old today and is beginning to plan for his retirement. He wants to set aside an equal amount at the end of each of the next 25 years so that he can retire at age 60. He expects to live to the maximum age of 80 and wants to be able to withdraw $25,000 per year from the account on his 61st through 80th birthdays. The account is expected to earn 10 percent per annum for the entire period of time. Determine the size of the annual deposits that must be made by Mr. Moore. a. $212,850 b. $23,449 c. $2,164

d. $8,514 ANS: C Solution: PVAN = PMT(PVIFA0.10,20) = $25,000(8.514) = $212,850 needed on 60th birthday $212,850 = PMT(FVIFA0.10,25) = PMT(98.347) PMT = $2,164 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 36. Determine (to the nearest dollar) the amount you would be willing to pay for a $1,000 par value bond paying $80 interest each year and maturing in 12 years, assuming you wanted to earn a 9 percent rate of return. a. $929 b. $573 c. $1,316 d. $1,960 ANS: A Solution: PV0 = $80(PVIFA0.09,12) + $1000(PVIF0.09,12) = $80(7.161) + $1000(.356) = $928.88 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Bond valuation 37. Determine how much you would be willing to pay for a bond that pays $60 annual interest indefinitely and never matures (i.e. a perpetuity), assuming you require an 8 percent rate of return on this investment. a. $480 b. $743 c. $1,000 d. $750 ANS: D Solution: PVPER = PMT/i = $60/.08 = $750 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Understand time value of money TOP: Perpetuity

NAT: Analytic skills

38. Air Atlantic (AA) has been offered a 3-year old jet airliner under a 12-year lease arrangement. The lease requires AA to make annual lease payments of $500,000 at the beginning of each of the next 12 years. Determine the present value of the lease payments if the opportunity cost of funds is 14 percent. a. $2,830,000 b. $13,635,500 c. $6,000,000 d. $3,226,200 ANS: D Solution: PVAND = PMT [PVIFAi,n(1+i)] ; n = 12; i = 0.14; PMT = $500,000 = $500,000[5.660(1+.14)] = $3,226,200

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity due 39. If you invest $10,000 in a 4-year certificate of deposit (CD) paying 10 percent interest compounded annually, determine how much the CD will be worth at the end of 4 years. a. $13,600 b. $45,730 c. $14,640 d. $15,958 ANS: C Solution: FV4 = PV0(FVIFi,n); PV0 = $10,000; n = 4; i = 0.10 = $10,000(1.464) = $14,640 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value 40. You sold 100 shares of stock today for $30 per share that you paid $20 for 6 years ago. Determine the average annual rate of return on your investment, assuming the stock paid no dividends. a. 25% b. 8.33% c. 150% d. 7% ANS: D Solution: PV0 = FVn(PVIFi,n); n = 6; PV0 = $20; FV6 = $30 $20 = $30 (PVIFi,6) (PVIFi,6) = 0 .667; Therefore i = 7% from Table II. PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 41. Your grandparents put $1,000 into a savings account for you when you were born 20 years ago. This account has been earning interest at a compound rate of 7 percent. What is its value today? a. $3,870 b. $1,967 c. $3,026 d. $3,583 ANS: A Solution: FV20 = $1000(3.870) = $3,870 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value 42. Baggos has seen their EPS increase from $0.30 to $3.16 in seven years. What has been the growth rate of Baggos's EPS? a. about 30% b. about 40% c. about 20% d. about 10%

ANS: B Solution: FVIFi,7 = $3.16/$0.30 = 10.53; or 40 percent from Table I PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Growth rate calculation 43. You have just won a $50,000 bond that pays no interest and matures in 20 years. If the discount rate is 10%, what is the present value of your bond? a. $7,450 b. $8,175 c. $8,900 d. $1,490 ANS: A Solution: PV = $ 50,000(0.149) = $7,450 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 44. BB&C bank has agreed to lend you $30,000 today, but you must repay $42,135 in 3 years. What rate is the bank charging you? a. 10% b. 11% c. 12% d. 13% ANS: C Solution: PVIFi,3 = $30,000/$42,135 = 0.712; or 12% from Table II PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 45. The Florida lottery agrees to pay the winner $250,000 at the end of each year for the next 20 years.

What is the future value of this lottery if you plan to put each payment in an account earning 9 percent? a. $2.28 million b. $12.79 million c. $14.32 million d. $ 5.00 million ANS: B Solution: FVAN 20 = $250,000(51.160) = $12,790,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 46. Billy Bob has decided to put $2,400 a year (at the end of each year) into an IRA over his 40 year working life and then retire. What will Billy have if the account will earn 10 percent compounded annually? a. $394,786

b. $ 23,470 c. $1,062,223 d. $810,917 ANS: C Solution: FVAN40 = $2,400(442.593) = $1,062,223 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 47. Jane wants to have $200,000 in an account in 20 years. If her account earns 11 percent per annum over the accumulation period, how much must she save per year (end of year) to have the $200,000? a. $25,116 b. $3,115 c. $10,000 d. $3,492 ANS: B Solution: PMT = $200,000/64.203 = $3,115 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 48. Many IRA funds argue that investors should invest at the beginning of the year rather than at the end.

What is the difference to an investor who invests $2,000 per year at 11 percent over a 30 year period? a. $43,785 b. $36,189 c. $54,244 d. There is no difference ANS: A Solution: FVAN30 = $2,000(199.021) = $398,042 FVAND30 = $2,000(199.021)(1.11) = $441,827 Difference = $43,785 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity and an annuity due 49. An insurance company offers you an end of year annuity of $48,000 per year for the next 20 years.

They claim your return on the annuity is 9 percent. What should you be willing to pay today for this annuity? a. $429,600 b. $438,144 c. $408,672 d. $398,144 ANS: B Solution: PVAN = $48,000(9.128) = $438,144 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity

50. New Jersey Mutual has offered you a single premium annuity that will pay you $12,000 per year (end of year) for the next 15 years. If you must pay $109,296 today for this annuity, what is your expected rate of return? a. 8% b. 9% c. 7% d. 10% ANS: C Solution: PVIFA = $109,296/$12,000 = 9.108; or 7% from Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 51. Columbia Bank & Trust has just given you a $20,000 term loan to pay for a new concrete mixer. The loan requires five equal annual end of the year payments. If the loan provides the bank with a 12 percent return, what will be your annual payments? a. $5,548 b. $3,148.12 c. $6,000 d. $1,666.67 ANS: A Solution: PMT= $20,000/3.605 = $5,547.85 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 52. Idlewild Bank has granted you a seven year loan for $50,000. If your seven annual end of the year payments are $11,660.45, what is the rate of interest Idlewild is charging? a. 14% b. 23% c. 12.6% d. 11% ANS: A Solution: PVIFA = $50,000/$11,660.45 = 4.288; or 14% from Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 53. Your firm, New Sunrise, has just leased a $28,000 BMW for you. The lease requires six beginning of the year payments that will fully amortize the cost of the car. What is the amount of the payments if the interest rate is 12 percent? a. $6,810.99 b. $7,766.99 c. $6,423.74 d. $6,081.25 ANS: D Solution:

PMT = $28,000 / (4.111)(1.12) = $6,081.25 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of annuity due 54. The lease on a new office requires an immediate payment of $24,000 plus $24,000 per year at the end of each of the next 10 years. At a discount rate of 14 percent, what is the present value of this stream of lease payments? a. $130,872 b. $149,194 c. $142,710 d. $264,000 ANS: B Solution: PVAND = $24,000(5.453)(1 + 0.14) = $149,194 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity due 55. Alabama Power has preferred stock that pays an annual dividend of $9.44. If the security has no maturity, what is it's value to an investor who wishes to obtain a 9 percent rate of return? a. $84.96 b. $104.89 c. $95.34 d. $94.40 ANS: B Solution: PVPER = $9.44/0.09 = $104.89 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Understand time value of money TOP: Perpetuity

NAT: Analytic skills

56. Designs Now is opening a showcase office to display and sell it's computer designed poster art.

Designs expects cash flows to be $120,000 in the first year, $180,000 in the second year, $240,000 in the third year. If Designs uses 11 percent as its discount rate, what is the present value of the cash flows? a. $429,720 b. $457,620 c. $456,000 d. $424,820 ANS: A Solution: PV = $120,000 (0.901) + $180,000(0.812) + $240,000(0.731) = $429,720 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of unequal cash flows 57. In six years, your daughter will be going to college. You wish to have a fund that will provide her $10,000 per year (end of year) for each of her four years in college. How much must you put into that fund today if the fund will earn 10 percent in each of the 10 years? a. $29,744.65 b. $29,783.76

c. $17,878.80 d. $21,651.10 ANS: C Solution: PVAN = $10,000 (3.170) = $31,700 PV = $31,700 (0.564) = $17,878.80 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 58. What is the future value of a $10,000 college tuition fund if the nominal rate of interest is 12 percent compounded monthly for five years? a. $17,623.42 b. $18,170 c. $16,105.10 d. $16,122.26 ANS: B Solution: FV = $10,000 (1+ 0.12/12)12(5) = $18,170 (using 1% factor for 60 periods from Table I) PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value with monthly compounding 59. What is the effective rate of interest on a CD that has a nominal rate of 9.5 percent with interest compounded monthly? a. 9.92% b. 9.74% c. 10.02% d. 9.86% ANS: A Solution: ieff = (1 + .095/12)12 - 1 = 0.0992 or 9.92% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculation 60. John is 25 years old and wishes to retire in 30 years. His plan is to invest in a mutual fund earning a 12 percent annual return and have a $1 million retirement fund at age 55. How much must he invest at the end of each year to achieve this goal? a. $7,499.96 b. $5,024.60 c. $4,143.65 d. $33,333.33 ANS: C Solution: PMT = $1,000,000 / 241.333 = $4,143.65 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity

61. Joe Brady just won a $450,000 lottery in Pennsylvania. Instead of receiving a lump sum, he found that he would receive $22,500 annually (end of year) for 20 years. Joe is 75 years old and wants his money now. He has been offered $140,827 to sell his ticket. What rate of return is the buyer expecting to make if Joe accepts the offer? a. less than 1% b. 15% c. 18% d. 12% ANS: B Solution: PVIFA = $140,827/$22,500 = 6.259; or 15% from Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 62. A bank has agreed to loan you $10,000 at 11% for 5 years. You are required to make equal, annual, end-of-year payments that include both principal and interest on the outstanding balance. Determine the amount of these annual payments (to the nearest dollar). a. $2,000 b. $3,100 c. $2,706 d. $1,100 ANS: C Solution: PVANo = $10,000; n = 5; i = 11% PVANo = PMT(PVIFAi,n ) $10,000 = PMT(PVIFA0.11,5 ) = PMT(3.696) PMT = $2,706 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 63. Sales for Triad Inc. have grown from $2 million to $8.092 million in 10 years. What is the implied growth rate of sales for Triad? a. 24.72% b. 4.05% c. 15.0% d. 12.2% ANS: C Solution: 2 = 8.092 (PVIFi,10) .2472 = PVIFi,10 From Table II, i = 15% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Understand time value of money TOP: Growth rate

NAT: Analytic skills

64. If you invest the $10,000 you receive at graduation (age 22) in a mutual fund that averages a 12% annual return, how much will you have at retirement in 40 years? a. $909,090 b. $930,510 c. $783,879 d. $510,285

ANS: B Solution: FV = 10,000 (93.051) = $930,510 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value 65. Five years after an accident, you received $100,000 to pay the medical expenses incurred at the time of the accident. What is the present value (at the time of the accident) of the payment? Assume interest rates are 9%. a. $153,900 b. $ 68,100 c. $ 65,000 d. $ 70,800 ANS: C Solution: PV = 100,000 (.65) = $65,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 66. You purchased a piece of property for $30,000 nine years ago and sold it today for $83,190. What was your rate of return on your investment? a. 12% b. 11% c. 10% d. 9% ANS: A Solution: 30,000 = 83,190 (PVIF i,9) .3606 = PVIF i, 9 From Table II, i = 12% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Rate of return 67. What is the most you should pay to receive the following cash flows if your required rate of return is 12 percent?

Year 1 Year 2 Year 3 Year 4-10 a. b. c. d.

$5,000 $8,000 $12,000 $15,000

$58,580 $104,135 $68,105 $40,000

ANS: C Solution: PV =$ 5,000(0.893) + $8,000(0.797) + $12,000(0.712) + $15,000(5.650 - 2.402) = $68,105

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of unequal cash flows 68. Seebee makes quarterly (end of period) payments of $30,000 into a pension fund earning 12 percent per year compounded quarterly for 10 years. How much interest will they have earned in 10 years? a. $2,262,030 b. $2,105,880 c. $905,880 d. $1,062,030 ANS: D Solution: FVAN40 = $30,000 (75.401) = $2,262,030 Fund balance after 10 years of $2,262,030 less Payments of $1,200,000 results in Interest = $1,062,030 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 69. John borrowed $20,000 to finance his college education. If the finance charge on the loan is 6 percent, and he will pay off the loan in 10 equal, annual, end of year payments, how much total interest will he pay? a. $7,173.90 b. $2,717.39 c. $12,000.00 d. $25,924.23 ANS: A Solution: PMT = $20,000/7.360 = $2,717.39; Total payments = $27,173.90 I = $27,173.90 - $20,000 = $7,173.90 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity 70. Your brother, who is 6 years old, just received a trust fund that will be worth $25,000 when he is 21 years old. If the fund earns 10 percent interest compounded annually, what is the value of the fund today? a. $104,602 b. $6,575 c. $5,975 d. $6,875 ANS: C Solution: PV = $25,000(0.239) = $5,975 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 71. California Life has just offered you a single premium annuity for $5,000 that will pay $5,144.12 per year for 20 years, the first payment being received exactly 31 years from today. What is the implied rate of return on this annuity? a. 7% b. 8% c. 9%

d. 6.5% ANS: B Solution: Trial and error, Try 8% PVAN = $5,144.12(PVIFAi,20) = $5,144.12(9.818) = $50,505 PVAN (PVIFi,30) = $50,505 (0.099) = $5,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of a deferred annuity 72. Jackie plans to open her own book store in 10 years. To raise the "seed" money she has committed $10,000 she now has in a mutual fund. In addition, she plans to save $2,000 per year (end of year) for the next 5 years and $3,000 per year (end of year) for the following 5 years. How much "seed" money will Jackie have in 10 years if the investments earn 10 percent per year compounded annually? a. $76,129 b. $63,925 c. $44,255 d. $159,370 ANS: B Solution: FV = $10,000(2.594) + $2,000(6.105)(1.611) + $3,000(6.105) = $63,925 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of single amounts and annuities 73. You just purchased a new $25,000 car and agreed to pay for the car in 50 monthly payments. If the monthly interest rate is 1 percent, what is your total financing cost? a. $637.82 b. $12,500 c. $574.25 d. $6,891 ANS: D Solution: PMT = $25,000/39.196 = $637.82 I = $637.82(50) - $25,000 = $6,891 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Interest on a monthly loan 74. A zero coupon bond with a $1,000 par value is selling for $356 and matures in 12 years. What is the implied discount rate (yield to maturity)? a. 9% b. 9.36% c. 9.12% d. 9.4% ANS: A Solution: PVIF = $356/$1000 = 0.356; or 9% from Table II PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value

75. Roy, who has just turned 40, would like to have an annual annuity of $20,000 paid over a 20 year period, the first payment occurring on his 66th birthday. How much must Roy save each year (end of year) for the next 25 years to have this annuity, if the investment will earn 12 percent compounded annually? a. $16,000 b. $19,046 c. $1,120 d. $944.10 ANS: C Solution: PVAN = $20,000 (7.469) = $149,380 PMT = $149,380 / 133.334 = $1,120 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity and future value of an annuity 76. Your local bank offers 4-year certificates of deposit (CD) at a 12 percent annual nominal interest rate compounded quarterly. Determine how much additional interest you will earn over 4 years on a $10,000 CD that is compounded quarterly compared with one that is compounded annually. a. $6,050 b. $0 c. $310 d. $220 ANS: C Solution: PVo = $10,000; inom = 0.12 Quarterly compounding (m = 4) FV4 = $10,000 (1 + 0.12/4)4x4 = $10,000 (FVIF0.03,16 ) = $10,000 (1.605) = $16,050 Annual compounding (m = 1) FV4 = $10,000 (1 + 0.12)1x4 = $10,000 (FVIF0.12,4 ) = $10,000 (1.574) = $15,740 Difference = $16,050 - $15,740 = $310 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Differential compounding periods 77. How much will you have at the end of 5 years in a European vacation account if you deposit $200 a month in an account that is paying a nominal 12 percent per year, compounded monthly? a. $16,334 b. $15,247 c. $16,497 d. $15,817 ANS: A Solution: FVAN =$200(81.670) = $16,334 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity

78. You wish to save $500,000 in the next 25 years. You notice that a corporate bond fund earns about 11 percent per year and that is where you put your savings. How much must you save each year to obtain your goal? a. $20,000.00 b. $ 3,749.98 c. $ 4,370.13 d. $ 2,000.00 ANS: C Solution: 500,000 = PMT(114.413) PMT = $4,370.13 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 79. You plan to lease a Saab automobile that sells for $22,657 and has no salvage value. If the monthly lease is $499, with the first of 60 payments due immediately. What is the implied annual interest rate on your lease? a. 10% b. 11.5% c. 12% d. 13.5% ANS: C Solution: PVAND = 499(44.955)(1.01) = $22,656.87 The above solution came by either using a trial and error method (using 1%/month or 12%/yr) or a financial calculator to obtain 12% per year.

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of an annuity due 80. What is the present value of the following net cash flows if the discount rate is 12%: Year 1-5 6-10 11-15 a. b. c. d.

Cash Flow $10,000 each year $15,000 each year $17,000 each year

$151,400 $ 86,462 $144,037 $ 79,252

ANS: B Solution: PV = $10,000(3.605) + $15,000(5.65 - 3.605) + $17,000(6.811 - 5.65) = $86,462 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of deferred annuities 81. If the discount rate is 12%, what is the present value of the following cash flows:

Year 1 2 3 4 5 6-15 a. b. c. d.

Cash Flow $10,000 $11,000 $12,000 $13,000 $14,000 $15,000 each year

$144,618 $127,923 $127,197 $ 90, 537

ANS: D Solution: PV = $10,000(0.893) + $11,000(0.797) + $12,000(0.712) + $13,000(0.636) + $14,000(0.567) + $15,000(6.811 - 3.605) = $90,537 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: PV of even cash flows plus a deferred annuity 82. You wish to have $10,000 per year as a retirement supplement for 20 years (from age 65-85). You are now 40 years old. How much must you save each year for the next 25 years if you assume your savings will earn 12% annually? a. $ 560.17 b. $1,499.99 c. $5,403.87 d. none of the above ANS: A Solution: PVAN = 10,000(7.469) = 74,690 FVAN = PMT(133.334) PMT = 74,690/133.334 = $560.17 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value and future value of an annuity 83. What is the present value of the following net cash flows if the discount rate is 10%?

Year 1-10 11-15 16-20 a. b. c. d.

Net Cash Flow $20,000 each year $15,000 each year $10,000 each year

$217,675 $153,895 $322,130 $167,515

ANS: B Solution: PV = $20,000(6.145) + $15,000(7.606 - 6.145) + $10,000(8.514 - 7.606) = $122,900 + $21,915 + $9,080 = $153,895

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of deferred annuities 84. The Summer Breeze Hotel borrowed $100,000 from the Meadowlands Bank to pay for a new air conditioning system. The loan is for a period of 5 years at an interest rate of 10% and requires 5 equal end-of-year payments that include both principal and interest on the outstanding balance. What will be the outstanding balance after the third payment? a. $60,000 b. $20,865 c. $45,788 d. $50,866 ANS: C Solution: PMT = $100,000/3.791 = $26,378.26 Balance = $100,000 - $16,378 - $18,016 - $19,818 = $45,788 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Capital recovery problem 85. Keith Stone has a 10-year old daughter, Kate, who will be entering college in 8 years. Keith estimates college costs to be $16,000, $17,000, $18,000 and $19,000 payable at the beginning of each of Kate's four years in college. How much must Keith save each year (assume end of year payments) for each of the next 8 years to have enough savings to pay for Kate's education? Assume Keith can earn 9% on his savings. a. $5,569 b. $7,720 c. $5,108 d. $7,677 ANS: A Solution: Year 1 2 3 4

Present Value $16,000(1.000) = $16,000 17,000(0.917) = 15,589 18,000(0.842) = 15,156 19,000(0.772) = 14,668 $61,413

PMT = $61,413/11.028 = $5,569 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Combination problem 86. 1st Bank offers you a car loan at an annual interest rate of 10% compounded monthly. What effective annual interest rate is the bank charging you? a. 10.38% b. 10.42% c. 10.45% d. 10.47% ANS: D Solution:

ieff = (1 + 0.10/12)12 - 1 = .1047 or 10.47% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 87. Your monthly statement from your bank credit card shows that the monthly rate of interest is 1.5%.

What is the annual effective rate of interest you are being charged on your credit card? a. 18.00% b. 18.64% c. 19.56% d. 29.74% ANS: C Solution: ieff = (1 + 0.18/12)12 - 1 = .1956 or 19.56% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 88. What monthly rate of interest will yield an annual effective rate of interest of 14%? a. 1.17% b. 1.10% c. 1.08% d. 1.14% ANS: B Solution: im = (1.14)1/12 - 1 = .01098 or 1.1% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 89. What is the present value of $1,000 received 2 years from today if the nominal interest rate is 9% and compounded monthly? a. $842 b. $914 c. $833 d. $836 ANS: D Solution: PV = $1,000/(1 + .09/12)12x2 = $836 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effect of compounding periods 90. Cosmos Touring wishes to replace its luxury bus in 10 years by accumulating funds in a special account. The new bus is expected to cost $180,000. How much must Cosmos put into the fund in equal, end-of-year amounts if earnings are expected to be 8% for the first 4 years and 10% thereafter? a. $12,107 b. $11,465 c. $9,901 d. $14,727 ANS: B

Solution: $180,000 = PMT(4.506)(1.772) + PMT(7.716) $180,000 = PMT(15.7006) PMT = $11,465 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 91. Al Corbin is 25 years old today and he wishes to accumulate enough money over the next 35 years to provide for a 20 year retirement annuity of $100,000 at the beginning of each year, starting with his 60th birthday. He can save $2,000 at the end of each of the next 10 years and $3,000 each year for the following 10 years. How much must he save each year at the end of years 21 through 35 to obtain his goal? Assume that the average rate of return over the entire period will be 10%. a. $9,642 b. $26,969 c. $12,321 d. $24,289 ANS: C Solution: PVAN = $100,000(8.514)(1.10) = $936,540 $936,540 = $2,000 (15.937)(10.835) + $3,000 (15.937)(4.177) + PMT (31.772) $936,540 = $345,355 + $199,707 + 31.772PMT PMT = $12,321 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Combines present value of annuity/future value of annuity 92. If a 16 year old high school student put $2,000 at the end of each year for 4 years into an IRA that earned a rate of 9%, how much would she have accumulated by age 65? Assume funds are left to accumulate for 45 years (age 20 - 65) at 9%. a. $442,014 b. $386,616 c. $1,767,995 d. $9,146 ANS: A Solution using a calculator: PART I N=4 I=9 PMT = -$2,000 Solve for FV = $9,146.26 PART II N = 45 I=9 PV = -$9,146.26 Solve for FV = $442,014 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand time value of money

NAT: Analytic skills

TOP: Future value of an annuity (solution requires a calculator) 93. If your parents put $2,000 a year into an IRA account for you in each of your last 4 teenage years (age 16,17,18, and 19), how much would the IRA account have in it at your retirement 45 years later if the account earned 12% each year? (Assume end-of-year payments.) a. $1,569,758 b. $ 68,613 c. $3,457,169 d. $1,148,958 ANS: A Solution: FV = 2000 (4.779)(93.051)(1.765) = $1,569,758 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value of an annuity 94. What is the value in 10 years of $10,000 deposited in an account earning 8% compounded monthly? a. $33,004 b. $22,285 c. $102,530 d. $21,589 ANS: B Solution: FV = 10,000 (1 + .08/12 )12x10 = $22,285 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value | monthly compounding 95. Assume you purchased a home and borrowed $100,000 at a rate of 8% compounded monthly over 30 years. What is your monthly payment? a. $917.77 b. $733.76 c. $666.67 d. $878.14 ANS: B Solution using a calculator: PV = -$100,000 I = 8 ÷ 12 N = 30 X 12 Solve for PMT $733.76 by calculator PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Monthly payment 96. Inco purchased a computer for $200,000 and this machine is expected to generate annual cash flows of $48,271 over the next 5 years. What is the expected rate of return on this investment? a. 8.84% b. 26.58% c. 6.61% d. none of the above

ANS: C Solution using a calculator: N=5 PV = -$200,000 PMT = $48,271 Solve for I = 6.61% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Rate of return 97. When you purchased a car, you borrowed $20,000 from the bank and agreed to make monthly payments of $423.17 for 5 years. What rate of interest is the bank charging you? a. 9.82% b. 5.00% c. 25.39% d. 10.00% ANS: A Solution using a calculator: N = 5 X 12 PV = -$20,000 PMT = $423.17 Solve for I = .818 X [12 (convert to annual)] = 9.82% 9.82% by calculator PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Rate of return 98. When you purchased a car, you borrowed $20,000 from the bank at 9.20% and agreed to make monthly payments for 3 years. What is your monthly payment? a. $153.33 b. $637.86 c. $584.12 d. $559.78 ANS: B Solution using a calculator: N = 3 X 12 I = 9.20 ÷ 12 PV = -$20,000 Solve for PMT = $637.86 $637.86 by calculator PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Monthly payment 99. What is the present value of the following mixed cash flow stream if interest is 6% (rounded)?

YEAR CASH FLOW 1 $5,000 2 $8,000 3 $9,500 a. $25,370 b. $19,813

c. $21,225 d. $18,750 ANS: B Solution using a calculator: CF0 = 0 CF1 = 5,000 CF2 = 8,000 CF3 = 9,500 I=6 Solve for NPV = $19,813 by calculator.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value of unequal cash flows 100. Which of the following statements is/are correct?

I. At 6% interest, the present value of: $400 for the first year, $600 for the second year, and $800 for the third year is $1,603.00.

II. The future value of a mixed cash flow stream (if it is from an annuity due): $400 for the first year, $600 for the second year, and $800 for the third year is $1,999 (rounded). a. I only b. II only c. Both I and II d. Neither I nor II ANS: B Solution using a calculator: CF0 = 0 CF1 = 400 CF2 = 600 CF3 = 800 I=6 Solve for NPV = $1,583.05 by calculator Calculator should be in END mode N= 4 I=6 PV = -1,583.05 Solve for FV = $1,998.57 by calculator PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Combination problem 101. Approximately how long would it take to double my money if I invest it now at 18%? a. 6 years b. 4 years c. 12 years d. It cannot be determined ANS: B PTS: 1 NAT: Reflective thinking TOP: Rule of 72

OBJ: TYPE: E. Prob.

LOC: Understand time value of money

102. Based on the Rule of 72, what interest rate do you need to earn to double your money in 6 years? a. 8% b. 12%

c. 7% d. 6% ANS: B PTS: 1 NAT: Reflective thinking TOP: Rule of 72

OBJ: TYPE: E. Prob.

LOC: Understand time value of money

103. Jenny Genius wants to purchase a new car. She knows that she can afford to pay $250 per month and that her bank will charge her 8% interest on the car loan. She intends to pay off the car in five years.

Of the following, which is the most expensive vehicle in her price range that she could consider? a. A Taurus selling for $11,900 b. A Malibu selling for $12,320 c. A Civic selling for $14,670 d. A Celica selling for $17,500 ANS: B Solution using a calculator: N = 5 X 12 I = 8 ÷ 12 PMT = $250 Solve for PV The most she could pay for a car is $12,329.61.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Present value 104. Bill Swill decides to try his luck at Powerball where the projected winnings are $12,000,000. If he wins, he can choose the annuity option (to be paid over 20 years) or a lump sum settlement that he can invest at 8% interest. How much must the lump sum option be to make the lump sum option equal to the annuity option (rounded)? a. $2,574,578 b. $1,743,620 c. $1,130,668 d. $1,200,000 ANS: A Solution using a calculator: N = 20 I=8 FV = $12,000,000 Solve for PV $2,574,578.49 by calculator.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Reflective thinking LOC: Understand time value of money TOP: Present value of an annuity ESSAY 1. What is/are the difference(s) between simple interest and compound interest?

ANS: Simple interest is earned or paid on principal only.

Compound interest is earned or paid on both principal and interest that has not been previously withdrawn. Compounding provides a greater return and would result in a higher effective interest rate.

PTS: 1 OBJ: TYPE: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Simple interest vs. compound interest

2. What is the difference between the nominal interest rate and the effective interest rate?

ANS: The effective interest rate is the actual rate of interest earned by the lender and is generally the most economically relevant definition of interest rates. The effective interest rate is affected by the frequency of compounding.

The nominal interest rate is the stated annual interest rate at the time of the loan.

PTS: 1 OBJ: TYPE: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Interest

3. Why does an annuity due have a greater future value than a regular annuity - all things being equal?

ANS: An ordinary annuity assumes that payments are made at the end of each period. An annuity due assumes that payments are made at the beginning of each period. In essence, the annuity due earns one extra period of interest as opposed to the regular annuity when using the same time period.

PTS: 1 OBJ: Type: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Future Value of an Annuity Due

4. Explain the concept of interest and compare it to rate of interest.

ANS: Interest is the return earned by or the amount paid to someone who has forgone current consumption or alternative investment opportunities and “rented” money in a creditor relationship. The rate of interest is the percentage on the principal that the borrower pays the lender per time period as compensation for forgoing other investment or consumption opportunities.

PTS: 1 OBJ: Type: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Interest

5. Compare the difference between compound interest and simple interest.

ANS: Simple interest is the money paid on borrowed money or earned on invested money based solely on the principal. Simple interest is equal to the product of the principal times the rate per time period times the number of time periods.

Compound interest is interest that is paid not only on the principal but also on any interest earned but not withdrawn during earlier periods. Compound interest provides a higher return on an investment because of this principal.

PTS: 1 OBJ: Type: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Compound Interest and Future Value

6. Explain a perpetuity and list some investment vehicles that can be perpetuities.

ANS: A perpetuity is a financial instrument that promises to pay an equal cash flow per period forever. It will provide an infinite series of payments. Some bonds and some preferred stocks take the form of a perpetuity because they never mature - there is no redemption of these investments at their face value anytime in the future.

PTS: 1 OBJ: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Perpetuities

7. What is the net present value rule?

ANS: The net present value of an investment is equal to the present value of the expected future cash flows generated by the investment minus the initial outlay. The future cash flows are discounted back to the present at a required rate of return that reflects the perceived risk of the investment. The net present value of an investment made by a firm represents the contribution of that investment to the value of the firm, and, as such, to the wealth of the shareholders.

PTS: 1 OBJ: Type: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Net Present Value Rule

Chapter 6—ANALYSIS OF RISK AND RETURN MULTIPLE CHOICE 1. The _______ is a statistical measure of the mean or average value of the possible outcomes. a. probability distribution b. standard deviation c. expected value d. coefficient of variation ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Expected values

2. The _______ the standard deviation, the _______ the investment. a. smaller, larger the expected return on b. larger, riskier c. smaller, riskier d. larger, smaller the expected return on ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Standard deviation: An absolute measure of risk

3. The _______ is an absolute measure of risk, and the _______ is a relative measure of risk. a. systematic risk, unsystematic risk b. standard deviation, coefficient of variation c. correlation, covariance d. security market line, characteristic line ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coefficient of variation: A relative measure of risk

4. When comparing two equal-sized investments, the _______ is an appropriate measure of total risk.

a. b. c. d.

standard deviation coefficient of variation correlation covariance

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Standard deviation: An absolute measure of risk

5. The slope of the characteristic line for a specific security is an estimate of _______ for that security. a. beta b. systematic risk c. total risk d. both beta and systematic risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Beta: A measure of systematic risk

6. The _______ is the ratio of _______ to the _______. a. standard deviation, covariance, expected value b. covariance, expected value, standard deviation c. coefficient of variation, standard deviation, expected value d. coefficient of variation, systematic risk, expected value ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coefficient of variation: A relative measure of risk

7. The coefficient of variation is a(n) _______ measure of risk. a. relative b. absolute c. systematic d. unsystematic ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coefficient of variation: A relative measure of risk

8. Values of the _______ can range from +1.0 to -1.0. a. coefficient of variation b. correlation coefficient c. standard deviation d. covariance ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Investment diversification and portfolio risk analysis

NAT: Reflective thinking

9. The _______ of a portfolio of two or more securities is equal to the weighted average of the _______ of each of the individual securities in the portfolio. a. standard deviation, standard deviation b. risk, risk c. expected return, expected return d. standard deviation, risk ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Expected returns from a portfolio

10. The primary difference between the standard deviation and the coefficient of variation as measures of risk is: a. the coefficient of variation is easier to compute. b. the standard deviation is a measure of relative risk whereas the coefficient of variation is a measure of absolute risk. c. the coefficient of variation is a measure of relative risk whereas the standard deviation is a measure of absolute risk. d. the standard deviation is rarely used in practice whereas the coefficient of variation is widely used.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coefficient of variation: A relative measure of risk

11. Security A's expected return is 10 percent while the expected return of B is 14 percent. The standard deviation of A's returns is 5 percent, and it is 9 percent for B. An investor plans to invest equal amounts in A and B. Which of the following statements is true about this portfolio consisting of stock A and stock B. a. The risk of the portfolio is equal to 7 percent. b. The lower the correlation of returns between the two stocks, the higher the portfolio's risk. c. The risk of the portfolio is primarily dependent on the utility function of the investor. d. The higher the correlation of returns between the two stocks, the higher the portfolio's risk.

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking, Analytic skills LOC: Understand risk and return TOP: Portfolio risk 12. Which of the following is not an example of a source of systematic risk? a. interest rate changes b. foreign competition with an industry's products c. changes in the overall economic outlook d. changes in the inflation rate ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Systematic and unsystematic risk

13. The security market line a. is defined as the slope of a line relating an individual security's return to the returns of other securities in that firm's primary industry. b. provides a picture of the risk-return tradeoff required by diversified investors considering various risky assets. c. has as its slope the beta of the security d. is determined by the prevailing level of risk-free interest rates minus a risk premium ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Security market line and beta

14. All other things being equal, what is the major impact that an increase in the expected inflation rate would be expected to have on the security market line? a. reduce its slope b. shift it down and to the right c. shift it up and to the left d. reduce required returns for investors in any individual asset ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Inflation and the security market line

15. Beta is defined as: a. a measure of volatility of a security's returns relative to the returns of a broad-based market portfolio of securities. b. the ratio of the variance of market returns to the covariance of returns on a security with the market c. the inverse of the slope of the security regression line d. all of the above ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Beta: A measure of systematic risk

16. A beta value of 0.5 for a security indicates a. the security has average systematic risk b. the security has above-average systematic risk c. the security has no unsystematic risk d. the security has below-average systematic risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Beta: A measure of systematic risk

17. The security market line can be thought of as expressing relationships between required rates of return and a. the time value of money b. beta c. total risk d. portfolio diversification ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Security market line and beta

18. Users of the CAPM should be aware of some of the problems in its practical application. These problems include which of the following? a. estimating expected future market returns b. determining the most appropriate measure of the risk- free rate c. determining an asset's future beta d. all of the above are problems in application of the CAPM ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Assumptions and limitations of the CAPM

19. Recalling the meaning and calculation of beta, a security that is completely uncorrelated (j,m = 0) with the market portfolio would have a beta of a. -1 b. 0 c. +1 d. -100 ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Beta: A measure of systematic risk

20. All of the following are primary sources of systematic risk except a. changes in the amount of foreign competition facing an industry b. changes in investor expectations about the economy c. interest rate changes

d. changes in purchasing power ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Systematic and unsystematic risk

21. The _______ correlated the returns from two securities are, the _______ will be the portfolio effects of risk reduction. a. more positively, greater b. greater, greater c. less positively, greater d. lower, lower ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Portfolio risk

22. All of the following factors have their primary impact on unsystematic risk except a. availability of raw materials b. effects of foreign competition c. changes in inflation d. strikes ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Systematic and unsystematic risk

23. The risk remaining after extensive diversification is primarily: a. unsystematic risk b. systematic risk c. coefficient of variation risk d. standard deviation risk ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Systematic and unsystematic risk

24. The most relevant risk that must be considered for any widely traded individual security is its _______. a. unsystematic risk b. standard deviation c. covariance risk d. systematic risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Systematic and unsystematic risk

25. Texas Computers (TC) stock has a beta of 1.5 and American Water (AW) stock has a beta of 0.5.

Which of the following statements will be true about these securities? a. The addition of TC would reduce portfolio risk more than the addition of AW. b. The addition of AW would reduce total portfolio risk more than the addition of TC. c. The required return for TC is greater than the required return for AW. d. The required return for AW is greater than the required return of TC. ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Security market line and beta

26. The risk premium for an individual security is equal to the a. beta times the market return b. difference between the required return and the risk free rate

c. weighted average of the individual security betas in a portfolio d. the security's covariance divided by the variance of the market ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Security market line and beta

27. The risk-free rate of return can be thought of as consisting of the following two components: a. a real rate of return, a default premium b. unanticipated inflation, bond default premium c. a real rate of return, an inflation premium d. a zero beta component, an expectation premium ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Inflation and the security market line

28. What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors become more risk averse ? a. shift up and have a steeper slope b. shift down and have the same slope c. shift down and have a steeper slope d. shift up but have less slope ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Risk aversion and the security market line

29. Arbitrage pricing theory is a model that relates expected returns on securities to a. security risk and yield spreads b. yield spreads and yield curve slope c. anticipated economic factors d. multiple risk factors ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arbitrage pricing theory

30. Which of the following is not an approach for managing risk: a. hedging b. gaining control over the operating environment c. limited use of firm-specific assets d. ignoring systematic risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other approaches for managing risk

31. Which of the following (if any) is a relative (rather than absolute) measure of risk? a. standard deviation b. standard normal probability distribution c. expected value d. coefficient of variation ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Meaning and measurement of risk

32. In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be __________. a. less than +1.0 b. equal to 0.0

c. less than 0.0 d. equal to -1.0 ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Portfolio risk

33. A portfolio is efficient if __________ . a. for a given standard deviation, there is no other portfolio with a higher expected return b. for a given expected return, there is no other portfolio with a lower standard deviation c. its standard deviation is equal to -1.0 d. for a given standard deviation, there is no other portfolio with a higher expected return and if, for a given expected return, there is no other portfolio with a lower standard deviation ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Efficient portfolios and the capital market line

34. In general, when the correlation coefficient between the returns on two securities is __________, the risk of a portfolio is __________ the weighted average of the total risk of the two individual securities. a. equal to +1.0; equal to b. less than +1.0; less than c. a and b d. none of the above ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Portfolio risk

35. An increase in the expected future inflation rate has the effect of __________. a. increasing the slope of the security market line b. shifting the security market line upward by the amount of the expected increase in inflation c. increasing systematic risk d. none of the above ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Inflation and the SML

36. An increase in uncertainty regarding the future economic outlook has the effect of __________. a. increasing the slope of the security market line b. shifting the security market line upward c. reducing risk d. none of the above ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Inflation and the SML

37. In the __________, the expected return on a security is equal to the risk-free rate plus a single risk premium that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate times the sensitivity of the security's returns to the market return. a. Arbitrage Pricing Theory b. Capital Asset Pricing Model c. Dividend Valuation Model d. Risk premium on debt model ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Security market line and beta

38. The _____ is a relative measure of variability because it measures the risk per unit of expected return. a. coefficient of variation b. correlation coefficient c. covariance d. standard deviation ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coefficient of variation

39. The security returns from multinational companies tend to have ________ systematic risk than domestic companies. a. more b. less options with c. less d. more hedging of ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Int'l issues: Diversification/multinational corporations

NAT: Reflective thinking

40. Investors generally are considered to be risk _____ because they expect to be compensated for assuming risk. a. adverse b. seekers c. averse d. takers ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Relationship between risk and return

41. Investors can obtain high returns in their investments if: a. they use hedging techniques b. they assume high risks c. they invest only international securities d. they invest in legal Ponzi type securities ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Ethical issues: High risk securities

42. The term structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all respects except for differences in a. tax status b. liquidity c. risk of default d. maturity ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The maturity risk premium

43. The term structure of interest rates is the pattern of interest rate yields for securities that differ only in a. default risk b. liquidity premiums c. the yield to maturity d. the length of time to maturity ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand risk and return

TOP: The maturity risk premium

44. The maturity premium reflects a preference by many lenders for a. shorter maturities b. reducing yields c. high yield securities d. longer maturities ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The maturity risk premium

45. The default risk premium reflects the fact that a. the premium remains constant over time b. there is a positive relationship between risk and maturity c. there is a positive relationship between default risk and required returns d. the premium varies depending on the time to maturity ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The default risk premium

46. The business risk of a firm refers to the a. results from using fixed-cost sources of funds b. variability in the price of a firm's securities c. variability in the firm's operating earnings over time d. influence of government regulations on business earnings ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Business and financial risk premiums

47. The following yields on 20 year bonds prevailed in January for the three securities shown: Aa-rated corporate bond Baa-rated corporate bond B-rated corporate bond

9.98% 10.34% 11.12%

The difference in yields is due primarily to a. maturity risk premium b. default risk premium c. seniority risk premium d. financial risk premium ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The default risk premium

48. The ability of an investor to buy and sell a company's securities quickly and without a significant loss of value is known as the a. financial risk b. marketability risk c. business risk d. security risk ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The marketability risk premium

49. According to the _____, long-term interest rates are a function of expected short-term interest rates.

a. b. c. d.

Maturity theory Expectations theory Market segmentation theory Preferred habitat theory

ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Maturity risk premium

50. The term structure of interest rates is related to the __________. a. default risk premium b. seniority risk premium c. marketability risk premium d. maturity risk premium ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The maturity risk premium

51. __________ refers to the ability of an investor to buy and sell a company's securities quickly and without a significant loss of value. a. Default risk b. Business and financial risk c. Maturity risk d. Marketability risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The marketability risk premium

52. The risk-free rate of return is composed of which of the following elements: a. risk premium and inflation b. cost of capital and risk premium c. real rate of return and risk premium d. real rate of return and inflation ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The risk-free rate of return

53. The two elements that make up the risk-free rate of return are a. the supply of funds and the demand for funds b. the yield on 90-day Treasury bills plus an inflation premium c. the real rate of return plus an inflation premium d. the required return plus a risk premium ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: The risk-free rate of return

54. The _____ theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. a. expectations b. market segmentation c. preferred habitat d. liquidity premium ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Maturity risk premium

55. Business risk is influenced by all the following factors except:

a. b. c. d.

variability in interest expenses variability in sales diversity of its product line choice of production technology

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Business and financial risk

56. _____ can be achieved by investing in a set of securities that have different risk-return characteristics. a. Indexing b. Capital Asset pricing c. Diversification d. Asset allocation ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Portfolio risk

57. On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is obtained by _____. a. lending money b. borrowing money c. reducing risk d. investing in index funds ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Efficient portfolios and the CML

58. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: Price

Rate of Return

Probability

$16 20 24 28

-20% 0% +20% +40%

0.25 0.30 0.25 0.20

Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the expected rate of return on Phoenix Stock. a. 8% b. 0% c. 10% d. 40% ANS: A Solution: E(R) = -20%(0.25) + 0%(0.30) + 20%(0.25) + 40%(0.20) = 8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Expected returns 59. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now:

Price

Rate of Return

Probability

$16 20 24 28

-20% 0% +20% +40%

0.25 0.30 0.25 0.20

Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the standard deviation of possible rates of return on Phoenix stock (to the nearest tenth of a percent). a. 456% b. 20.9% c. 2.2% d. 21.4% ANS: D Solution: Expected return = 8% (See problem 55 solution.) = [(-20% - 8%)2(0.25) + (0% - 8%)2(0.30) + (20% - 8%)2(0.25) + (40% -8%)2(0.20)].5 = 21.4% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Standard deviation 60. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Barney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: Price

Rate of Return

Probability

$16 20 24 28

-20% 0% +20% +40%

0.25 0.30 0.25 0.20

Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the coefficient of variation for the rate of return on Phoenix stock. a. 0.0 b. 2.68 c. 2.61 d. 0.275 ANS: B Solution: Expected return = 8%; Standard deviation = 21.4% v = 21.4% / 8% = 2.68 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Coefficient of variation 61. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning more than 21% on FTC common stock. a. 1.00 b. 0.8413 c. 0.0013 d. 0.1587

(Note: Table V is required to work this problem.)

ANS: D Solution: z = (21% - 14%) / 7% = 1; From Table V, p = 15.87% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Reflective thinking LOC: Understand risk and return TOP: Normal probability distribution 62. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning a negative rate of return (i.e. less than 0%) on FTC common stock. a. 0.0228 b. 2.00 c. 0.5000 d. 0.9772 (Note: Table V is required to work this problem.)

ANS: A Solution: z = (0% - 14%) / 7% = -2.0; From Table V, p = 2.28% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Normal probability distribution 63. Elephant Company common stock has a beta of 1.2. The risk-free rate is 6 percent and the expected market rate of return is 12 percent. Determine the required rate of return on the security. a. 7.2% b. 14.4% c. 19.2% d. 13.2% ANS: D Solution: kj = 6% + 1.2(12% - 6%) = 13.2% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic thinking LOC: Understand risk and return TOP: Security market line 64. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25 percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12 percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the expected return on the investor's portfolio. a. 14% b. 12% c. 13% d. 9% ANS: C Solution: E(Rp) =0 .75(12%) + 0.25(16%) = 13%

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio expected returns 65. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25 percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on Epsilon is 16 percent. The standard deviation of returns on Gamma is 8 percent and on Epsilon is 12 percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the standard deviation of returns for this investor's portfolio. a. 73.8% b. 6.71% c. 3.00% d. 8.59% ANS: D Solution: p=[(0.75)2(8%)2 +(0.25)2(12%)2 +2(0.75)(0.25)(0.8)(8%)(12%)].5 = 8.59% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio risk 66. Compute the risk premium for the stock of Omega Tools if the risk-free rate is 6%, the expected market return is 12%, and Omega's stock has a beta of .8. a. 10.8% b. 4.8% c. 48.0% d. 16.8% ANS: B Solution: Risk premium = 0.8(12% - 6%) = 4.8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Risk premium calculation 67. The return expected from a risky investment is 24 percent, and the standard deviation of this return is 17 percent. If returns from this investment are normally distributed, what is the probability that the investment may earn a negative rate of return? (Note: Table V is required to work this problem.) a. 8.33% b. 7.93% c. 6.88% d. 5.44% ANS: B Solution: z = (0% - 24%) / 17% = - 1.41; From Table V, p = 7.93% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Normal probability distribution 68. The expected rate of return for 3COM is 18 percent, with a standard deviation of 10.98 percent. The expected rate of return for Just the Fax is 26 percent with a standard deviation of 15.86%. Which firm would be considered the riskier from a total risk perspective? a. 3COM b. Just the Fax

c. Neither, both have the same risk d. Cannot be determined ANS: C Solution: 3COM : v = 10.98% /18% = 0.61 Just the Fax: v = 15.86% / 26% = 0.61 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Coefficient of variation 69. Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is Don's expected return on his portfolio? a. 12.42% b. 12.20% c. 11.81% d. Cannot be determined ANS: A Solution: E(Rp) = (3/19)11.6% + (10/19)12.8% + (6/19)12.2% = 12.42% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Expected returns from a portfolio 70. Sally's broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the expected return of the remaining portion of her portfolio? a. 20.9% b. 18.8% c. 12.5% d. cannot be determined ANS: B Solution: 14.2% - 0.4(10.3%) - 0.2(12.8%) = 0.4 X X = 18.8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Expected returns from a portfolio 71. Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and replacing it with another security with a lower beta. What must be the beta of the replacement security? a. 1.21 b. 0.91 c. 0.73 d. 1.62 ANS: C Solution: To find the beta for the 7 securities: 1.28 = 7/8(x) + 1/8(1.75)

x = 1.21 New security's beta would be: 1.15 = 7/8 (1.21) + 1/8 beta beta = 0.73 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta calculation 72. A college student owns two securities: Apple and Coca- Cola. Apple has an expected return of 15 percent with a standard deviation of those returns being 11 percent. Coca-Cola has an expected return of 12 percent, and a standard deviation of 7 percent. The correlation of returns between Apple and Coca-Cola is 0.81. If the portfolio consist of $6,000 in Coca-Cola and $4,000 in Apple, what is the expected standard deviation of portfolio returns? a. 8.18% b. 13.20% c. 8.60% d. 9.71% ANS: A Solution: p = [(.6)2(.07)2+(.4)2(.11)2+2(.6)(.4)(.07)(.11)(.81)].5 = 0.0818 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio risk calculation 73. Assume you want to construct a portfolio with a 14 percent return from the following two securities: Security

Expected Return

Beta

1 2

16% 12.5%

1.12 0.94

What percentage of your portfolio should be invested in Security 1? a. 57% b. 47% c. 43% d. 53% ANS: C Solution: 0.14 = X (0.16) + (1 - X)(0.125) X = 0.43 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio expected returns 74. Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury bills was 9.17 percent. Over the same time period, the average annual inflation rate was 6.39 percent.

Therefore, a. the inflation premium was 2.78 percentage points b. the real expected rate of return was 9.17 percentage points c. the realized real rate of return was 2.78 percentage points d. the required rate of return was 6.39 percentage points ANS: C

Solution: 9.17% - 6.39% = 2.78% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: The risk-free rate of return 75. The real rate of interest is expected to be 3 percent and the expected rate of inflation for next year is expected to be 5.5 percent. If the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4 percentage points, what is the required return on a 1 year U.S. Treasury security? a. 9.6% b. 10.0% c. 8.5% d. 8.9% ANS: C Solution: Required return = 3% + 5.5% = 8.5% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Required return calculation 76. If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is 4.16%, then the real rate of return is: a. 2.86% b. 7.02% c. 4.70% d. 6.48% ANS: A Solution: 7.02% - 4.16% = 2.86% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: The risk-free rate of return 77. The yield to maturity on ACL bonds maturing in 2005 is 8.75 percent. The yield to maturity on a similar maturity U.S. Government Treasury bond in 7.06 percent and the yield on Treasury bills is 6.51 percent. What is the default risk premium on the ACL bond? a. 2.24% b. 1.69% c. 0.55% d. 8.75% ANS: B Solution: Risk premium = 8.75% - 7.06% = 1.69% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Risk premium 78. The risk-free rate of return is 5.51 percent, based on an expected inflation premium of 2.54 percent.

The expected return on the market is 12.8 percent. What is the required rate of return for Envoy common stock which has a beta of 1.35? a. 6.98% b. 16.24%

c. 15.35% d. 12.80% ANS: C Solution: kj = 5.51 + 1.35(12.8-5.51) = 15.35% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Required return 79. Determine the beta of a portfolio consisting of equal investments in the following common stocks: Security Apple Computer Coca-Cola Harley-Davidson Homestake Mining a. b. c. d.

Beta 1.15 1.05 1.50 0.50

1.05 1.00 1.10 0.95

ANS: A Solution: Bp = .25(1.15) + .25(1.05) + .25(1.50) + .25(.50) = 1.05 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: portfolio beta 80. Twin City Knitting (TCK) pays a current dividend of $2.20 and dividends are expected to grow at a rate of 7 percent annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2 percent and the market risk premium is 6 percent, at what price would you expect TCK's common stock to sell? a. $14.35 b. $33.63 c. $23.40 d. $25.04 ANS: D Solution: ke = 0.092 + 1.2(0.06) = 0.164 or 16.4% ke = $2.20 (1.07)/P0 + 0.07 = 0.164 P0 = $2.354 /0.094 = $25.04 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Security market line and valuation 81. Micromatic is considering expanding into a new product area. Micromatic's current beta is 1.2 and its beta is expected to increase to 1.45 after the expansion. The long-term growth rate of the firm's earnings is expected to increase from 6.5 percent to 10 percent. Micromatic's current dividend is $1.70 per share, the current risk-free rate is 9.1 percent, and the expected market return is 12.9 percent.

Should Micromatic undertake the planned expansion? a. No, stock price decreases $10.15 b. Yes, stock price increases $15.27

c. Yes, stock price increases $0.45 d. No, stock price decreases $15.27 ANS: B Solution: Current ke = 0.091 + 1.2 (0.129 - 0.091) = 0.1366 or 13.66% Current P = $1.70(1.065) / (0.1366 - 0.065) = $25.29 New ke = 0.091 + 1.45(0.129 - 0.091) = 0.1461 New P = $1.70 (1.10) / (0.1461 - 0.10) = $40.56 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Security market line and valuation 82. Quick Start, Inc. is expected to pay a dividend of $1.05 next year and dividends are expected to continue their 7 percent annual growth rate. The SML has been estimated as follows: kj = 0.08 + 0.064j If Quick Start has a beta of 1.1, what would happen to its stock price if inflation expectations went from the current 5 percent to 8 percent? a. decrease $8.14 b. decrease $3.55 c. decrease $3.18 d. stock price will not change ANS: B Solution: Current ke = 0.08 + 0.064(1.1) = 0.1504 Current P = $1.05/(0.1504 - 0.07) = $13.06 New ke = 0.11 + .064(1.1) = 0.1804 New P = $1.05/(0.1804 - 0.07) = $9.51 P = $3.55 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Security market line | valuation and inflation 83. Richtex Brick has a current dividend of $1.70 and the market value of its common stock is $28. The expected market return is 13 percent and the risk-free rate is 9 percent. If Richtex stock is half as volatile as the market, and the market is in equilibrium, what rate of growth is expected for Richtex's dividends assuming a constant growth valuation model is appropriate for Richtex? a. 4.93% b. 4.65% c. 5.37% d. 5.41% ANS: B Solution: ke = 0.09 + 0.5(0.13 - 0.09) = 0.11 $28 = $1.70(1+g) / (0.11 - g) g = 0.04646 or 4.65% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Systematic risk and valuation

84. AKA's stock is currently selling for $11.44. This year the firm had earnings per share of $2.80 and the current dividend is $0.68. Earnings are expected to grow 7% a year in the foreseeable future. The risk-free rate is 10 percent and the expected market return is 14.2 percent. What will be the effect on the price of AKAs' stock if systematic risk increases by 40 percent, all other factors remaining constant? a. an increase of $1.14 b. a decrease of $0.40 c. a decrease of $1.99 d. cannot determine from the given data ANS: C Solution: Old ke = 0.10 + j(0.142 - 0.10) = 0.10 + 0.042j P = $0.68(1.07)/(0.10 + 0.042j - 0.07) = $11.44 j = 0.80 New ke = 0.10 + 0.8(1.4)(0.042) =0 .147 P =$ 0.7276/(0.147 - 0.07) = $9.45 A decrease of $1.99 a share PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Systematic risk and valuation 85. Given the following information on securities E and F, calculate the expected return and standard deviation of returns on a portfolio consisting of 40% invested in E and 60% invested in F.

Expected Return Standard Deviation of Returns Correlation coefficient of returns a. b. c. d.

Security E 12% 10%

Security F 15% 20% -0.50

13.5%; 15% 13.8%; 14.4% 13.8%; 10.6% 13.5%; 8.7%

ANS: C Solution: Rp = we Re + wf Rf Rp = 0.40 (12%) + 0.60 (15%) = 13.8% p = [(.40)2 (10)2 + (.60)2 (20)2 + 2 (.40) (.60) (-0.50) (10) (20)].5 = 10.6% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio risk and return calculation 86. Gates Industries current common stock dividend (year 0) is $2.50 per share and is expected to continue growing at a rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the estimated market risk premium (i.e., km - rf) is 8.3%. Value Line has estimated Gates Industries beta to be 1.10. Determine the expected price for Gates Industries common stock. a. $21.50 b. $15.03 c. $15.78 d. $22.57

ANS: D Solution: ke = 7.5% + 1.10 (8.3%) = 16.63% P0 = $2.50(1.05)/(0.1663 - 0.05) = $22.57 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Systematic risk and valuation 87. An investor, who believes the economy is slowing down, wishes to reduce the risk of her portfolio.

She currently owns 12 securities, each with a market value of $3,000. The current beta of the portfolio is 1.21 and the beta of the riskiest security is 1.62. What will the portfolio beta be if the riskiest security is replaced with a security of equal market value but a beta of 0.80? a. 1.14 b. 1.18 c. 1.05 d. 1.10 ANS: A Solution: 1.21 = 11/12(x) + 1/12(1.62) so x = 1.17 portfolio beta = 11/12(1.17) + 1/12(.80) = 1.14 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta calculation 88. Assume that the rate of return on Calengry common stock over the coming year is normally distributed with an expected value of 16% and a standard deviation of 20%. What is the probability of earning a negative rate of return? (Note: Table V is required to work this problem.) a. 10.56% b. 40.13% c. 21.19% d. 3.59% ANS: C Solution: z = 0 - 16 = -0.8 p = 0.2119 or 21.19% 20 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Probability distributions 89. Determine the beta of a portfolio consisting of the following common stocks: Security Boeing Exxon Duke Power Blockbuster Video Coca-Cola a. b. c. d.

0.93 0.85 1.00 1.14

Market Value $5,000 $4,000 $2,500 $2,000 $7,500

Beta 1.2 0.8 0.6 1.4 1.0

ANS: C Solution: p = (5/21)1.2 + (4/21)0.8 + (2.5/21)0.6 + (2/21)1.4 + (7.5/21)1.0 p = 1.00 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta 90. HDTV has planned on diversifying into the dual-VCR field. As a result, HDTV's beta would rise to 1.6 from 1.2 and the expected future long-term growth rate in the firm's earnings would increase from 12% to 16%. The expected market return, km, is 14%; the risk free rate, rf, is 7%; and the current dividend, Do, is $0.50. Should HDTV go into the dual-VCR field? a. No-stock price decrease $7.82 b. Yes-stock price increase $9.89 c. Yes-stock price increase $3.81 d. No-stock price decrease $3.78 ANS: B Solution: kold = .07 +1.2(.14-.07) = .154 knew = .07 +1.6(.07) = .182 Po = .50(1.12)/(.154 - .12) = $16.47 Pn = .50(1.16)/(.182 - .16) = $26.36 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Constant growth rate model 91. Christy is considering investing in the common stock of One Liberty and Heico. The following data are available for these two securities:

Expected return Standard deviation of returns

One Liberty .12 .08

Heico .16 .20

If she invests 30% of her funds in Heico and 70% in One Liberty, and if the correlation of returns between these securities is +0.65, what is the portfolio's expected return and standard deviation? a. 14% and 15.67% b. 14.8% and 9.44% c. 13.2% and 10.54% d. 13.1% and 9.67% ANS: C Solution: Rp = 0.3(0.16) + 0.7(0.12) = 0.132 or 13.2% p= [0.32(0.20)2 + 0.72(0.08)2 + 2(0.3)(0.7)(0.08)(0.20)(0.65)].5 = 0.1054 or 10.54% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio risk and return

92. Jim Bowles is an investor who believes the economy is gaining strength and, therefore, wishes to increase the risk of his 14 security portfolio. Each security has a current market value of $5,000 and the current beta of the portfolio is 1.02. The beta of the least risky security is .76. If Jim replaces the least risky security with another security with the same market value but a beta of 1.45, what will the portfolio beta be then? a. 1.03 b. 1.07 c. 1.08 d. 1.04 ANS: B Solution: 1.02 = (13/14)(X) + (1/14)(.76) So X = 1.04 p = (13/14)(1.04) + (1/14)(1.45) = 1.069 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta 93. Kermit Industries current common stock dividend is $1.35 per share and the dividend is expected to grow at 6% per year into the foreseeable future. Currently the risk-free rate is 4.5% and the estimated market risk premium is 8.5%. Merrill Lynch has estimated KI's beta to be 1.10. Compute the expected price for KI's common stock. a. $17.20 b. $10.33 c. $18.23 d. $49.35 ANS: C Solution: ke = .045 + 1.10(0.085) = 0.1385 P0 = $1.35(1.06) / (0.1385 - 0.06) = $18.23 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Systematic risk and valuation 94. Determine the beta of a portfolio consisting of the following common stocks: Security Glaxo SCANA BancOne Pepsi AFLAC Votec a. b. c. d.

1.00 1.12 1.09 1.11

ANS: D Solution: p = 2.6 / 20(1.24) + 3.7 / 20(.88) + 2.9 / 20(.95) + 3.4 / 20(1.05)

Market Value

Beta

$2,600 3,700 2,900 3,400 3,000 4,400

1.24 .88 .95 1.05 1.09 1.41

+ 3.0 / 20(1.09) + 4.4 / 20(1.41) = 1.11 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta 95. The beta of Sanafil is 1.2. Sanafil is evaluating a merger with Matra, a firm that has a beta of 0.95.

Sanafil's stock sells for $40 per share and there are 10 million shares outstanding. Matra's stock sells for $60, but there are only 2 million shares outstanding. If these two firms merge, what will be the merged firm's beta? a. 1.00 b. 1.14 c. 1.05 d. 1.16 MVS = $40(10,000,000) = $400,000,000 MVM = $60(2,000,000) = $120,000,000 ANS: B Solution: p = (120 / 520)(0.95) + (400 / 520)(1.2) = 1.14 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Portfolio beta 96. Lotte Group is planing on diversifying into the transportation industry. As a result, Lotte's beta would rise to 1.3 from 1.1 and the expected long-term growth rate in the firm's earnings would increase from 11% to 14%. Currently the risk-free rate is 5.0% and the market risk premium is 8.6%. If Lotte's current dividend is $1.30, should Lotte diversify into the transportation industry? a. No, stock price does not increase b. No, stock price declines about $10.11 c. Yes, stock price increases about $19.42 d. Yes, stock price increases by about $26.27 ANS: D Solution: kold = 0.05 + 1.1(0.086) = 0.1446 P0 = $1.30(1.11) / (0.1446 - 0.11) = $41.71 knew = 0.05 + 1.3(0.086) = 0.1618 Pnew = $1.30(1.14) / (0.1618 - 0.14) = $67.98 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Systematic risk evaluation 97. Security A offers an expected return of 14% with a standard deviation of 8%. Security B offers an expected return of 11% with a standard deviation of 6%. If you wish to construct a portfolio with a 12.8% expected return, what percentage of the portfolio will consist of security A? a. 55% b. 60% c. 65% d. 45% ANS: B Solution: wA = (12.8 - 11.0) / (14 - 11) = 0.60 or 60%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand risk and return TOP: Risk

NAT: Analytic skills

98. Which of the following statements is/are correct?

I. Unsystematic risk can be eliminated through diversification.

II. Unsystematic risk is the relevant portion of an asset’s risk attributable to market factors that affect all firms, like inflation, political events, etc. a. b. c. d.

I only II only Both I and II Neither I nor II

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective skills TOP: Portfolio risk

99. Correlation is a statistical measure of the relationship between a series of numbers representing data.

Which of the following statements about correlation is/are correct?

I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of -1.

II. Perfectly positively correlated describes two positively correlated stocks that have a correlation coefficient of 0. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Investment diversification and portfolio risk analysis

NAT: Reflective thinking

100. Total risk of a security can be viewed as consisting of two parts. Which of the following apply?

I. verifiable risk II. non-verifiable risk a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Investment diversification and portfolio risk analysis

NAT: Reflective thinking

101. All of the following statements about risk are correct EXCEPT: a. Risk can be defined as the chance for financial loss. b. The term risk is used interchangeably with uncertainty. c. Risk refers to the certainty of returns associated with a given asset. d. The more certain the return from an asset, the less variability and therefore less risk.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Risk

NAT: Reflective thinking

102. Which of the following statements regarding risk is/are correct?

I. A portfolio of two negatively correlated assets has less risk than either of the individual assets and risk could be further reduced to 0 or below.

II. There is no case where creating a portfolio of assets will result in greater risk than that of the riskiest asset included in the portfolio. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Investment diversification and portfolio risk analysis

NAT: Reflective thinking

103. What kind of probability distribution shows all possible outcomes for a given event? a. discrete b. expected value c. bar chart d. continuous ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Standard deviation: An absolute measure of risk

104. That portion of the risk premium that is based on the ability of the borrower to repay principal and interest is the: a. Maturity risk b. Default risk c. Seniority risk d. Business risk ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Risk Premium

105. An investor, by investing in combinations of stocks, develops a _____________ portfolio a. simple b. structured c. diversified d. energetic ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Investment Diversification and Portfolio Risk Analysis 106. What is the beta of the following project?

Comparative Returns in the Market Project’s Returns 12% 15% 10% 8% 6.5% 7% 2% -1% a. b. c. d.

1.11 .95 2.15 1.43

ANS: D Answer was determined by using a financial calculator.

NAT: Reflective thinking

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand risk and return TOP: Beta: A measure of Systematic Risk 107. Find beta and determine the required rate of return. The market risk premium is 12% and the risk-free rate is 5%.

Comparative Returns in the Market Returns on the Stock 8% 4% 9% 10% 2% 1% 10% 6% a. b. c. d.

12.61% 8.27% 10.11% 14.84%

ANS: D Answer was determined by using a financial calculator.

Beta = .82 RRR = 5% + .82(12%) = 14.84% PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills LOC: Understand risk and return TOP: Beta, A Measure of Systematic Risk 108. Find beta and determine the risk premium. The market risk premium is 8% and the risk-free rate is 2%.

Comparative Returns in the Market Returns on the Stock 10% 8% 11% 12% 6% 2% 5% 1% a. b. c. d.

16.82% 20.76% 10.15% 18.11%

ANS: B Beta is 1.73 Risk premium = 1.73(12) = 20.76% (The risk-free rate is surplus information) PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Beta: A Measure of Systematic Risk ESSAY 1. What is an efficient portfolio?

ANS:

A portfolio is efficient if, for a given standard deviation, there is no other portfolio with a higher expected return, or for a given expected return, there is no other portfolio with a lower standard deviation. An efficient portfolio maximizes return for a given level of risk, or minimizes risk for a given rate of return.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Efficient portfolios and the capital market line

2. List types of events that influence systematic (non-diversifiable) risk.

ANS: Events that are broad in scope and affect the market as a whole will impact systematic risk. These events include: war inflation political events interest rate changes international incidents changes in investor expectations about the overall economy PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Systematic and Unsystematic Risk

3. List the various risk elements that are considered when determining the risk premium.

ANS: The risk elements include: 1. maturity risk premium 2. default risk premium 3. seniority risk premium 4. marketability risk premium PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Risk premium

4. How can standard deviation, a statistical measure of dispersion, be used in investment analysis?

ANS: The standard deviation can be used to measure the variability of return from an investment. It gives and indication of the risk involved in the asset or security. The larger the standard deviation, the more variable an investment’s return and thus the riskier the investment.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Standard Deviation: An Absolute Measure of Risk

5. Explain marketability risk and marketability premium.

ANS: Marketability risk refers to the ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value. Usually the stock of companies listed on the NYSE is considered easy to sell and has a ready buyer. The marketability risk premium is that extra interest rate charged on loans to companies whose stock may not be easy to sell. The lender, in order to be adequately compensated for the risk taken in making the loan, receives a higher return.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Risk Premium

6. Why is risk an increasing function of time?

ANS: Investment decisions require that returns be forecasted several years into the future. The riskiness of these forecasted returns may be thought of as an increasing function of time. Returns that are generated early can generally be predicted with more certainty than those that are anticipated farther out into the future. The farther into the future that performance is forecasted, the greater the chance that the forecast will be incorrect. Even though cash flows from an investment or project may be equal each year, it is reasonable to assume that the riskiness of these flows increases over time as more and more presently unknown variables have a chance to affect the investment’s or project’s cash flows.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Rusk as an Increasing Function of Time

Chapter 7—FIXED INCOME SECURITIES: CHARACTERISTICS AND VALUATION MULTIPLE CHOICE 1. Which of the following types of debt securities protect investors against interest rate risk? a. floating rate bonds b. extendible notes c. original issue deep discount bonds d. floating rate bonds and extendible notes ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

2. Zero coupon bonds are an example of a. original issue deep discount bonds b. extendible notes c. convertible bonds d. floating rate notes ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

3. Original issue deep discount bonds have decreased in popularity over the last several years due to: a. changes in tax laws b. issuance by brokerage firms of lower risk substitutes c. increased interest in equity securities d. changes in tax laws and issuance by brokerage firms of lower risk substitutes ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

4. Merrill Lynch's "TIGR's" a. are backed by U.S. Treasury bonds b. pay no interest c. are purchased at a discount from face value and are redeemed for the full face value at maturity d. all of the above ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand stocks and bonds

TOP: Features of long-term debt

5. Extendable notes are redeemable at par at the option of the a. holder b. company c. trustee d. holder and trustee ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

6. If a firm could sell a mortgage bond at an 8% interest rate, it could sell an otherwise identical debenture at a. a rate less than 8% b. 8% c. a rate greater than 8% d. cannot be determined ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

7. When the market for an asset is in equilibrium, the expected rate of return on the asset is equal to the: a. risk-free rate b. marginal investor's required rate of return c. historical cost of capital d. perpetual capitalization rate ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Market value of assets and market equilibrium

8. The _______ the investor's required rate of return on a bond, the _______ will be the value of the bond to the investor. a. lower, higher b. higher, higher c. lower, lower d. higher, lower ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Market value of assets and market equilibrium

9. The value of a perpetual bond is equal to the annual interest payment divided by the: a. risk-free rate b. required rate of return c. bank interest rate d. after-tax historical cost of capital ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Perpetual bonds

10. The yield-to-maturity of a bond with a finite maturity date is a function of all of the following variables except: a. the current price b. the required rate of return on the bond c. the uniform annual interest payments d. the maturity value

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bonds having finite maturity dates

11. Which of the following statements concerning preferred stocks is true? a. Preferred stockholders have a prior claim on the income and assets of the firm as compared to the claims of lenders. b. Preferred stock dividends per share are normally increased as the earnings of the firm increase. c. Preferred dividends per share are usually not cut or suspended unless the firm is faced with serious financial problems. d. The par value of a stock is always the same as the initial selling price.

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Characteristics of preferred stock

12. Rank in ascending order (lowest to highest) the relative risk associated with holding the preferred stock, common stock and bonds of a firm: a. preferred stock, bonds, common stock b. bonds, common stock, preferred stock c. common stock, preferred stock, bonds d. bonds, preferred stock, common stock ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Characteristics of preferred stock

13. Potential sellers of an asset can be represented as a __________ schedule showing the __________ prices at which they are willing to sell given quantities of the asset. a. supply, maximum b. demand, maximum c. supply, minimum d. supply, average ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Market value of assets and market equilibrium

14. By the capitalization-of-cash flows method, the value of an asset is a function of a. the book value of the asset b. the risk of the asset's cash flows c. the age of the asset d. both the book value and the age of the asset ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capitalization of cash flow method

15. Which of the following is not a characteristic of long- term debt? a. interest paid to bond holders is a tax-deductible expense to the firm b. firm is not legally required to pay interest to bond-holders c. usually has a specific maturity d. all of the above are characteristics of long-term debt ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Introduction

16. The quality of a debenture depends on the a. general credit-worthiness of the issuing company

NAT: Reflective thinking

b. value of the assets used as collateral c. the coupon rate of the debenture d. length of time to maturity ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

17. The indenture is a contract between the issuer and lenders that does all the following except: a. specifies the manner in which the principal must be repaid b. details the nature of the debt issue c. gives management's expectations about return of the proceeds d. lists any restrictive covenants ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

18. The call feature of a long-term bond a. is an optional retirement provision b. states the call price c. allows the issuer to replace a high coupon bond with one with a lower coupon bond d. all the above are correct ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

19. A sinking fund allows the issuer to a. redeem an entire debt issue prior to maturity b. purchase a portion of the debt each year in the open market or call a portion of the debt for mandatory redemption c. call the entire debt issue d. accumulate interest expenses into a sinking fund account ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

20. Normally the coupon rates on new bonds a. do not change over the life of the issue b. are set equal to the market rate plus an inflation premium c. float with changes in the prime rate d. are set just over the prevailing prime rate ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

21. Junk bonds are a. usually rated Ba or higher b. are issued by firms with a high debt ratio c. issued with coupon rates at least 8 percentage points or more above the highest quality issues d. are issued by firms with a low debt ratio ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond ratings

22. Large companies build up short-term debt over the period of 1 to 2 years, then sell long-term debt using a portion of the proceeds to repay the short-term borrowings. This procedure is called:

a. b. c. d.

"drawing down" long-term credit funding short-term debt reducing the tax bite extending the rates

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Users of long-term debt

23. The major advantages of long-term debt include all the following except: a. decrease in financial risk b. relatively low, explicit after-tax cost c. owners are able to maintain control d. increased earnings per share through using financial leverage ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and disadvantages of long-term debt financing 24. The value of a 15-year bond will change ________ for a given change in the required rate of return than the value of a 5 year bond. a. more b. less c. the same percentage d. exactly the same ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bonds having finite maturity dates

25. When the required rate of return is ________ the coupon rate, the bond will sell at a discount. a. less than b. greater than c. the same as d. equal to ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bonds having finite maturity dates

26. Equipment trust certificates are used mainly by a. equipment manufacturers b. oil drilling companies c. state governments d. trucking companies ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

27. All of the following types of bonds are secured except a. collateral trust b. mortgage c. debentures d. equipment trust certificates ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

28. The call feature is an advantage to the issuing firm

a. b. c. d.

if the bond has a floating rate if interest rates decline if the bond has a low par value if interest rates increase

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt |

29. Which of the following is the highest risk debt issue? a. senior debt b. mortgage bond c. equipment trust certificate d. debenture ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

30. There is a(n) _______ relationship between the value of a bond and its required rate of return. a. direct b. distant c. inverse d. turgid ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bonds having finite maturity dates

31. The _______ represents the debtholders in dealings with the issuing company. a. trustee b. stakeholders c. broker d. investment banker ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

32. If an American Water Company bond has a coupon rate of 9.0 percent and is selling for $920, then the yield to maturity must be: a. greater than 9% b. equal to 9% c. less than 9% d. cannot be determined ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Analytic skills TOP: Bonds having finite maturity dates

33. "Junk bond" is a term used to describe a bond that a. is in default b. is rated Ba or lower c. is currently paying interest d. has been downgraded by Moody's ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond ratings

34. The basic relationship in bond valuation is for a given percentage point change in the required rate of return, the _______ the time to maturity, the _______ the change in value.

a. b. c. d.

shorter, greater longer, smaller longer, greater shorter, smaller

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bonds having finite maturity dates

35. Preferred stock has a priority over common stock with regard to the company's a. assets b. voting rights c. dividends d. assets and dividends ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Characteristics of preferred stock

36. The principal disadvantage of preferred stock financing is a. its high after-tax cost as compared with long-term debt b. the decrease in the firm's degree of financial leverage c. the required payment of dividends d. the reduction in control ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and disadvantages of preferred stock financing 37. __________ are not secured by specific assets. a. Equipment trust certificates b. Mortgage bonds c. Debentures d. Collateral trust bonds ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

38. A zero coupon bond is an example of a(n) __________. a. fixed income security b. original issue deep discount bond c. tax-exempt bond d. fixed income security and an original issue deep discount bond ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Coupon rates

39. Junk bonds (i.e., bonds issued by companies with weak financial positions) rated __________or lower

by Moody's. a. Baa b. BBB c. Ba d. CCC ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond ratings

40. The required rate of return on an asset is a function of the __________.

a. b. c. d.

risk associated with the asset risk-free interest rate age of the asset risk associated with the asset and the risk-free interest rate

ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capitalization of cash flow method

41. Which of the following features (if any) of preferred stock provides the investor with a measure of protection against inflation? a. adjustable dividend rate b. cumulative feature c. call feature d. after-tax cost ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of preferred stock

42. Which of the following features (if any) of debt securities provides the investor with a measure of protection against inflation? a. sinking fund b. call feature c. floating coupon rates d. poison put covenant ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

43. The __________ of a debt issue is equal to the difference between the __________ and the __________. a. call price; market price; par value b. call price; market price; call premium c. call premium; call price; par value d. call premium; market price; par value ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Call feature

NAT: Reflective thinking

44. ________ bonds normally are denominated in the currency of the country of sale. a. Eurodollar b. International c. Foreign d. LIBOR ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: International issues: The international bond market

45. The following is a bond quotation from The Wall Street Journal: IBM 101/4 27

9.8

18

104 1/2

-1/2

If the bond has a face (par) value of $1000, what was the market price? a. $1025 b. $1045 c. $950

d. $980 ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Analytic skills TOP: Information on debt financing activities

46. A zero coupon bond is a bond that a. originally sold at a discount b. will sell for a premium c. is a premium value bond d. has a high current yield ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Information on debt financing activities

47. The following bond quotation indicates that the holder expects to receive ______ in interest annually: PAC EI 11s 09 a. $90 b. $116 c. $95 d. $110

11.6

20

95

ANS: D PTS: 1 LOC: Understand stocks and bonds

-1

OBJ: TYPE: Fact NAT: Analytic skills TOP: Information on debt financing activities

48. In the Treasury bill quote that follows, the price of the bill can be calculated from the _____ price.

Mat. date 9-24 a. b. c. d.

Bid 8.34

Asked 8.29

Yield 8.58

bid asked yield none of the above

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Information on debt financing activities

49. Treasury bills a. have a stated interest rate b. pay no explicit interest c. are sold for exactly $10,000 d. are quoted in terms of yield to maturity ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Information on debt financing activities

50. Treasury notes typically have initial maturities ranging from a. 1 to 3 years b. 1 to 5 years c. 1 to 10 years d. 10 to 30 years ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Information on debt financing activities

51. An AT&T 5 1/2s 05 bond with a current yield of 6.2% must be selling ________ its face value. a. above b. at c. below d. any of the above could be correct ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Analytic skills TOP: Information on debt financing activities

52. In reading price quotes on U.S. Treasury bills, you would ________ expect to find the "asked" price higher than the "bid". a. always b. never c. sometimes d. seldom ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Information on debt financing activities

53. Users of preferred stock include: a. Utility companies b. Acquiring firm in mergers and acquisitions c. Large commercial banks d. All of the above are users ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Users of preferred stock

54. What is the yield to maturity for a Pep Boys zero coupon bond that matures in 14 years if the bond is selling for $530.00? a. 5.84% b. 4.64% c. 4.28% d. 5.49% ANS: B Solution: N = 14 PV = -530 PMT = 0 FV = 1000 Solve for I 4.64% by calculator PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: YTM | zero coupon bond 55. If an Allied Chemical zero coupon bond due in 12 years is selling for $420.00, what is its yield to maturity? a. 7.50% b. 4.64% c. 6.51% d. 5.26% ANS: A

Solution: N = 12 PV = -420 PMT = 0 FV = 1000 Solve for I 7.50% by calculator PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: YTM | zero coupon bond 56. The State of Adaven issued $50 million of perpetual bonds in 1990. The bonds were issued in $100 denominations with an annual coupon interest rate of 5%. Determine the value of these bonds today to an investor who requires a 10% return on his investment. a. $25 b. $5 c. $10 d. $50 ANS: D Solution: P0 = $5/0.10 = $50 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Perpetual bond valuation 57. The State of Adaven issued $50 million of perpetual bonds in 1990. The bonds were issued in $100 denominations with an annual coupon interest rate of 5%. Determine the rate of return or current yield on these bonds if they are purchased at the current price of $40. a. 12.5% b. 8.0% c. 5.0% d. 1.25% ANS: A Solution: kd = $5/$40 = 0.125 or 12.5% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Perpetual bond valuation 58. A General Electric 7 1/2s 25 bond closed at 98. What is the current yield? a. 7.65% b. 7.81% c. 7.50% d. 7.34% ANS: A Solution: 75/980 = .0765 or 7.65% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond quotations

59. A Treasury bill with 182 days to maturity is quoted at 5.62 bid, 5.60 asked, and an asked yield of 5.84.

How much would you pay for this security? a. $9,440 b. $9,720 c. $9,708 d. $9,438 ANS: B Solution: $10,000 - $10,000(0.056/2) = $9,720 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Government security price quotations 60. How much would you have to pay for a U.S. Government bond ($1,000 maturity value) scheduled to mature in February, 2010 and quoted at 118:07 "bid" and 118:15 "asked"? a. $1,182.19 b. $1,181.50 c. $1,184.69 d. $1,180.70 ANS: C Solution: 118.46875% of $1,000 or $1,184.69 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Government security price quotations 61. J. C. Penney has an 11s 22 bond that closed at 102 3/8. What is the current yield on this bond? a. 10.74% b. 10.84% c. 10.78% d. 11.00% ANS: A Solution: $110/$1023.75 = 0.1074 or 10.74% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond quotations 62. A WPI 10s 08 bond closed at 89. What is the current yield on this bond? a. 10.10% b. 11.35% c. 10.73% d. 11.24% ANS: D Solution: $100/$890 = 0.1124 or 11.24% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond quotations

63. A Treasury bill with a July 11th maturity date is quoted today at 8.46 bid and 8.40 asked. How much would you pay today (January 11th) for one bill? a. $9,577 b. $9,580 c. $9,588 d. $8,400 ANS: B Solution: 10,000 - 10,000(0.084/2) = $9,580 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Government security price quotations 64. Two-years ago, Trans-Atlantic Airlines sold a $250 million bond issue to finance the purchase of new jet airliners. These bonds were issued in $1000 denominations with an original maturity of 12 years and a coupon rate of 12%. Determine the value today of one of these bonds to an investor who requires a 14% rate of return on these securities. a. $626 b. $463 c. $897 d. $270 ANS: C Solution using a calculator: N= (12-2) = 10 I = 14 PMT = 120 FV = 1000 Solve for PV = $896.68 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Finite maturity bond valuation 65. Two years ago, Trans-Atlantic Airlines sold $250 million worth of bonds at $1,000 each. The bonds had a maturity of 12 years and a coupon rate of 12%. Today these bonds are selling for $910.

Determine the yield-to-maturity (to the nearest tenth of one percent). a. 13.2% b. 5.6% c. 13.7% d. 12.0% ANS: C Solution using a calculator: N = (12-2) =10 PV = -910 PMT = 120 FV = 1000 Solve for I =13.71% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity calculation

66. Assume that the dividend on Central Power Company's $3.25 preferred stock issue is paid annually at the end of the year. Determine the value of this preferred stock to an investor who requires a 12 percent rate of return. a. $3.25 b. $39 c. $12 d. $27.08 ANS: D Solution: P0 = $3.25/0.12 = $27.08 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Preferred stock valuation 67. An Allied Northern preferred stock pays a $3.84 annual dividend. What is the value of the stock to an investor who requires a 9.5 percent return? a. $40.42 b. $42.67 c. $38.40 d. $37.60 ANS: A Solution: P0 = $3.84/0.095 = $40.42 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Preferred stock valuation 68. What is the rate of return on a preferred stock that has a par value of $50, a market price of $46.50, and a dividend of $4.10? a. 8.20% b. 11.34% c. 8.82% d. 12.20% ANS: C Solution: kp = Dp/P = $4.10/$46.50 = 0.0882 or 8.82% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Rate of return on preferred stock 69. What is the value of a $1000 par value Consul perpetual bond with a 6 percent coupon rate if the required rate of return is 9 percent? a. $1,000 b. $666.67 c. $333.33 d. $540 ANS: B Solution: P = $60/0.09 = $666.67 PTS: 1

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Understand stocks and bonds

TOP: Valuation of a perpetual bond

70. A refrigerator manufacturer, Zero King, issued a zero coupon bond with 10 years to maturity. What is the yield-to-maturity of this bond if it is sold for $352? a. 12.2% b. 10% c. 11% d. 9% ANS: C Solution using a calculator: N = 10 PV = -352 PMT = 0 FV = 1000 Solve for I = 11% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity on zero coupon bonds 71. Marko needs to raise capital through a zero-coupon bond debt offering. If the bonds will have 12 years to maturity and the rate of return on a bond in Marko's risk class is 11 percent, what will be the selling price of the bond? a. $302.50 b. $335.50 c. $269.50 d. $286.00 ANS: D Solution: PVIF0.11,12 = 0.286 P = $1,000(0.286) = $286 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Valuation of zero coupon bonds 72. Five years ago, the City of Baltimore sold at par a $1,000 bond with a coupon rate of 8 percent and 20 years to maturity. If this bond pays interest semiannually, what is the value of this bond to an investor who requires an 8 percent rate of return? a. $607.72 b. $692.00 c. $1,000 d. $1,080 ANS: C Solution: No calculation needed because yield to maturity equals the coupon rate PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Finite maturity bond valuation 73. A Dow Chemical bond carries a 9 percent coupon, pays interest semiannually, and has 10 years to maturity. What is the bond's yield to maturity if the bond is selling for $937.75? a. 8.0% b. 10.0%

c. 9.0% d. 7.5% ANS: B Solution: Because the bond is selling at a discount, the YTM must be greater than the coupon of 9%. Therefore, try 10% (5% semiannually). $937.75 = $45(12.462) + $1000(0.377) $937.75  $937.79 therefore YTM =10% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity 74. Determine the yield to maturity to the nearest tenth of 1 percent of a zero coupon bond with 8 years to maturity that is currently selling for $404. a. 11.3% b. 12.3% c. 11.7% d. 12.0% ANS: D Solution: $404 = $1000(PVIFkd,8) kd = 12% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity of zero coupon bond 75. What is the value of an Orion bond that has a 10 percent coupon, pays interest semiannually, and has 10 years to maturity, if the required rate of return is 12 percent? a. $1,200 b. $885.50 c. $895.27 d. $1,000 ANS: B Solution: P = $ 50(11.470) + 1000(0.312) = 885.50 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation with semiannual compounding 76. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 14 percent coupon, that pays interest semiannually. The bond can be called in 7 years, has a call premium of $140, and is currently selling for $1154. a. 12.0% b. 16.2% c. 13.7% d. 14% ANS: A Solution: Because the bond is selling for a premium, the YTC must be less than 14 percent.

Try 12 percent: P = $70(9.295) + $1140(0.442) = $1,154.53

or using a calculator: N=7 PV = -1154 PMT = 140 FV = 1140 Solve for I = 12.01% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to call date 77. What is the value of a Northern Pacific bond with an 11 percent coupon, maturing in 15 years?

Assume the market rate for this bond is 14 percent and that the interest is paid semiannually. a. $1,000 b. $790.74 c. $813.50 d. $853.30 ANS: C Solution: P =$55(12.409) + 1000(.131) = $813.50 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation with semiannual compounding 78. What is the market value of a zero coupon bond with 5 years to maturity? The bond was originally sold with a yield to maturity equal to 11 percent, but the market rate today is 9 percent. a. $593 b. $650 c. $621 d. $577 ANS: B Solution: P = $1000(0.650) = $650 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond valuation 79. What is the value of a PacTen bond with a 10 percent coupon that matures in 15 years? Assume the current market rate for this bond is 16 percent and that interest is paid semiannually. a. $661.90 b. $1,227.78 c. $1,000 d. $875.51 ANS: A Solution: P = $50(11.258) + $1,000(0.099) = $661.90 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation with semiannual discounting 80. What is the required rate of return to the investor who is willing to purchase a Duke Power preferred stock with a $8.70 dividend, a par value of $100, and a current market price of $87? a. 10.7%

b. 8.7% c. 9.4% d. 10.0% ANS: D Solution: kp = D0/P0 = $8.70/$87 = 10% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Preferred stock valuation 81. Determine the yield to maturity (to the nearest tenth of 1 percent) of an 8-year zero coupon bond ($1,000 par value) that is currently selling for $521. a. 6.0% b. 11.5% c. 7.9% d. 8.5% ANS: D Solution: $521 = $1,000 (PVIFkd, 8) PVIFkd,8 = 0.521 kd = 8.5% by calculator or interpolation

Solution using calculator: N=8 PV = -521 PMT = 0 FV = 1000 Solve for I = 8.49%

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity 82. ICX Company has an issue of perpetual bonds (par value to $1,000) that pays 5% annual interest.

Determine the yield (to the nearest tenth of 1 percent) if the bonds are currently selling for $625. a. 5.0% b. 8.0% c. 3.1% d. 6.25% ANS: B Solution: kd = $50/$625 = 0.08 or 8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity on perpetual bonds 83. Mid-States Utility Company sold a 10-year note with a 7 7/8% coupon and a par value of $1,000. If the note sold at a discount for $930, what was the implied yield-to-maturity to the nearest tenth of one percent? Assume interest is paid semiannually. a. 8.5% b. 8.7% c. 8.9% d. 9.4% ANS: C Solution: N = 10 PV = -930

PMT = 78.75 FV = 1000 Solve for I = 4.47 X 2 = 8.94 Calculator solution: 4.47 percent per 6 months or 8.94% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield-to-maturity 84. Baywa has an outstanding bond that has a coupon rate of 8.3%. What is the market price of this bond if it pays interest semi-annually, has 15 years to maturity, and the current required rate of return is 9% on bonds of similar quality? a. $943 b. $1059 c. $954 d. $1,000 ANS: A Solution: P0 = $41.50(16.29) + $1,000(.267) = $943 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 85. Rascal Corporation bonds have a 10.60% coupon and a maturity value of $1,000. The bonds, which pay interest semi-annually, will mature in 15 years, but the firm has the option to call the bond in 10 years at a premium of 106. You believe that Rascal will call the bonds in 10 years. If you require a pre-tax return of 9.5% on bonds of this risk, how much would you pay for one of these bonds today? a. $1,000 b. $1,094 c. $1,034 d. $1,058 ANS: B Solution: P0 = $53(PVIFA.0475,20) + $1060(PVIF.0475,20) = $1,094 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 86. Zimmer, Inc. issued zero coupon bonds that sold for $190 and are due in 15 years. Determine the yield to maturity (to the nearest tenth of 1 percent) if you purchased the bond at the issue price. a. 19.0% b. 11.4% c. 10.9% d. 11.7% ANS: D Solution: P0 = M(PVIFkd,15) PVIF = $190/$1,000 = .190 YTM = kd = 11.7%

PTS: 1

Solution using calculator: N = 15 PV = -190 PMT = 0 FV = 1000 Solve for I = 11.7%

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Understand stocks and bonds

TOP: Zero coupon bond valuation

87. King World zero coupon bonds were issued in 1998 at $124. These bonds will mature in 2018. What will these bonds sell for in 2008 if the required rate of return in 2008 is 9.5%? a. $352 b. $404 c. $413 d. $163 ANS: B Solution: P0 = $1,000(PVIF.095,10) = $1,000(.404) = $404 Solution using calculator: N = 10 I = 9.5% PMT = 0 FV = 1000 Solve for PV = $403.51 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond valuation 88. RJR issued a 10-year, 16% bond in 2003 that is callable at $1,100 in 5 years. In 2008 (today) the required return on bonds of this risk was 11%. The bonds pay interest semi-annually. What would you be willing to pay for one of these bonds today if you believe the bond will be called today? a. $1188 b. $832.25 c. $1,100 d. $1,000 ANS: C Solution using a calculator: N=5X2 I = 112 PMT = 160  FV = 1100 Solve for PV = $1,246.98 The call price ($1,100) puts a ceiling on the value of the bond.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation with call feature 89. Determine the value of a LASKA 6.25% cumulative preferred stock, series D, par value $75 to an investor who requires a 9.5% rate of return on a security with this risk. a. $65.79 b. $49.37 c. $75.00 d. $114.00 ANS: B Solution:

P0 = .0625($75) = $4.69 in annual dividends P0 = 4.69/.095 = $49.37 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Preferred stock valuation 90. At what price will Gohm have to sell a 10-year zero coupon bond that will yield 8.75% if held to maturity. a. $453 b. $875.00 c. $87.50 d. $432 ANS: D Solution: P0 = $1,000(PVIF.0875,10) = $432 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond valuation 91. What is the issue price of a zero coupon bond with 15 years to maturity if it is sold to yield 7.55%? a. $250.00 b. $362.31 c. $335.62 d. $1000.00 ANS: C Solution using a calculator: N = 15 I = 7.55 PMT = 0 FV = 1000 Solve for PV = $335.62 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond valuation 92. A U.S. Government bond was quoted at 95:13 "bid" and 95:15 "asked". How much would you have to pay for one of these $1,000.00 face value bonds? a. $951.50 b. $950.13 c. $950.15 d. $954.69 ANS: D Solution: 95 15/32%(1,000) = $954.69 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Government bond 93. What is the value of an MDI $2.67 perpetual preferred stock to an investor who requires a 7% annual rate of return? Assume the par value is $60.00. a. $85.71

b. $38.14 c. $59.33 d. $60.00 ANS: B Solution: p = 2.67 = $38.14 .07 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Preferred stock 94. UOP, a petroleum processing technology firm, issued a 10% coupon, 20 year to maturity first mortgage bond five years ago. If the current market rate of debt for UOP is 8%, at what price should this bond sell, to the nearest dollar? Assume a par value of $1,000, and pays interest semi-annually. a. $1,170. b. $999 c. $1,095 d. $1,173 ANS: D Solution: Po = 50(17.292) + 1000(.308) = $1,172.60 Solution using a calculator: N = 15 X 2 I=82 PMT = 100  2 FV = 1000 Solve for PV = 1172.92 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 95. National Medical has a zero coupon bond outstanding that sells for $242.60 and has 15 years to maturity. What is the yield to maturity on the bond to the nearest tenth of one percent? a. 10.5% b. 9.1% c. 9.9% d. 11.0% ANS: C Solution using a calculator: N = 15 PV = -242.60 PMT = 0 FV = 1000 Solve for I = 9.9% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond yield to maturity 96. An Exxon bond carries an 8 percent coupon, pays interest semiannually, and has 10 years to maturity.

If this bond is currently selling for $925, what is the exact yield to maturity(to the nearest tenth of 1 percent)?

a. b. c. d.

9.2% 8.8% 9.8% 10.2%

ANS: A Solution using a calculator: N = 10 x 2 PV = -925 PMT = 80  2 FV = 1000 Solve for I = 4.58 X 2 = 9.16% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: Yield to maturity of finite maturity bond (semiannual...

NAT: Analytic skills

97. The current required rate of return on a bond issued by Who LTD is 11 percent. "Who" has a bond issue outstanding that pays interest semiannually, is selling for $845 and matures in 8 years. What is the coupon rate on the outstanding bond? a. 4.00% b. 8.00% c. 10.68% d. 6.05% ANS: B Solution: $845 = I/2(PVIFA0.055,16) + $1000(PVIF0.055,16) I/2 = 40.01 so coupon is $80 or 8 percent Solution using a calculator: N=8X2 I = 11  2 PV = -845 FV = 1000 Solve for PMT = 40.18 X 2 = 80.36 Convert $80 into a % = 80.36  PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation - solving for coupon rate 98. An EAL bond has a coupon rate of 16 percent, pays interest semiannually, and matures in 15 years. If the bond is selling for $968.82, what is its yield to maturity? a. 8.3% b. 16.1% c. 16.6% d. 14.3% ANS: C Solution: N = 15 X 2 PV = -968.82 PMT = 160  2 FV = 1000

Solve for I = 8.28% X 2 = 16.56% kd = 16.6 by calculator PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity of finite maturity bond with...

99. How many semiannual interest payments remain on a bond that is selling for $917.25? The coupon rate of the bond is 8 percent, interest is payable semiannually, and the current market rate of return on a similar risk bond is 10 percent. a. 5 b. 10 c. 11 d. 7 ANS: C Solution: Solve by trial and error or calculator. Try 5.5 years or 11 payments $917.25 = $40(8.306) + $1000(0.585) = $917.24 Solution using a calculator: I = 10  2 PV = -917.25 PMT = 80  2 FV = 1000 Solve for N = 10.9 payments (roughly 11 payments) or 5.5 years PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Payments remaining on finite maturity bond 100. CUP Company 8% bonds are currently selling for $950. These bonds (par value of $1,000) mature in one year and pay interest annually. Determine the yield to maturity (to the nearest tenth of 1 percent) on this bond issue. a. 13.7% b. 13.0% c. 13.3% d. 5.0% ANS: A Solution: $950 = $1,080 (PVIFkd, 1 ) PVIFkd, 1 = 0.880 kd = 13.7% by calculator or interpolation Solution using a calculator: N=1 PV = -950 PMT = 80 FV = 1000 Solve for I = 13.68% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity

101. What is the yield to maturity of a TVA bond that has a 9 1/2 percent coupon, pays interest semi-annually, has 12 years to maturity, and sells for $871.50? a. 11.3% b. 11.5% c. 11.8% d. 12.1% ANS: B Solution: YTM = 11.5% try 10% 871.50 = 47.50(13.799) + 1000(0.310) = $965.45 try 12% 871.50 = 47.50(12.55) + 1000(0.247) = $843.13

YTM = 10% +

$93.95 (12% - 10%) = 11.5% $ 93.95 + $28.37

Solution using a calculator: N = 12 X 2 PV = -871.50 PMT = 95  2 FV = 1000 Solve for I = 5.75% X 2 = 11.5% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: YTM

NAT: Analytic skills

102. Grace Corp. has a zero-coupon bond outstanding that matures in 15 years. This bond is selling for $327.50 today and will pay $1,000 at maturity. What is the yield to maturity to the investor who buys the bond and holds it until maturity? a. 7.73% b. 9.33% c. 9.23% d. 9.77% ANS: A Solution: 327.50 = 1000(PVIFkd,15) kd = 7.73% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero coupon bond-YTM 103. WPI has a bond issue outstanding that has a coupon rate of 10%, and a current yield of 11%. The yield to maturity on this bond is 12%. What is the market price, to the nearest dollar, of the WPI bond if it pays interest semi-annually and has 10 years to mature? a. $ 941 b. $1021 c. $1000 d. $ 885 ANS: D Solution: P0 = $50(11.470) + $1000(0.312) = $885

Solution using a calculator: N = 10 X 2  I = 12  2 PMT = 100  2 FV = 1000 Solve for PV = 885.30 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 104. What is the yield to maturity of a RJR bond with 10 years to maturity, and a coupon of 15%? The current price of this bond is $1,109. Assume interest is paid annually. a. 12.0% b. 12.5% c. 13.0% d. 13.5% ANS: C Solution: at kd = 13% then P0 = $150(5.426) + $1000(0.295) = $1,109 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield to maturity 105. What is the yield-to-maturity of an Acme bond selling for $1107.50 with 5 years to maturity, a 12 1/2% coupon, and semi-annual compounding? a. 10.36% b. 11.29% c. 9.74% d. 10.20% ANS: C Solution: 9.73% by calculator N=5X2 PV = -1,107.50 PMT = 125  2 FV = 1000 Solve for I = 4.87 X 2 = 9.74% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: YTM

NAT: Analytic skills

106. What is the yield-to-maturity of a Viacom bond which is selling for $948.75 with 6 years to maturity and a 7% coupon? a. 7.01% b. 8.11% c. 8.38% d. 7.38% ANS: B Solution:

8.11% by calculator N=6 PV = -948.75 PMT = 70 FV = 1000 Solve for I = 8.11% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: YTM

NAT: Analytic skills

107. WXAM has an outstanding bond issue with a coupon rate of 6 1/8%, and a current yield of 6.9%. The yield to maturity on this bond is 7 5/8%. What is the market price of this bond if it pays interest semi-annually and has 12 years to maturity? a. $883.42 b. $937.45 c. $943.65 d. $1000.00 ANS: A Solution: $883.42 by calculator N = 12 X 2 I = 7.625  2 PMT = (.06125 X 1000)  FV = 1000 Solve for PV = $883.42 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 108. What would a GMA 6% coupon bond maturing in 14 years sell for if the current yield is 6.9% and the yield-to-maturity is 7.48%? a. $950.20 b. $920.02 c. $1051.54 d. $872.90 ANS: D Solution: $874.21 by calculator N = 14 I = 7.48 PMT = 60 FV = 1000 Solve for PV = $874.21 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond valuation 109. Which of the following is NOT one of the many differences between long-term debt and preferred stock?

a. b. c. d.

Long-term debt pays interest which is tax-deductible to the borrower.

Preferred stockholders are paid before bondholders if the company bankrupts.

Preferred stockholders are considered owners of the company.

The firm is not legally required to pay preferred stock dividends, but must pay interest to bondholders.

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

110. There are consequences associated with not paying interest to bondholders. Which of the following apply?

I. Not paying an interest payment automatically puts the company in default making the entire loan due.

II. Interest on debt is not required to be paid, but the corporation generally does so for public relations reasons. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

111. Which of the following is/are correct regarding the maturity date on securities?

I. Long-term debt has a shorter maturity date than preferred stock.

II. Preferred stock can have no specific maturity date, so can be perpetual. a. I only b. II only c. Both I and II d. Neither I nor II ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

112. Debt is usually issued with a par value of a. $500. b. $0. c. $1000. d. $5000.

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

113. Which of the following is NOT one of the various types of long-term debt? a. Junior debentures b. Secured loans c. Senior debentures d. Preferred stock ANS: D PTS: 1 LOC: Understand stocks and bonds 114. The largest user of mortgage bonds is a. credit unions. b. commercial banks.

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

c. utility companies. d. small companies.

ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

115. Which of the following statements is/are correct about long-term loans?

I. Debentures are generally sold with a lower interest rate than mortgage bonds or secured bonds.

II. The quality of a debenture depends on the general creditworthiness of the issuing company. a. I only b. II only c. Both I and II d. Neither I nor II ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Types of long-term debt

116. An indenture on long-term debt does all of the following EXCEPT: a. It lists restrictions placed on the borrower by the lender. b. It specifies the manner in which the principal must be repaid. c. It allows the borrower to borrow extensively so that the interest may be regularly paid. d. It details the nature of the debt issue.

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of long-term debt

117. Mighty Mollusk, Inc. issued a 30-year bond which is callable in 8 years. It has a coupon rate of 5.5% payable semi-annually, a yield to maturity of 8% and a call premium of one year’s interest. What is the yield to call? a. 6.75% b. 13,67% c. 4.82% d. 11.42% ANS: D Solution using a calculator: First find the price of the bond: N = 30 X 2 I=82 PMT = 55  2 FV = 1000 Solve for PV = 717.21 Solve for Yield to Call: N=8X2 PV = - 717.21 PMT = 55  2 FV = 1055 Solve for I = 5.71 X 2 = 11.42% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Yield To Call Date 118. An advantage of preferred stock financing is: a. Preferred stockholders can vote for the Board of Directors and be an integral part of the

direction of the company. b. Preferred stock dividends are tax-deductible for the investor. c. Preferred stock dividends are flexible. The penalties for not paying a dividend are not severe. d. Preferred stock is the most preferred method of raising capital.

ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and Disadvantages of Preferred Stock Financing ESSAY 1. List the restrictions that an indenture places on the borrower of long-term debt.

ANS: 1. It thoroughly details the nature of the debt issue.

2. It specifies the manner in which the principal must be repaid.

3. It lists any covenants that are placed on the borrower. Among these are: a. a minimum interest coverage ratio that must be maintained. b. A minimum level of working capital that must be maintained. c. The maximum amount of dividends that the firm can pay on its preferred and common stock. d. Restrictions on further leasing or borrowing that the firm may utilize.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Features of Long-Term Debt

2. What is the collateral used in collateral trust bonds and who is its primary user?

ANS: Collateral trust bonds are backed by stocks or bonds of other corporations. This type of financing is principally used by holding companies whereby it pledges the stocks and/or bonds of its subsidiaries as collateral.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Types of Long-Term Debt

3. List the advantages and disadvantages of long-term debt financing: ANS: Advantages: 1. The firm has a relatively low after-tax cost due to the tax deductibility of interest.

2. The firm has increased earnings per share possible through financial leverage.

3. This type of financing allows the firm’s owners to maintain greater control over the firm.

Disadvantages: 1. This type of financing can increase the financial risk of the firm.

2. It may require that restrictions be placed on the firm by the lenders.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and Disadvantages of Long-Term Debt Financing

4. How does a firm value an asset?

ANS: The value of any asset is based on the expected future benefits that the owner will receive over the life of the asset. The cash flows are derived from increased revenues and/or reduced costs plus any salvage value received from the sale of the asset.

The value of a financial asset is based on the expected cash flows the asset will generate for the owner during the holding period. These payments are usually dividend payments or interest received while the asset is owned plus any money received when the asset is sold.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Valuation of Assets

Chapter 8—COMMON STOCK: CHARACTERISTICS, VALUATION, AND ISSUANCE MULTIPLE CHOICE 1. Which of the following is not a characteristic of common stock: a. has no maturity date b. considered a permanent form of long-term financing c. has claims on assets prior to those of preferred stock d. is a residual form of ownership ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Characteristics of common stock

2. Stockholders' equity includes all of the following except: a. Common stock at par b. Treasury stock c. Contributed capital in excess of par d. Retained earnings ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

3. The book value per share of common stock is calculated by dividing _______ by the number of shares outstanding a. market value of common stock b. total assets c. total stockholders' equity plus preferred stock d. total common stockholders' equity ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

4. The market value of common stock is primarily based on a. the firm's future earnings b. book value c. total assets d. retained earnings ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

5. Common stockholders have a number of general rights, including all of the following except: a. voting rights b. management rights c. asset rights d. dividend rights ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stockholder rights

6. The book value of an asset represents a. the market value b. the discounted cash flow value c. the historic acquisition cost of the asset d. stockholders' acquisition value ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

7. From an accounting standpoint, when a stock is split a. the number of shares outstanding does not change b. the firms' account balances are changed c. its par value is changed d. retained earnings will change ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

8. In a reverse stock split a. the number of shares are decreased b. the market value is decreased c. retained earnings decrease d. par value decreases ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

9. Which of the following is not an advantage of common stock financing? a. no fixed dividend obligation b. can lower the firm's weighted cost of capital c. allows the firm a greater degree of flexibility in financial planning d. involves relatively high flotation costs ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and disadvantages of common stock financing 10. AVIX has 6.8 million shares outstanding and the firm's charter provides for a majority voting procedure. The company has seven directors up for reelection. What is the minimum number of shares needed to ensure the election of one director? a. 850,001 b. 5,950,001 c. 3,400,001 d. there is no correct answer listed ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand stocks and bonds

TOP: Stockholder voting

11. A change in the market price of an asset will occur as a result of changes in: a. investors' required rates of return b. investors' expected returns from the asset c. book value of the asset d. investors’ required rates of return and their expected returns from the asset ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: A general dividend valuation model

12. In the constant-growth dividend valuation model, the required rate of return must be _______ the dividend growth rate in order for the formula price to be meaningful. a. less than b. equal to c. greater than d. proportional to ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

13. In the constant-growth dividend valuation model, the required rate of return on a common stock can be shown to be equal to the sum of the dividend yield plus: a. Yield-to-maturity b. Cost of capital c. Present value yield d. Price appreciation yield ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

14. The valuation of common stock is considerably more complicated than the valuation of bonds or preferred stocks because: a. The returns can take two forms, i.e. annual cash payments and price appreciation b. Common stock dividends are normally expected to grow and not remain constant c. The returns from common stocks are generally larger and more certain than the returns from bonds and preferred stocks d. The returns can be in annual cash payments or price appreciation, and they are normally expected to grow and not remain constant ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

15. Many preferred stocks are treated as _______ in determining their values. a. Fixed assets b. Perpetuities c. Convertible securities d. Constant growth securities ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Zero-growth dividend valuation model

16. In the valuation of common stock, the simple annuity and perpetuity formulas used in the valuation of bonds and preferred stock are not generally applicable because: a. Investors buy common stock for much different reasons than they buy bonds or preferred

stock. b. Returns accruing to common stock should never be capitalized (discounted) in order to determine a price. c. Unlike bonds and preferred stock, common-stock is a short term investment. d. Common stock dividends are normally expected to grow over time, rather than being constant as are payments on most bonds and most preferred stock.

ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

17. One of the assumptions of the constant growth dividend valuation model is that a. the investor's required rate of return is equal to the expected dividend yield. b. the required rate of return is greater than the dividend growth rate c. the required rate of return increases at a constant rate d. the dividend rate (in dollars) will remain constant ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

18. The most important factor to be considered in the valuation of a closely held firm is a. earnings growth b. book value of the firm c. earnings capacity d. the general economic outlook ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds TOP: Entrepreneurial finance: Valuation of closely held firms

NAT: Reflective thinking

19. Stockholders' equity equals a. both preferred stock and common equity b. total claims c. additional paid-in capital plus capital surplus d. total liabilities and total surplus ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

20. A common stock's book value is calculated a. as a multiple of the stock's price / earning ratio b. on the basis of income statement ratios c. on the basis of balance sheet figures d. on the value of income statement figures ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Common stock and accounting

21. When a stock is split 2 for 1, then the ______ figure on the firm's balance sheet is cut in half. a. value of the common stock b. par value c. capital surplus d. retained earnings ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

22. From an accounting standpoint, stock dividends involve a transfer from the a. common stock account b. cash account c. retained earnings account d. capital surplus account ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

23. Which one of the following is not a reason a firm may decide to repurchase its own stock. a. future corporate needs b. financial restructuring c. investment d. disposition of excess warrants ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

24. Dillinger, Inc. is planning to raise additional capital for expansion by selling 500,000 common shares at $16 each. The existing stockholders' equity section of their balance sheet is shown below. What will the retained earnings figure be immediately after the sale of the new equity?

Common stock; $1 par value; authorized, 3,000,000 shares; issued and outstanding, 3,000,000 shares Additional paid-in capital Retained earnings Total stockholders' equity a. b. c. d.

$ 3,000,000 6,500,000 4,752,000 $14,252,000

$12,252,000 $14,000,000 $4,752,000 $3,500,000

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Analytic skills TOP: Common stock and accounting

25. The returns investors receive from holding common stocks may be in two forms. They are a. cash dividend payments and capital gains b. future earnings and treasury stock c. stock splits and stock dividends d. cash dividends and stock dividends ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of common stock

26. The constant growth dividend valuation model does not hold when a. ke is greater than g b. dividends are growing faster than 4 percent c. g is greater than ke d. the current dividend is known ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

27. If the general level of interest rates in the economy moves up, then investors will require a _______ rate of return on securities, and, in general, stock prices should _______, ceteris paribus. a. lower, decline b. higher, increase c. higher, decline d. lower, increase ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: A general dividend valuation model

28. If competition in an industry increases, the future growth potential should a. decrease b. increase c. not be affected d. be negative ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Nonconstant growth dividend valuation model

29. The zero growth dividend valuation model is used when a firm's future dividends are expected to remain constant, a. so the value of the firm should also remain constant b. so the required rate of return should also remain constant c. and the firm can not be valued d. forever ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Zero growth dividend valuation model

30. When evaluating a firm based on price/earnings multiples, the evaluator must determine the price/earnings multiple for a. the general market b. the S&P 500 c. firms in the same industry d. small capitalization firms ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds TOP: Determination of an appropriate price-earnings multiple

NAT: Reflective thinking

31. The rights of stockholders to share equally on a per share basis in any distributions of corporate earnings is known as __________. a. preemptive rights b. voting rights c. asset rights d. dividend rights ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stockholder rights

32. __________ result in what is known as treasury stock. a. Stock dividends b. Stock repurchases c. Stock splits d. Reverse stock splits

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

33. A firm that wishes to raise additional equity capital by selling a portion of the existing owners' stock while maintaining control of the firm should consider a __________. a. stock split b. stock dividend c. share repurchase d. separate class of nonvoting stock ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other features of common stock

34. A firm may use a stock repurchase __________. a. as part of a financial restructuring b. to dispose of excess cash c. to reduce overhead d. as part of a financial restructuring and to dispose of excess cash ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock repurchases

35. A firm may use a stock repurchase for all of the following reasons except a. to dispose of excess cash b. to increase retained earnings c. as part of a financial restructuring d. to reduce takeover risk ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock repurchases

36. In the constant growth dividend valuation model, the required rate of return on a common stock is equal to the sum of the __________. a. capital gains yield and cost of capital b. present value yield and dividend yield c. cost of capital and dividend yield d. capital gains yield and dividend yield ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

37. In the constant growth dividend valuation model, it is assumed that the __________. a. dividend growth rate exceeds the required rate of return b. firm's future dividend payments are expected to grow at a constant rate forever c. dividend cannot be forecast for any future time d. firm is experiencing a period of poor performance, after which normal growth is expected ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Constant growth dividend valuation model

38. An arrangement whereby an investment banker agrees to purchase an entire new issue of securities is called a. competitive bidding b. syndication c. a negotiated bid

d. underwriting ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Public cash offerings

39. The difference between the selling price to the public of a new issue and the net the issuing firm actually receives is known as the a. negotiating spread b. underwriting spread c. bid spread d. SEC cost ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Direct issuance costs

40. A _______ is a group of underwriters who agree to underwrite a new issue in order to spread the risk. a. purchasing syndicate b. cartel c. bidding group d. financial institution ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Public cash offerings

41. All of the following are advantages of private security placements (over a public offering) except a. reduced flotation costs b. greater flexibility c. lower interest rates d. save time ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Private placements

42. A firm may sell its common stock directly to its existing stockholders through a a. private placement b. cash offering c. rights offering d. direct placement ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Rights offerings and standby underwriters

43. Direct issuance costs are a. higher for common stock than for preferred stock issues b. dependent on the quality of the issue c. dependent on the size of the issue d. all of the above are correct ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Direct issuance costs

44. In marketing a new security issue, the investment banker assumes the risk of not being able to sell the security at a favorable price in each of the following cases except: a. a best efforts offering b. a negotiated underwriting c. a competitively bid underwriting

d. assumes the risk in all of the above ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Public cash offerings

45. An investment banker is generally thought to be qualified to advise a corporation on a variety of matters, including all the following except: a. long range financial planning b. the marketing of securities c. the timing of securities d. the firm's new product marketing decisions ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: The security offering process: Role of the investment banker 46. In addition to direct costs, there are other costs associated with new security offerings. These other costs include all of the following except: a. the cost of incentives such as the "Green Shoe" option b. the cost of overpricing c. the cost of stock price declines d. the cost of management time ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other issuance costs

47. A procedure that allows a firm to file a master registration statement with the SEC and then sell an offering of common stock in small increments is known as ________. a. A Green Shoe option b. an IPO c. rule 215 d. a shelf registration ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Shelf registration

48. Which of the following are reasons why large multinational corporations may sell equity in international markets rather than selling stock only in the country in which they are domiciled? a. Global equity offerings result in higher price per share. b. The existence of a 12-hour per day trading schedule c. Higher positive returns around the time of the announcement to sell in global markets d. Private placements are not an option.

ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: International issues: global equity markets

49. From the following stock quotation, what is AT&T's dividend yield?

ATT 1.20 4.3 19 1667 29.50 29 29 -.25 a. 1.2% b. 12% c. 4.3% d. 19% ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Understanding stock quotations

50. The P/E ratio indicates a. how much investors are willing to pay for $1 of current earnings b. the current yield c. the current price d. how risky the stock is ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Understanding stock quotations

51. Common stock dividends normally are paid a. monthly b. quarterly c. semi-annually d. annually ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Understanding stock quotations

52. In stock quotations, the last column, showing the net change, indicates the net change in a. a share's price during the day b. the dividend yield c. the closing price from the previous day's close d. a share's high price during the day ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Understanding stock quotations

53. What is the value of a share of stock of HOV Inc. to an investor who requires a 12 percent rate of return if HOV's current dividend is $1.20? Assume earnings and dividends are expected to grow at a compound annual rate of 7 percent. a. $24.00 b. $18.34 c. $25.68 d. $19.62 ANS: C Solution: P0 = $1.20(1 + 0.07) / (0.12 - 0.07) = $25.68 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation 54. The current price of Zebar is $32.00 and the current dividend is $.60. What is an investor's required rate of return on Zebar if dividends are expected to grow perpetually at a compound annual rate of 8 percent? a. 9.88% b. 11.38% c. 18.75% d. 10.03% ANS: D Solution: ke = $0.60(1.08)/$32 + 0.08 = 10.03%

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation 55. Fast Wheels, Inc. expects to pay an annual dividend of $0.72 next year. Dividends have been growing at a compound annual rate of 6 percent and are expected to continue growing at that rate. What is the value of a share of stock of Fast Wheels to an investor who requires a 14 percent rate of return? a. $9.00 b. $5.14 c. $9.54 d. $8.16 ANS: A Solution: ke = $0.72/(0.14 - 0.06) = $9.00 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation 56. What is the current value of the common stock of the Limited if you know the current dividend yield is 6.14%, the PE is 16, and the annual dividend is $1.35? a. $21.60 b. $21.99 c. $8.29 d. $98.24 ANS: B Solution: Price = dividend/current yield = $1.35/0.0614 = $21.99 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Understanding stock quotations 57. Bell South pays a quarterly dividend of $0.70, has a PE ratio of 14 and closed yesterday at $48.25.

What is the dividend yield? a. 5.45% b. 1.45% c. 5.8% d. 7.25% ANS: C Solution: .70(4)/48.25 = .058 or 5.8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Understanding stock quotations 58. If the common stock of Comdisco pays an annual dividend of $0.28, has a PE ratio of 11 and closed at 25, what are the current earnings per share? a. $3.08 b. $2.27 c. $7.00 d. $1.12 ANS: B Solution:

EPS = P/PE = $25/11 = $2.27 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Understanding stock quotations 59. The quote for the common stock of ALLTEL showed a daily "Hi" of 40.50, and a "Lo" of 40 and a "Close" of 40.40. If the "Net Chg" was +0.50, then the previous close was ________. a. 39.90 b. 40.90 c. 40.40 d. 39.88 ANS: A Solution: 40.40 - 0.50 = 39.90 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Understanding stock quotations 60. If American Brands pays an annual dividend of $1.54, has a PE of 13, and its last closing price was 40, then its dividend yield must be: a. 11.85% b. 3.85% c. 15.40% d. 3.25% ANS: B Solution: $1.54/$40 = 0.0385 or 3.85% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Understanding stock quotations 61. Zero-Sum Enterprise expects to pay an annual dividend of $0.48 next year. Dividends and earnings have been growing at a compound annual rate of 8 percent and are expected to continue growing at that rate. What is an investor's required rate of return on Zero-Sum if the current price is $12? a. 12.3% b. 12.0% c. 10.0% d. 10.3 ANS: B Solution: ke = $0.48/$12 + 0.08 = 12% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation 62. Assume Zero-Sum Enterprise pays an annual dividend of $1.40 per share and that neither earnings nor dividends are expected to grow in the future. What is the value of Zero-Sum's stock to an investor who requires a 14 percent rate of return? a. $14.00 b. $10.00 c. $20.00 d. 0

ANS: B Solution: P0 = $1.40/0.14 = $10 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero growth dividend valuation 63. Over the past 7 years the dividends of Sunshine Mining have grown from $0.24 to the current level of $.53. What is the approximate annual compound growth rate of Sunshine's dividends? a. 20.8% b. 12.0% c. 9.5% d. 10.0% ANS: B Solution: $0.53/$0.24 = 2.2083 or approximately 12% from Table I PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Growth rate calculation 64. Assume that the dividend( $3.25) on Central Power Company's common stock issue is paid annually at the end of the year. This dividend is not expected to increase for the foreseeable future. Determine the value of this stock to an investor who requires a 12 percent rate of return. a. $3.25 b. $39 c. $12 d. $27.08 ANS: D Solution: P0 = $3.25/0.12 = $27.08 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero-growth valuation 65. During the past 8 years, Wellington Company's common stock dividends have grown from $2.00 to $3.19. Estimate the compound annual dividend growth rate over the 8 year period. a. 59.5% b. 6% c. 12% d. 19% ANS: B Solution: $2.00 = $3.19(PVIFg,8) (PVIFg,8) = $2.00/$3.19 = .627 g = 6%, from Table II PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Growth rate calculation

66. Wilshire Company's earnings and common stock dividends have been growing at an annual rate of 4 percent over the past several years. The firm currently (t = 0) pays an annual dividend of $4.00.

Assuming that Wilshire's common stock dividends continue growing at the past rate for the foreseeable future, determine the value of the company's common stock to an investor who requires a 13 percent rate of return on these securities. a. $44.44 b. $36.81 c. $46.22 d. $48.62 ANS: C Solution: P0 = $4.16/(0.13 - 0.04) = $46.22 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 67. What is the rate of return to an investor in the stock of Bajo, Inc. if the current dividend of $0.80 is not expected to change in the foreseeable future? The current price of Bajo is $13.25. a. 6.04% b. 8.0% c. 24.15% d. 11.06% ANS: A Solution: D/P0 = .80 = .0604 or 6.04% 13.25 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Zero growth rate valuation 68. The stock of Music City is selling for $37.50 and pays a current annual dividend of $1.10. What is the implied growth rate of dividends for this firm (assume dividends are expected to grow at a constant rate) if an investor's required rate of return is 14 percent? a. 11.07% b. 14.0% c. 11.4% d. 10.75% ANS: D Solution: $37.50 = $1.10(1 + g)/ (0.14 - g) g = 10.75% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 69. If the stock of Sun Computers is selling for $34 and the current dividend is $0.48, what is the implied constant growth rate of dividends to an investor who requires a 14% rate of return? a. 12.54% b. 12.41% c. 14.00% d. 15.41%

ANS: B Solution: 34 = .48(1+g)/(.14-g) g = 12.41% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 70. Phillips Industries common stock currently sells for $50 and is expected to pay a dividend of $3.00 next year. Determine the implied growth rate for Phillips Industries dividends assuming that an investor's required rate of return on this stock is 14%. a. 6% b. 8% c. 14% d. 20% ANS: B Solution: 0.l4 = $3.00/$50 + g g = 0.08 or 8% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 71. CPU Company currently (t = 0) pays a dividend of $2.50 per share on its common stock. Dividends are expected to increase at the rate of $.25 per share for the next several years. Determine the current value of CPU's common stock to an investor who expects to be able to sell the stock for $35 per share after 3 years, given that the investor requires a 14 percent rate of return on this security. a. $24 b. $30.54 c. $19.64 d. $68.75 ANS: B Solution: P0 = $2.75(0.877) + $3.00(0.769) + $3.25(0.675) + $35(0.675) = $30.54 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Non-constant growth rate valuation 72. What is the current value of Bandag Inc. to an investor who has a required rate of return of 12 percent?

The current dividend is $1.00 and the dividends are expected to grow 8 percent per year for 3 years. At the end of 3 years the investor expects to sell the security for $76. a. $79.51 b. $56.90 c. $51.13 d. $76.00 ANS: B Solution: $1(1.08) = $1.08(0.893) = $1.08(1.08) = $1.166(0.797) = $1.166(1.08) = $1.26(0.712) = $76(0.712) =

$0.964 $0.930 $0.897 $54.11

Total

=

$56.90

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Non-constant growth rate valuation 73. What is the current value of a share of HiGro common stock that does not pay a current dividend?

Earnings are growing at a 20 percent per year rate for the next 10 years. Assume the investor has a required rate of return of 15 percent and expects to sell the security in 5 years. Current earnings are $1.50 per share. a. $56.87 b. $62.21 c. $25.00 d. There is insufficient information to solve this problem.

ANS: D Solution: None of the answers are correct. There is insufficient information in the problem.

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: Non-constant growth rate valuation - with zero dividend

NAT: Analytic skills

74. What is the current value of a share of Augat common stock if its current dividend is $1.50 and dividends are expected to grow at the annual compound growth rate of 20 percent into the foreseeable future? Assume the investor has a required rate of return of 15 percent, and expects to sell the security in 5 years. a. $56.87 b. $30.00 c. $25.00 d. The constant growth rate model cannot be used because the growth rate is greater than the required rate of return.

ANS: D Solution: The constant growth rate model cannot be used because the growth rate is greater than required rate of return.

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 75. What is the current value of a share of Chyrox if its current dividend is $1.50 and dividends are expected to grow at an annual rate of 20 percent for the next 5 years? Assume the investor has a required rate of return of 15 percent and expects to sell the security in 5 years for $72. a. $44.31 b. $35.78 c. $39.63 d. $72.00 ANS: A Solution: $1.50(1.20) = 1.80(0.87) $1.80(1.20) = 2.16(0.756) $2.16(1.20) = 2.59(0.658) $2.59(1.20) = 3.11(0.572)

= $ 1.57 = 1.63 = 1.70 = 1.78

$3.11(1.20) = 3.73(0.497) $72(0.497) Total

= 1.85 = 35.78 = $44.31

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Non-constant growth rate valuation 76. The earnings and dividends of MicroSun Computer Co. are expected to grow at an annual rate of 15 percent over the next 4 years and then slow to a constant growth rate of 8 percent per year. MicroSun currently pays a dividend of $0.50 per share. What is the value of MicroSun stock to an investor who requires a 14 percent rate of return? a. $9.31 b. $15.73 c. $11.35 d. $2.04 ANS: C Solution: Year 1 2 3 4

$0.50(1.15) = 0.575(.877) = $0.575(1.15) = 0.661(.769)= $0.661(1.15) = 0.760(.675)= $0.760(1.15) = 0.874(.592)= P4 = $0.944/(0.14 - 0.08) = $15.73(0.592)=

Total

$0.504 .509 .513 .518 = $2.04 9.31 = $11.35

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Non-constant growth rate valuation 77. During the past 8 years, UTX Company common stock dividends have grown from $2.70 to $5.00 per share (currently). Determine the value of UTX common stock to an investor who requires a 16% rate of return, assuming that dividends continue growing for the foreseeable future at the same rate as over the past 8 years. a. $62.50 b. $31.25 c. $67.50 d. $46.96 ANS: C Solution: PV0 = FVn (PVIFg,n) $2.70 = $5.00 (PVIFg, 8) g = 0.08 (8%) from Table II P0 = $5.40/(0.16 - 0.08) = $67.50 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 78. Lawton Company common stock currently sells for $38 and pays (year 0) a dividend of $2. Determine the implied growth rate for Lawton assuming that an investor's required rate of return is 12% and that the stock can be evaluated using a constant growth valuation model. a. 6.74% b. 17.26%

c. 6.40% d. 3.80% ANS: C Solution: 0.12 = $2(1 + g)/$38 + g g = 0.064, or 6.4% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 79. Helix common stock currently sells for $30 and its current dividend is $1.50. If the required rate of return on Helix stock is 15%, what is the implied growth rate of its earnings and dividends? a. 13.5% b. 9.5% c. 10.0% d. 30.0% ANS: B Solution: 0.15 = $1.50(1+g) + g $30

so g = 0.095

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 80. Over the past 5 years, NBA's common stock earnings per share have grown from $0.62 to $0.91. If an investor is NBA stock is assumed to have a required rate of return of 14%, what is the current value of NBA if its current dividend is 0.12? Assume EPS will continue to grow at a constant rate. a. $2.16 b. $1.62 c. $4.94 d. $2.00 ANS: A Solution: $0.91 = $0.62(FVIFg,5) FVIF = $0.91/$0.62 = 1.468 so g = 8% P0 = $0.12(1.08)/(0.14 - 0.08) = $2.16 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 81. Morton Industries' common stock sells for $54. Dividends are expected to continue to grow at a rate of 8% annually. If investors in Morton require a 13% rate of return, what is the current dividend? a. $2.70 b. $2.50 c. $4.00 d. $3.25 ANS: B Solution: $54 =

D0(1.08) 0.13 - 0.08

D0 = $2.50 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 82. Pace Enterprises' common stock sells for $29, and its dividends are expected to grow at a rate of 9 percent annually. If investors in Pace require a return of 14%, what is the expected dividend next year? a. $1.33 b. $2.40 c. $1.45 d. $1.60 ANS: C Solution: $29 =

D0(1.09) 0.14 - 0.09

so D0 = 1.33 and D1= 1.33(1.09) =$1.45

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 83. The common stock of Kyocera currently sells for $88.50 and its current (D0) dividend is $1.10.

Determine the implied growth rate for Kyocera assuming that an investor's required rate of return is 14% and that earnings and dividends are expected to grow at a constant rate. a. 13.9% b. 12.3% c. 13.8% d. 12.6% ANS: D Solution: $89 =

$1.10(1+g) 0.14 - g

so g = 0.126 or 12.6%

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth rate valuation 84. Heleveton, Inc. currently pays a dividend of $1.20 per share. Dividends are expected to increase at the rate of $0.10 per share for the next eight years. Determine the current value of Heleveton's common stock to an investor who expects to be able to sell the stock for $28 after 5 years. Assume that the investor requires a 12 percent rate of return on the security. a. $66 b. $28 c. $21.20 d. $15.88 ANS: C Solution: P0 = $1.30(.893)+$1.40(.797)+$1.50(.712) $1.60(.636)+ $29.70(.567) = $1.1609+$1.1158+$1.068+$1.0176+$16.3399 = $21.20

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock valuation 85. Over the past 10 years the dividends of Allegro have grown from $0.45 to $1.82 per share. Determine the value of Allegro's common stock to an investor who requires a 20% rate of return, assuming that dividends continue growing at the same rate as they grew over the past 10 years. a. $36.40 b. $41.86 c. $43.68 d. $20.93 ANS: B Solution: P0 = FV(PVIFg,n) $.45 = $1.82(PVIFg,10) (PVIFg,10) = 0.247 g = 15% from Table II P0 = $1.82(1.15)/(0.20 - 0.15) = $41.86 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth valuation 86. Zimmer's common stock sells for $37 and its dividend is expected to grow at a rate of 8 percent annually. What is the expected dividend (D1) given that an investor requires a return of 16 percent? a. $2.74 b. $3.20 c. $5.92 d. $2.96 ANS: D Solution: $37 = D1/(0.16 - 0.08) D1 = $2.96 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth valuation 87. The earnings of Mylanta Company are expected to grow at an annual rate of 14% over the next 5 years and then slow to a constant rate of 10% per year. Mylanta currently pays a dividend of $0.36 per share.

What is the value of Mylanta's stock to an investor who requires a 16% rate of return? a. $7.97 b. $7.76 c. $14.42 d. $11.11 ANS: B Solution: Year 1 2 3 4 5

$.36(1.14) = $.410(.862) = .41(1.14) = .468(.743) = .467(1.14) = .533(.641) = 533(1.14) = .608(.552) = .608(1.14) = .693(.476) = P5 = $.693(1.10) / (0.16 - 0.10) = $12.71(0.476) =

$.352 .348 .342 336 .330 6.050

$7.758

Total

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Nonconstant growth valuation 88. During the past 10 years, Saturn's common stock dividends have grown from $0.24 to $0.62. If the past growth of dividends is expected to continue at the same rate in the future, what is the current value of Saturn's common stock to an investor who requires an 18% rate of return? a. $7.75 b. $3.79 c. $8.53 d. $10.42 ANS: C Solution: FV = P0(FVIFg,n) $.62 = $.24(FVIFg,10) (FVIFg,10) = 2.5833 g = 9.95 (or approx. 10%) P0 = $.62(1.10) / (0.18 - 0.10) = $8.53 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth valuation 89. HiGlo's common stock sells for $23.50 and its earnings are expected to grow at a rate of 12% annually.

What is the current dividend (Do) for an investor who requires a 15% return? a. $0.71 b. $0.63 c. $0.34 d. $0.31 ANS: B Solution: 23.50 =

Do(1.12) .15 - .12

Do = $0.63

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth valuation model 90. During the past 7 years, Lippo's earnings have grown from$0.78 to $1.95 per share. If the past growth rates are expected to continue into the future, what is the current value of Lippo's common stock to an investor who requires a 16% rate of return? a. $97.50 b. $13.93 c. $111.15 d. $48.50 ANS: C Solution: .78/1.95 = .4 = PVIF Po =

1.95(1.14) .16 - .14

i = 14% from Table II = $111.15

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth valuation model 91. Quantum, Inc. has 5.4 million shares outstanding and the firm's charter provides for cumulative voting.

The company has a twelve-member board of directors, all of whom are up for reelection. What is the minimum number of shares needed to ensure the election of one director? a. 450,001 b. 415,386 c. 431,251 d. 425,421 ANS: B Solution: Number of shares =

1x(5,400,000) + 1 = 415,386 12 + 1

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stockholder voting rights 92. AVIX has 6.8 million shares outstanding and the firm's charter provides for cumulative voting. The company has a seven member-board of directors, all of whom are up for reelection. What is the minimum number of shares needed to ensure the election of two directors? a. 850,001 b. 5,950,001 c. 3,400,001 d. 1,700,001 ANS: D Solution: # shares = 2 x 6,800,000 + 1 = 1,700,001 7+1 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stockholding voting 93. What is the estimated price of Once in a Blue Moon stock that has the following dividends? The return on similar investments is 18%. (Round the growth rate to the nearest whole percent) YEAR DIVIDENDS 2003 $2.50 2002 $2.48 2001 $2.36 2000 $2.32 a. b. c. d.

$17 $13 $22 $50

ANS: A Find the dividend growth rate using a calculator N= 3 PV = -2.32

FV = 2.50 Solve for I = 2.52% rounded to the nearest whole percent - Dividend growth rate is 3% To find the expected dividend = 2.50(1.03) = 2.58 Expected dividend (D1) is $2.58. $2.58 = $17.17 .18-.03 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation model 94. Listed below are some of the responsibilities of investment bankers. Which of the following is NOT one of them? a. They can purchase securities b. They market securities c. They directly influence the objectives and direction of the company. d. They arrange private loans and leases ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: The security offering process: Role of the investment banker 95. The zero growth method is used to value a. common stock b. required rate of return c. bonds d. preferred stock ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Zero-growth dividend valuation model

96. All of the following are ways that securities are offered to the public in a public offering EXCEPT: a. Securities are sold through competitive bidding b. Securities are sold through negotiated underwriting to a purchasing syndicate c. Securities are sold through excess-market pricing d. Securities are sold on a best efforts basis ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: The security offering process: Role of the investment banker 97. Which of the following statements is/are correct about the following stock quotation: +12.5 +.50

26

17.50

Dove Assoc.

DOA

.20

1.0

6

306

20.25

I. The second and third columns show the price range of the stock during the previous 52 weeks.

II. The highest price that was paid for this stock over a 52-week time period was $20.25. a. b. c. d.

I only II only Both I and II Neither I nor II

ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Understanding stock quotations

98. In a liquidation of a firm due to bankruptcy, which of the following usually gets paid last? a. bondholders b. preferred stockholders c. common stockholders d. employees wages ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stockholder rights

99. The returns from most common stocks are a. positively correlated with each other b. negatively correlated with each other c. uncorrelated with each other d. correlated to future forecasted earnings ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds TOP: Investment diversification and portfolio risk analysis

NAT: Reflective thinking

100. By-Your-Leave Travel Agency has reported the dividends listed below. What return could be expected? The price of the stock is $18. (Round the growth rate to the nearest whole percent) Years Dividends 2002 $1.12 2003 $1.15 2004 $1.18 2005 $1.21 2006 $1.24 a. b. c. d.

10.11% 12.02% 8.15% 9.74%

ANS: A Finding the growth rate by calculator: N= 4 PV = -1.12 FV = 1.24 Solve for I = 2.57 Rounded to 3% Find the next dividend D1: 1.24(1.03) = 1.28 1.28 + .03 = 10.11% 18 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Constant growth dividend valuation model 101. Chill Pill Pharmaceuticals is expecting a growth rate of 14% for the next two years due to its new drug. Thereafter it should level to an 8% growth rate. The last dividend paid was $.65 per share.

What price should the stock sell for if investors require 12% return. a. $18.14

b. $22.75 c. $19.47 d. $20.16 ANS: C Solution using a calculator: D1 .65(1.14) = .74 D2 .74(1.14) = .84 DL .82(1.08) = .91 .12 - .08

= 22.75

Find the PV of the Dividends and Price using a calculator: N=1 I = 12 FV = .74 Solve for PV = .66 N=2 I = 12 FV = .84 Solve for PV = .67 N=2 I = 12 FV = 22.75 Solve for PV = 18.14 .66 + .67 + 18.14 = $19.47 PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills LOC: Understand stocks and bonds TOP: Nonconstant growth dividend valuation model 102. Common stockholders’ claim on assets is considered after which of the following: a. Board of Director’s pay b. Preferred Stockholders c. Both a and b d. Neither a nor b ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE; Fact NAT: Reflective thinking TOP: Characteristics of common stock

ESSAY 1. List the various rights of common stockholders.

ANS: 1. Dividend rights - they share equally on a per-share basis in any distribution of corporate earnings.

2. Asset rights - in liquidation, they have the right to assets that remain after senior obligations have been satisfied.

3. Preemptive rights - they have the right to share proportionately in any new stock sold.

4. Voting rights - they have the right to vote on stockholder maters such as the selection of the board of directors.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Stockholder rights

2. What are the advantages and disadvantages of common stock financing?

ANS: Advantages: 1. There is no fixed-dividend obligation.

2. Common stock is less risky to the firm than fixed-income securities.

3. Are not restricted by restrictive covenants.

4. Common stock can lower the firm’s weighted cost of capital.

Disadvantages: 1. From the investor’s perspective, common stock is riskier than preferred stock or debt and may have a higher required rate of return.

2. It frequently results in an initial dilution of per-share earnings.

3. It involves relatively high issuance costs (flotation costs) when sold to the public.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Advantages and disadvantages of common stock financing 3. List the responsibilities of the investment bankers.

ANS: Investment bankers are an important source of financial market expertise and an important part of the security offering process.

They are involved in: 1. Long-range financial planning 2. The timing of security issues 3. The purchase of securities 4. The marketing of securities 5. The arrangement of private loans and leases 6. The negotiation of mergers PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: The security offering process: Role of the investment banker 4. What are some of the costs associated with new security offerings?

ANS: 1. There are direct costs called an underwriting spread or underwriting discount.

2. There is a cost of management time in preparing the offering.

3. There is the cost of underpricing which occurs because the new security is priced below the current or correct market price. This is due to the riskiness of the new security.

4. The cost of stock price declines for stock offerings by firms whose shares are already outstanding.

5. The cost of other incentives provided to the investment banker. This includes the overallotment or “Green Shoe” option. The option gives the investment banker the right to buy up to 15% of the new offering at a price equal to the offering price. This option normally lasts for 30 days.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: The security offering process: Role of the investment banker 5. Why do closely held firms need to have an outside appraiser to determine their value? What are the reasons for valuation?

ANS: In general a corporation’s value is determined by the marketability of its stock and its price as listed on an exchange. An active market for closely held firms normally does not exist. This necessitates using an independent appraiser to determine its value.

A firm needs to know its current value for: 1. Mergers and acquisitions, divestitures and liquidation 2. initial public offerings

3. estate and gift tax returns 4. leveraged buyouts 5. recapitalizations 6. employee stock ownership plans 7. divorce settlements 8. estate valuation 9. litigation PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Entrepreneurial issues: Valuation of closely held firms

Chapter 9—CAPITAL BUDGETING AND CASH FLOW ANALYSIS MULTIPLE CHOICE 1. The value of resources used in an investment project should be measured in terms of their a. acquisition cost b. historical cost c. opportunity cost d. depreciated cost ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Principles of estimating cash flows

NAT: Reflective thinking

2. Sale of an asset for less than book value creates an operating loss which effectively reduces the company's taxes by an amount equal to ________ times ________. a. one-half the loss, the company's marginal tax rate b. the loss, one minus the company's marginal tax rate c. one-half the loss, one minus the company's marginal tax rate d. the loss, the company's marginal tax rate ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value

NAT: Reflective thinking

3. There is neither a gain or a loss on the sale of a depreciable asset for an amount exactly equal to its _______. a. acquisition cost b. tax book value c. opportunity cost d. historical cost ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value

NAT: Reflective thinking

4. The ______ is a schedule of projects arranged in _______ order according to their expected rates of return. a. investment opportunity curve, ascending b. marginal cost of capital curve, ascending c. investment opportunity curve, descending d. marginal cost of capital curve, descending

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting

NAT: Reflective thinking

5. Which of the following would not be classified as a capital expenditure for decision-making purposes? a. purchase of a building b. investment in a management training program c. purchase of 90-day Treasury Bills d. development of a major advertising campaign ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

6. A firm's cost of capital is: a. an important financial ratio b. equal to 10 percent c. rarely used in practice d. an important input in the capital budgeting process ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of capital

7. The decision by the Municipal Transportation Authority to either refurbish existing buses, to buy new large buses, or to supplement the existing fleet with mini-buses is an example of: a. independent projects b. mutually exclusive projects c. contingent projects d. separable projects ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: How projects are classified

8. Which of the following is not a major difficulty in implementing the basic capital budgeting model? a. determining the schedule of available projects before a decision on any one project can be made b. accounting for the risk of individual projects. c. projecting the cost of funds over the investment decision horizon d. choosing an appropriate criterion for selecting among various investment alternatives ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting

NAT: Reflective thinking

9. Which of the following is not a major step in the capital budgeting process? a. generating investment project proposals b. estimating cash flows c. analyzing the effect of a project on the firm's financial ratios d. performing a project post-audit and review ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting

NAT: Reflective thinking

10. Which of the following is a basic principle when estimating a project's cash flows? a. cash flows should be measured on a pretax basis

b. cash flows should ignore depreciation because it is a non-cash charge c. only direct effects of a project should be included in cash flow calculations d. cash flows should be measured on an incremental basis ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net operating cash flows

11. Which of the following items is not considered as a part of the net investment calculation? a. the first year's net cash flow b. increase in net working capital c. salvage of an old piece of equipment that is being replaced d. installation and shipping charges ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net investment

12. The effect of a one dollar increase in depreciation expenses is to ________ the typical firm's net cash flows by _______ one dollar. a. increase, less than b. increase, exactly c. decrease, more than d. increase, more than ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Depreciation

13. The dollar amount of interest charges is: a. always considered in the net cash flow calculation b. normally not considered in the net cash flow calculation c. always considered as a part of the net investment d. never a consideration ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Interest charges and net cash flows

NAT: Reflective thinking

14. Determining the net investment (NINV) of a project includes explicit consideration of all of the following except: a. estimated net cash flow b. project cost plus installation and shipping costs c. increases in net working capital d. taxes associated with the sale of an existing asset and/or the purchase of a new one ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cash flows

NAT: Reflective thinking TOP: Net investment

15. Raider Productions has to decide whether to build its warehouse in Dallas or Houston. This decision falls into the class of: a. independent projects b. mutually exclusive projects c. contingent projects d. marginal projects ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: How projects are classified

16. The determination of net cash flows (NCF) should never include a. changes in depreciation b. changes in operating costs c. interest charges d. indirect effects ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Interest charges and net cash flow

NAT: Reflective thinking

17. Which of the following are (is) generally considered problems associated with cash flow estimation? a. uncertainty about the future cash flows b. the introduction of bias into the estimation of cash flows c. uncertainty about the magnitude of fixed cost financing charges d. uncertainty about the future cash flows and the introduction of bias into the estimation of cash flows ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Problems in cash flow estimation

NAT: Reflective thinking

18. Most firms choose accelerated depreciation methods because a. reported net income is higher b. tax payments are made sooner, resulting in a lower deferred tax liability c. operating expenses are correspondingly reduced d. income taxes are deferred ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Depreciation

19. Cash flows for all investment projects should be projected over the ________ of the project. a. MACRS recovery period b. depreciable life c. economic life d. smaller of depreciable or economic lives ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net operating cash flows

20. When a firm sells an asset for _________, it realizes a capital gain and must pay income taxes on it. a. book value b. less than book value c. more than book value but less than original cost d. more than its original cost ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value

NAT: Reflective thinking

21. _______ is the term used when the initial cost of all acceptable capital budgeting projects is greater than the total funds the firm has available. a. Profit maximization b. Funds constraint c. Mutually exclusive d. Contingent

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Availability of funds

22. In estimating the net investment, an outlay that has already been made is known as a (n) _________. a. sunk cost b. cash outflow c. opportunity cost d. expansion cost ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Principles of estimating cash flows

NAT: Reflective thinking

23. Depreciation is based on the asset cost plus all of the following except a. shipping costs b. increase in inventory c. installation d. cost of attached equipment acquired at the same time ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Depreciation

24. Depreciation ______ reported profits and it ______ taxes paid by a firm. a. increases, reduces b. reduces, reduces c. reduces, increases d. increases, increases ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net operating cash flows

25. If a firm sells an asset for less than its book value, a. there are no tax consequences b. the loss is treated as lost depreciation c. the loss reduces depreciation expenses d. the loss may be used to offset operating income ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value

NAT: Reflective thinking

26. The _______ the amount of depreciation charged in a period, the _________ will be the firm's taxable income. a. greater, lower b. lower, lower c. lower, greater d. greater, higher ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital 27. In terms of the capital budgeting process, net cash flows are a. the net cash outlays required to place a project in service. b. the funds invested in additional assets. c. incremental changes in a firm's cash flow.

NAT: Reflective thinking TOP: Depreciation

d. the outlays that have already been made.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Summary

28. A recent survey of Fortune 500 firms regarding their cash flow estimation procedures indicated that a. few firms prepared formal cash flow estimates b. the majority produced detailed cash flow projections c. a majority estimated cash flows for a range of estimates d. about 50 percent made comparisons between actual and projected cash flows.

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The practice of cash flow estimation

NAT: Reflective thinking

29. Depreciation a. does not affect cash flows. b. does not affect profits. c. is not a cash outflow. d. is a cash inflow.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Depreciation

30. The capital budgeting process is very important to the firm because it: a. highlights the impacts of a project on net income b. essentially plots the company's future direction c. is used in working capital analysis d. indicates the net cash flows available for employee education ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

31. A (n) __________ is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than 1 year. a. depreciation charge b. operating expenditure c. capital expenditure d. capital gain ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

32. The set of investment projects arranged in descending order according to their expected rates of return is known as the __________. a. marginal cost of capital schedule b. schedule of mutually exclusive projects c. schedule of contingent projects d. simplified capital budgeting model ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting

NAT: Reflective thinking

33. A(n) __________ project is one whose acceptance is dependent on the adoption of one or more other projects.

a. b. c. d.

contingent mutually exclusive independent perfectly correlated

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: How projects are classified

34. The net cash flows for any year during the life of capital expenditure project are equal to the change in __________ plus the change in __________. a. earnings before interest and taxes; depreciation b. earnings before taxes; depreciation c. earnings after taxes; depreciation d. revenues; costs ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net cash flows

35. The net investment calculation for an __________ project normally includes __________. a. asset expansion; pretax proceeds from the sale of the old asset b. asset replacement; pretax proceeds from the sale of the old asset c. asset expansion; after-tax proceeds from the sale of the old asset d. asset replacement; after-tax proceeds from the sale of the old asset ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Calculating the net investment

NAT: Reflective thinking

36. There is a capital gain on the sale of an asset for __________. a. more than its original cost b. more than its book value but less than its original cost c. its depreciation value d. its net present value ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value

NAT: Reflective thinking

37. The net investment calculation for an asset replacement decision normally includes any a. after-tax salvage value of the old asset b. increase in net working capital c. after-tax salvage value of the old asset and increase in net working capital d. cannot be computed ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Calculating the net investment

.

NAT: Reflective thinking

38. When calculating the net cash flow in a project's expected final year, a. recovery of any working capital invested is disregarded b. the after-tax salvage value of any project equipment is considered c. the remaining principal on any borrowed funds is considered d. the sales proceeds from any land associated with the project is disregarded ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Net operating cash flows

39. When managers knowingly bias estimates of cash flows from investment projects in order to serve their personal objectives, they are ________. a. performing management by exception b. increasing their total compensation c. departing from the shareholder wealth maximization goal d. increasing their confidence level ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Ethical issues: cash flow estimation biases

NAT: Reflective thinking

40. Capital expenditure projects may be classified in all the following types except: a. growth opportunities b. required to meet legal requirements c. cost reduction opportunities d. capital rationing ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Classifying investment projects

NAT: Reflective thinking

41. _____ have cash flow patterns with more than one sign change. a. conventional projects b. non-normal projects c. normal projects d. contingent projects ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Principles of estimating cash flow

NAT: Reflective thinking

42. A drill press costs $30,000 and is expected to have a 10 year life. The drill press will be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. This machine is expected to reduce the firm's cash operating costs by $4,500 per year. If the firm is in the 40 percent marginal tax bracket, determine the annual net cash flows generated by the drill press. a. $4,500 b. $900 c. $5,700 d. $3,900 ANS: D Solution: NCF = $(0 - ($-4,500) - $3,000)(1 - 0.40) + $3,000 = $3,900 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

43. An investment project is expected to generate earnings before taxes (EBT) of $60,000 per year.

Annual depreciation from the project is $30,000 and the firm's tax rate is 40 percent. Determine the project's annual net cash flows. a. $48,000 b. $66,000 c. $36,000 d. $52,000

ANS: B Solution: NCF = $60,000(1 - 0.40) + $30,000 = $66,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

44. Ten years ago J-Bar Company purchased a lathe for $250,000. It was being depreciated on a straight-line basis to an estimated $25,000 salvage value over a 15 year period. The firm is considering selling the old lathe and purchasing a new one. The new lathe would cost $500,000. The firm's marginal tax rate 40 percent. Determine the net investment required to purchase the new lathe, if the old lathe is sold for $100,000. a. $380,000 b. $397,500 c. $400,000 d. $418,000 ANS: C Solution: New lathe cost Less: Salvage value (old lathe) Net investment

$500,000 -100,000* $400,000

*Book value (old lathe) = $250,000 - 10[($250,000 - $25,000)/15] = $100,000. Because book value equals salvage value, no gain or loss is incurred on sale of old lathe.

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

45. Little Giant is building a manufacturing plant that will require a cash outlay of $300,000 for the initial purchase of a building, $450,000 for remodeling the first year, and $710,00 for new equipment in the second year. If the firm's cost of capital is 12 percent, what is the present value of the net investment at time 0? a. $1,460,000 b. $1,132,070 c. $1,267,720 d. $300,000 ANS: C Solution: PV of NINV = $300,000 + $450,000 (0.893) + $710,000(0.797) = $1,267,720 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

46. In Step Video is considering expanding its video rental library to 8,000 tapes. The purchase price of the additional videos will be $80,000 and the shipping cost is another $4,000. To house the tapes, the owner will have to spend another $10,000 for display shelves, increase net working capital by $5,000, and interest expenses will add another $8,000 to the operating cost. What is the net investment to In Step Video for this project? a. $95,000 b. $99,000 c. $84,000

d. $107,000 ANS: B Solution: NINV = $80,000 + $4,000 + $10,000 +$5,000 = $99,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

47. What is the net investment for an extruder that costs $42,000, if shipping costs are $1,500 and installation is $4,800? Assume this efficient machine is replacing an older extruder with a book and market value of zero. The replacement investment will reduce operating costs by $6,600 a year. a. $48,300 b. $54,900 c. $43,500 d. $51,000 ANS: A Solution: NINV = $42,000 + $1,500 + $4,800 = $48,300 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

48. Shunt Technology will spend $800,000 on a piece of equipment that will manufacture fine wire for the electronics industries. The shipping and installation charges will be $240,000 and net working capital will increase $48,000.The equipment will replace an existing machine that has a salvage value of $75,000 and a book value of $125,000. If Shunt has a current marginal tax rate of 34 percent, what is the net investment? a. $1,030,000 b. $1,163,000 c. $1,033,000 d. $996,000 ANS: D Solution: NINV = $800,000 + $240,000 + $48,000 - $75,000 - $17,000* = $996,000 * ($125,000 - $75,000)(0.34) = $17,000 tax saving on loss PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

49. Capital Foods purchased an oven 5 years ago for $45,000. The oven is being depreciated over its estimated 10-year life using the straight line method to a salvage value of $5,000. Capital is planning to replace the oven with a more automated one that will cost $150,000 installed. If the old oven can be sold for $30,000, what is the tax liability? Assume a marginal tax rate of 40 percent. a. $900 b. $2,000 c. $127,000 d. $25,000 ANS: B Solution: Book Value = $45,000 - 5($45,000 - $5,000)/10 = $25,000 Tax liability = ($30,000 - $25,000)(0.4) = $2,000

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Tax effects of salvage

50. The management of Jasper Equipment Company is planning to purchase a new milling machine that will cost $160,000 installed. The old milling machine has been fully depreciated but can be sold for $15,000. The new machine will be depreciated on a straight line basis over it's 10 year economic life to an estimated salvage value of $10,000. If this milling machine will save Jasper $20,000 a year in production expenses, what are the annual net cash flows associated with the purchase of this machine?

Assume a marginal tax rate of 40 percent. a. $15,000 b. $18,000 c. $27,000 d. $21,000 ANS: B Solution: Depreciation/yr. = ($160,000 - $10,000)/10 = $15,000 NCF = ($20,000 - $15,000)(1 - 0.4) + $15,000 = $18,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

51. Jim Bo's currently has annual cash revenues of $240,000 and annual operating expenses of $185,000 including $35,000 in depreciation. The firm's marginal tax rate is 40 percent. A new cutting machine can be purchased for $120,000 will increase revenues by $50,000 per year while operating expenses would increase to $205,000, including $42,000 in depreciation. Compute Jim Bo's annual incremental after-tax net cash flows. a. $25,000 b. $20,800 c. $93,000 d. $19,000 ANS: A Solution: NCF = ($50,000 - $20,000)(1 - 0.4) + $7,000 = $25,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

52. Moon Pie Company is considering automated baking equipment that costs $500,000 installed and would replace the present hand-made production method. The present equipment has a zero book and salvage value. The new equipment will not increase revenues but will reduce operating costs from a current level of $600,000 to $300,000 per year. The depreciation of the new equipment will be $73,000 per year. What are the annual incremental net cash flows? Assume a marginal tax rate of 40 percent. a. $296,800 b. $136,200 c. $192,200 d. $209,200 ANS: D Solution: NCF = ($300,000 - $73,000)(1 - 0.4) + $73,000 = $209,200

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

53. LISP Inc. is planning to purchase a new mixer/dubber for $50,000. The new equipment will replace an older mixer that has been fully depreciated but has a salvage value of $5,000. Compute the net investment required for this project. Assume a marginal tax rate of 40 percent. a. $47,000 b. $45,000 c. $48,000 d. $55,000 ANS: A Solution: NINV = $50,000 - $5,000 + $5,000(0.4) = $47,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

54. LISP Inc. is planning to purchase a new mixer for $50,000 that will qualify as MACRS 3-year property (first year depreciation rate = 33.33%). The new mixer should increase revenues by $20,000 per year with no increase in operating cost. If LISP's marginal tax rate is 40 percent, what is the net cash flow in the first year? a. $22,665 b. $19,000 c. $18,666 d. $21,500 ANS: C Solution: Dep. = $50,000(.333) = $16,665 NCF =($20,000 - $16,665) (1 - 0.4) + 16,665 = $18,666 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Net cash flow calculation with MACRS

NAT: Analytic skills

55. Outback is purchasing a new machine that will cost $98,000. The machine will qualify as MACRS 5-year property but has an economic life of 8 years. The new machine is expected to increase revenues by $35,000 per year and operating costs are expected to increase by $15,000 per year. If the firm's marginal tax rate is 34 percent and the first year's depreciation rate is 20 percent, what is the net cash flow in the first year. a. $264 b. $7,984 c. $19,864 d. $26,034 ANS: C Solution: NCF = ($35,000 - $15,000 - $19,600)(1 - 0.34) + $19,600 = $19, 864 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Net cash flow calculation with MACRS

NAT: Analytic skills

56. What is the net investment required for a pitting machine that will cost $35,000 including installation?

The machine replaces a machine that cost $5,000 when purchased five years ago. The old machine has been fully depreciated but has a market value of $6,000. Assume the marginal tax rate is 40 percent. a. $29,000 b. $31,400 c. $32,600 d. $34,505 ANS: B Solution: NINV = $35,000 - $6,000 + $6,000(0.4) = $31,400 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

57. Allen Company is considering an investment project that is expected to generate $100,000 in annual earnings before taxes. Annual depreciation will be $50,000. Allen's marginal tax rate is 40%.

Determine the project's annual net cash flows. a. $150,000 b. $110,000 c. $90,000 d. $60,000 ANS: B Solution: NCF = EBT (1 - T) + Dep = $100,000 (1 - 0.40) + $50,000 = $110,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow

58. Baker Company is considering an investment in a new metal lathe. If the new lathe is purchased, revenues will increase by $5,000 per year and cash operating costs will decline by $10,000 per year.

The lathe will cost $60,000 and will be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. Baker's marginal tax rate is 40%. Determine the annual net cash flows generated by the lathe. a. $11,400 b. $9,000 c. $600 d. $5,400 ANS: A Solution: NCF = ( R - 0 - Dep) (1 - T) + Dep = [$5,000 - (-$10,000) - $6,000] (1 - 0.40) + $6,000 = $11,400 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow

59. Basin Manufacturing (40% marginal tax rate) is considering a plant expansion project. The equipment will cost $100,000 and will require an additional $10,000 for delivery and installation. The expansion also will require Basin to increase immediately its net working capital by $25,000. The expansion is expected to generate revenues of $150,000 per year. Calculate the project's net investment. a. $ 81,000

b. $125,000 c. $131,000 d. $135,000 ANS: D Solution: NINV = $100,000 + $10,000 + $25,000 = $135,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment

60. Maritech purchased a pellet mill 4 years ago for $60,000. The mill is being depreciated over 7 years using MACRS. Maritech is planning to replace the mill with a higher volume unit that will cost $110,000 installed. If the old mill can be sold for $25,000, what is the tax liability? Assume a marginal tax rate of 40%. Use the rounded MACRS schedule listed below.

(7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $3,754 b. $7,498 c. $2,560 d. $16,502 ANS: C Solution: Book value = $60,000 X .31 = $18,600 OR 60,000 - (60,000 X .69) = 18,600 Tax liability = (25,000 - 18,600)(.4) = $2,560 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Tax liability

61. Rupp Pumps is purchasing an extruder for $80,000. The extruder will require an expenditure of $12,000 for installation and $4,000 for training new operators. The new equipment will require an increase of $5,000 in inventory, $4,000 in accounts receivable, and $3,000 in accounts payable. What is the net investment for this project? a. $108,000 b. $102,000 c. $ 98,000 d. $ 99,000 ANS: B Solution: NINV = $80,000 + $12,000 + $4,000 + (5,000+4,000-3,000) = $102,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment

62. Airstat is replacing an old stamping line that cost $80,000 five years ago, with a new, more efficient machine that will cost $225,000. Shipping and installation will cost an additional $20,000. The old machine has a book value of $15,000 but will be sold as scrap for $5,000. The new machine will be depreciated with a 7 year life under MACRS guidelines. With the increased production, inventories will increase $4,000, accounts receivable will increase $16,000, and accounts payable will increase $14,000. If Airstat has a marginal tax rate of 40 percent, what is the net investment? a. $274,000 b. $242,000 c. $260,000 d. $274,000

ANS: B Solution: NINV = $225,000 + $20,000 - $5,000 - $10,000(0.4) + $4,000 + $16,000 - $14,000 = $242,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment calculation

63. Ripstart is replacing an old, fully depreciated stamping line with a more efficient machine that will cost $245,000. The line will be depreciated as a 7-year MACRS asset. With the increased production, Ripstart expects revenues to increase by $55,000, and operating expenses to increase by $20,000. If Ripstart expects to sell the new machine at the end of year 5 for $40,000, compute the net cash flow in the fifth year. The MACRS depreciation rate during the fifth year is 8.93% and the accumulated MACRS depreciation after five years totals 77.69 percent of the cost of the asset. Assume the firm's marginal tax rate is 40 percent and that company does get to take the full benefit of year 5 depreciation. a. $29,751 b. $53,736 c. $75,615 d. $69,751 ANS: C Solution: Dep5 = 245,000(0.0893) = 21,878.50 Book value at the end of year 5 = $245,000 - $245,000 (0.7769) = $54,659.50 NCF5 = ($55,000 - $20,000 - $21,878.50)(1 - 0.4) + $21,878.50 +$40,000 + ($54,659.50 - $40,000)0.4 = $7,872.90 + $61,878.50 + $5,863.80 = $75,615.20 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Net cash flow calculation with MACRS and salvage

NAT: Analytic skills

64. Felix Industries purchased a grinder 5 years ago for $15,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It could be sold now for $6,000. The firm is considering selling it and purchasing a new one. The new grinder would cost $25,000 installed and would be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. The company's marginal tax rate is 40%. Determine the net investment if the old grinder is sold and the new one purchased. a. $19,000 b. $16,600 c. $17,400 d. cannot be computed ANS: C Solution: Cost of grinder (installed) Proceeds from sale of old grinder Net investment before taxes Tax saving on loss ($10,000 - $6,000 = $4,000) from sale of old grinder ($4,000 x 0.40) Net investment (NINV) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

$25,000 - 6,000 $19,000 - 1,600 $17,400

NAT: Analytic skills TOP: Net investment

65. Consider a capital expenditure project with an expected 10-year economic life and forecasted revenues equal to $40,000 per year; cash expenses are estimated to be $29,000 per year. The cost of the project equipment is $23,000, and the equipment's estimated salvage value at the end of the project is $9000.The equipment's $23,000 cost will be depreciated using MACRS depreciation (7-year asset).

The project requires a $7,000 working capital investment in year 0 and another $5,000 in year 5. The company's marginal tax rate is 40%. Calculate the expected net cash flow in year 10 of the project. a. $32,000 b. $27,000 c. $24,000 d. $18,000 ANS: C Solution: NCF10 = ($40,000 - $29,000)(1 - 0.4) + $12,000 + $9,000(1 - 0.4) = $24,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Cash flow calculation

66. The Johnson Drum Company is planning to build a new factory. The purchase of the land, building the plant, and installation of equipment will take place over a two year period. The following are planned cash outflows: Year 0 1 2

Cash Outflow $3,500,000 $4,750,000 $6,100,000

Johnson Drum's cost of capital is 14%, and its marginal tax rate is 35%. What is the NINV measured in present value terms today? a. $14,350,000 b. $12,356,650 c. $ 9,327,500 d. $ 8,035,788 ANS: B Solution: Year

Cash Outflow

PVIF

PV of NINV

0 1 2

$3,500,000 $4,750,000 $6,100,000

1.000 0.877 0.769

3,500,000 4,165,750 4,690,900 $12,356,650

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Net investment determination

NAT: Analytic skills

67. Anderson Clayton will purchase a new pellet mill that replace an older, less efficient, mill. The new mill costs $360,000 and shipping costs are $10,000. Improving the steam lines to the new mill will cost an additional $22,000. The old mill has a book value of $25,000 and can be sold for $12,000. The installation of the new mill will cause inventories to increase by $8,000, accounts receivable will go up $20,000, and accounts payable will increase $10,000. If Anderson Clayton has a marginal tax rate of 40%, what is the NINV for the new mill?

a. b. c. d.

$392,800 $412,800 $374,800 $398,000

ANS: A Solution: Installed cost Less: salvage Less: tax savings on sale Add: increase in NWC

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Net investment determination

$392,000 - 12,000 - 5,200 18,000 $392,800

NAT: Analytic skills

68. A Lotta Bread Corp. is replacing an entire baking line that was purchased for $420,000 and currently has a book value of $60,000. The new, more efficient line, will cost $940,000 installed and can be depreciated as a 7-year MACRS asset. With the increased efficiency, Lotta expects annual revenues to increase by $425,000, and operating expenses to increase by $170,000. The older machine, which was being depreciated at the straight-line rate of $20,000/year, will be sold for $30,000. What are the net cash flows for year 2? Assume the firm's marginal tax rate is 40% and that the year 2 depreciation rate is 24.49%. a. $26,996 b. $332,206 c. $237,082 d. $383,206 ANS: C Solution: Year 2 depreciation = $940,000(0.2449) = $230,206 Change Dep (Yr. 2) = $230,206 - $20,000 = $210,206 NCF2 = ($425,000 - $170,000 - $210,206)(0.6) + $210,206 = $237,082 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Net cash flow calculation with MACRS

NAT: Analytic skills

69. Parker Chemicals purchased a hexene extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It can be sold today for $10,000.

Parker is considering purchasing a new more efficient extractor that would cost $270,000 installed and would be depreciated as a 10-year MACRS asset. The company's marginal tax rate is 40%. Determine the NINV if the old extractor is sold and the new one is purchased. a. $252,000 b. $228,000 c. $260,000 d. $248,000 ANS: D Solution: Cost of extractor Sale of old extractor Tax savings

$270,000 - 10,000 - 12,000

NINV =

$248,000

Dep.(old extractor) = $120,000/15 = $8,000 per year Book value (old extractor = $120,000 - $80,000 = $40,000 Tax savings = ($40,000 - $10,000)(0.4) = $12,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment

70. Parker Chemicals purchased a hexene extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It can be sold today for $10,000.

Parker is considering purchasing a new more efficient extractor that would cost $270,000 installed and would be depreciated as a 10-year MACRS asset. (The depreciation rate for year one is 10 percent for this asset.) The company's marginal tax rate is 40%. If the new extractor is purchased, annual revenues will increase by $10,000 and annual operating expenses will decrease by $10,000. What is the net cash flow in year 1? a. $ 7,600 b. $19,600 c. $24,200 d. $600 ANS: B Solution: Dep. (old extractor) = $120,000/15 = $8,000/year Dep1(new extractor) = $270,000(.10) = $27,000 NCF = ($10,000 - (-$10,000) - $19,000)(1- 0.4) + $19,000 = $19,600 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow calculation

71. Com-Cat is considering expanding their current production facility. This year Com-Cat had an operating income (EBIT) of $760,000, interest expenses of $120,000, depreciation expenses of $45,000, and capital expenditures of $160,000. Next year, after the expansion is completed, operating income is expected to be $880,000, interest expenses will remain at $120,000, but depreciation will increase to $61,000. To support the expansion, cash is to expected to increase by $5,000, accounts receivable by $12,000, inventories by $8,000, and accounts payable by $7,000. What is the change in Com-Cat's net operating cash flows attributable to this project, if the tax rate is 40%? a. $80,400 b. $88,000 c. $106,000 d. $70,000 ANS: D Solution: NCF = ($880,000 - $760,000)(1 - 0.40) + ($61,000 - $45,000) - ($5,000 + $12,000 + $8,000 - $7,000) = $70,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow

72. The Weis Corp. purchased a new conveyor system to replace an older less automated system. The old system, which was 10 years old, was being depreciated on a straight line basis over its 20-year life at $25,000 per year. The new system will be depreciated as a 7-year asset for MACRS purposes. The more efficient machine, which costs $520,000 installed, will reduce operating costs by $74,000 per year. Compute the net cash flows in year 3 for the new system. Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $71,840 b. $80,779 c. $68,600 d. $149,917 ANS: A Solution: Dep3 = $520,000(0.18) = $93,600 NCF3 = [$74,000 - ($93,600 - $25,000)](1 - 0.40) + ($93,600 - $25,000) =$71,840 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow

73. Seduck has just replaced a set of hydraulic screens that had been in operation for 6 years with a newer screening system that cost $180,000 installed. The old system cost $140,000 and had been depreciated as a 10-year MACRS asset. Its salvage value is $10,000. What is the NINV for the new equipment?

Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (10-Year Depreciation Schedule: 10%, 18%, 14%, 12%, 9%, 7%, 7%, 7%, 7%, 6%, 3%)

a. b. c. d.

$170,000 $157,200 $202,514 $151,228

ANS: B Solution: Book value = $140,000(.30) = $42,000 Tax savings = ($42,000 - $10,000).40 = $12,800 Cost Salvage Tax savings NINV PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

$180,000 - 10,000 - 12,800 $157,200

NAT: Analytic skills TOP: Net investment

74. Martin Tartans, Inc. is considering the purchase of a new argyle sock knitting machine to replace a less automated one. The new machine will cost $220,000 plus $30,000 for shipping and installation. The machine being replaced was purchased five years ago for $140,000 and depreciated as a 7-year MACRS property. It can be sold for $24,000. Boll Mills has a marginal tax rate of 35%. Compute the NINV for the project. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. b. c. d.

$250,000 $226,000 $221,298 $223,620

ANS: D Solution: Book value = $140,000(0.22) = $30,800 Tax savings = ($30,800 - $24,000)(0.35) = $2380 New Machine Cost $220,000 Cost of Shipping & Installation $ 30,000 Salvage of Value of Old Machine ($24,000) Tax Savings ($ 2,380) Net Investment $223,620 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment

75. Pixaire purchased a new mixer to replace an older system. The older system which cost $100,000 is 5 years old now and was being depreciated over a MACRS life at 7 years. The new mixer, which will cost $270,000, will also be depreciated as a 7 year asset for MACRS purposes. The new mixer is expected to increase revenues by $64,000 with no additional operating expenses. Determine the net operating cash flows in year 2 for the new mixer. Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $66,974 b. $66,124 c. $61,277 d. $64,229 ANS: C Solution: Change in depreciation = 270,000(.25) - 100,000(.09) = $58,500 CF = (64,000 - 58,500)(1-.4) + $58,500 = $61,800 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net operating cash flows

76. Rough & Tumble Clothiers is considering the purchase of a new loom to replace a less efficient one.

The new machine will cost $240,000 including installation. The machine being replaced was purchased 5 years ago for $150,000 and is being depreciated as a 7-year MACRS property. It can be sold for $40,000. Compute the NINV for this project if KC has a marginal tax rate of 40%. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $200,000 b. $197,386 c. $202,614 d. $216,000 ANS: C Solution: Book value = $150,000 X .22 = $33,000 Tax on gain from sale = ($40,000 - 33,000) X .40 = $2,800 Cost of new machine $240,000 Salvage value of old machine ( $40,000) Tax due on sale of old machine $2,800 Net investment $202,800

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net investment

77. Adler is replacing its old packing line with a more efficient line. The old line was being depreciated on a straight-line basis at a rate of $20,000 per year. The old machine has a current book value of $100,000. The new line, which costs $910,000, will be depreciated on a 10-year MACRS schedule.

The more efficient operation is expected to increase revenues by $50,000 per year and reduce annual operating costs by $80,000. Compute the net cash flows for Adler in year 2. Assume Adler has a marginal tax rate of 40%. Use the rounded MACRS schedule listed below: (10-Year Depreciation Schedule: 10%, 18%, 14%, 12%, 9%, 7%, 7%, 7%, 7%, 6%, 3%)

a. b. c. d.

$143,520 $135,520 $39,520 $47,520

ANS: B Solution: Dep2 = $910,000(0.18) = $163,800 Change in depreciation = $163,800 - $20,000 = $143,800 NCF2 = [$50,000 - ($-80,000) - $143,800](1 - 0.40) + $143,800 = $135,520 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net cash flow

78. The difference between a capital expenditure and an operating expenditure is that a capital expenditure: a. is expected to generate returns greater than 10% b. involves replacement of a money market account with three-month treasury bills. c. is expected to to generate future cash benefits lasting longer than one year. d. involves a combined effort of the accounting department and the marketing department.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

79. Of the following, an example of a component of a firm’s cost of capital is: a. Repurchase of company stock. b. Investment of corporate funds into a money market account. c. The purchase of another company’s bonds. d. The return on common stock required by investors.

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Key terms and concepts in capital budgeting: Cost of capital 80. A contractor has a team of plumbers and assigns those plumbers to a new construction site. The fact that the plumbers are unavailable for any other job makes the construction site project a/an: a. independent project b. qualified project c. mutually exclusive project d. contingent project ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Key terms and concepts in capital budgeting: How projects are classified

ESSAY 1. List the steps that a firm uses in the capital budgeting process: ANS: The steps in the process are: 1. Generate capital investment project proposals.

2. Estimate cash flows.

3. Evaluate alternatives and select projects to be implemented.

4. Review the project’s performance after it has been implemented, and post auditing the performance of the project after its termination.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting 2. What are some of the different outlays that may be classified as capital expenditures?

ANS: 1. The purchase of new equipment, real estate, or a building for improved service or expansion purposes.

2. The replacement of existing equipment.

3. Expenditures for an advertising campaign.

4. Expenditures for research and development.

5. Investments in permanent increases of target inventory or levels of accounts receivable.

6. Employee education and training 7. The refunding of an old bond issue 8. Lease-versus-buy analysis 9. Merger and acquisition evaluation.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Introduction 3. What are the principles that should be applied when estimating cash flows for capital budgeting purposes?

ANS: 1. Cash flows should be measured on an incremental basis.

2. Cash flows should be measured on an after-tax basis.

3. All the indirect effects of a project should be included in the cash flow calculations.

4. Sunk costs should not be considered when evaluating a project.

5. The value of resources used in a project should be measured in terms of their opportunity costs.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Principles of estimating cash flows 4. There are four ways tax consequences may affect the after-tax net proceeds received from the sale of an asset. Describe the four ways and the tax impact.

ANS:

1. Sale of an asset for its book value: There is no gain or loss on the sale and thus no tax consequences.

2. Sale of an asset for less than its book value: This results in a capital loss thus reducing the company’s tax liability equal to the loss times the company’s marginal tax rate.

3. Sale of an asset for more than its book value but less than the original purchase price: The IRS treats this transaction as a recapture of depreciation and the firm’s taxes increase by the gain times the marginal tax rate.

4. Sale of an asset for more than its original purchase price: This transaction results in recaptured depreciation for all money received up to the purchase price. The difference between the sale price and the original purchase price is treated as a capital gain which is taxed at the capital gains rate for corporations. The end result is taxes due on the recaptured depreciation plus taxes due on the long-term capital gain.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Recovery of after-tax salvage value 5. List the reasons that the marginal cost of capital schecule increases as more funds are sought in the capital markets.

ANS: The reasons that the MCC schedule increases are: 1. Investors’ expectations about the firm’s ability to successfully undertake a large number of new projects.

2. The business risk to which the firm is exposed because of its particular line of business.

3. The firm’s financial risk, which is due to its capital structure.

4. The supply and demand for investment capital in the capital market.

5. The cost of selling new stock, which is greater than the cost of retained earnings.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Basic framework for capital budgeting 6. In classifying investment projects, there are several types of capital expenditures. List them.

ANS: Projects can be grouped as: 1. Projects generated by growth opportunities.

2. Projects generated by cost reduction opportunities.

3. Projects generated to meet legal requirements and health and safety standards.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Generating capital investment project proposals: Classifying investment projects.

Chapter 10—CAPITAL BUDGETING: DECISION CRITERIA AND REAL OPTION CONSIDERATIONS MULTIPLE CHOICE 1. Multiple internal rates of return can occur when there is (are): a. large abandonment costs at the end of a project's life b. a major shutdown and rebuilding of a facility sometime during its life

c. more than one sign change in the pattern of cash flows over a project's life. d. all of the above are correct ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 2. The _______ measures the present value return for each dollar of initial investment. a. payback period b. internal rate of return c. net present value d. profitability index ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Profitability index 3. The payback method is at best a crude measure of the risk of a project because it fails to consider the _______ of a project's returns. a. liquidity b. variability c. timing d. magnitude ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback period

4. According to the profitability index criterion, a project is acceptable if its profitability index is a. greater than 1 plus the cost of capital b. greater than 0 c. greater than or equal to 1 d. greater than 1.1 ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Profitability index 5. The payback period of an investment is defined as: a. the number of years required for cumulative profits from a project to equal the initial outlay. b. the number of years required for the cumulative cash flows from a project to equal the initial outlay. c. the number of years required for the cumulative cash flows from a project to equal the average investment in the project, when depreciation is considered. d. a period of time sufficient to earn a rate of return equal to the firm's cost of capital.

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback period

6. The advantages of the payback approach include all of the following except: a. it is easy to compute b. it considers a project's liquidity c. it considers cash flows, not net income d. it provides an objective measure of profitability ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital

TOP: Payback period

7. The disadvantages of the payback approach include: a. cash flows after the payback period are ignored in the calculation b. payback ignores the time value of money c. payback fails to provide an objective decision-making criterion d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback period

8. One weakness of the internal rate of return approach is that: a. it does not directly consider the timing of the cash flows from a project b. it fails to provide a straightforward decision-making criterion c. it implicitly assumes that the firm is able to reinvest the interim cash flows from a project at the firm's cost of capital. d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 9. The relationship between NPV and IRR is such that: a. both approaches always provide the same ranking of alternative investment projects. b. the IRR of a project is equal to the firm's cost of capital if the NPV of a project is $0. c. if the NPV of a project is negative, the IRR must be greater than the cost of capital. d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 10. When a project has multiple internal rates of return: a. the analyst should choose the highest rate to compare with the firm's cost of capital. b. the analyst should choose the lowest rate to compare with the firm's cost of capital c. the analyst should choose the rate that seems most "reasonable", given the project's cash flows, to compare with the firm's cost of capital. d. the analyst should compute the project's net present value and accept the project if its NPV is greater than $0 ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 11. The profitability index (PI) approach: a. fails to directly consider the timing of a project's cash flows b. considers only a project's contributions to net income and does not consider cash flow effects c. always gives the same accept-reject decisions for independent projects as does NPV and IRR d. always gives the same accept-reject decisions for mutually exclusive projects as does NPV and IRR ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital

TOP: Profitability index 12. In the case of mutually exclusive projects, NPV and PI are likely to yield conflicting decisions when: a. the projects require the same net investment b. the projects are significantly different in size c. multiple rates of return are a possibility d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Profitability index

13. The objective in solving capital rationing problems is to: a. accept all projects with a PI greater than 1.1 b. maximize the IRR of the projects that are accepted c. maximize the NPV of the projects that are accepted d. minimize the opportunity cost of the firm's funds ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital rationing and the capital budgeting decision

NAT: Reflective thinking

14. Which of the following is not a technique to handle the capital rationing problem? a. linear programming b. goal programming c. ranking projects according to payback d. ranking projects according to profitability index ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital rationing and the capital budgeting decision

NAT: Reflective thinking

15. In order to compensate for inflation in capital budgeting procedures, it is necessary to: a. use constant dollar estimates of costs and revenues b. use a low discount rate to avoid double counting for inflationary effects c. rely heavily on the payback procedures d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Inflation and capital expenditures

NAT: Reflective thinking

16. If a net present value analysis for a normal project gives an NPV greater than zero, an internal rate of return calculation on the same project would yield an internal rate of return ___________ the required rate of return for the firm. a. greater than b. less than c. equal to d. cannot be determined from the information given ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 17. When two or more normal ________ projects are under consideration, the profitability index, the net present value, and the internal rate of return methods will yield identical accept/reject signals.

a. b. c. d.

coincident mutually exclusive independent none of the above

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Profitability index

18. The net present value method assumes that the cash flows over the life of the project are reinvested at a. the computed internal rate of return b. the risk-free rate c. the market capitalization rate d. the firm's cost of capital ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: NPV vs. IRR: The reinvestment rate assumption

NAT: Reflective thinking

19. The internal rate of return method assumes that the cash flows over the life of the project are reinvested at: a. the risk-free rate b. the firm's cost of capital c. the computed internal rate of return d. the market capitalization rate ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: NPV vs. IRR: The reinvestment rate assumption

NAT: Reflective thinking

20. In the absence of capital rationing, the ________ method is normally superior to the ___________ method when choosing among mutually exclusive investments. a. net present value, internal rate of return b. internal rate of return, profitability index c. net present value, profitability index d. a and c ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Profitability index

21. Generally, the _______ is considered to be a more realistic reinvestment rate than the ____________. a. risk-free rate, internal rate of return b. internal rate of return, cost of capital c. cost of capital, internal rate of return d. risk-free rate, cost of capital ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: NPV vs. IRR: The reinvestment rate assumption

NAT: Reflective thinking

22. The profitability index is the ratio of the ________ to the _______. a. net present value, net investment b. net investment, net present value c. present value of future net cash flows, net investment d. net investment, present value of future net cash flows ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital

TOP: Profitability index

23. With the net present value approach, all net cash flows are discounted at the a. required rate of return b. discount rate c. cost of capital d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net present value

24. If the net present value of an investment project is positive then the: a. project would be unacceptable under the internal rate of return method b. project would be acceptable under the payback method c. project's rate of return is greater than the firm's cost of capital d. all of the above are correct ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net present value

25. The "value additivity principle" means that the a. firm should accept all projects with a positive net present value. b. firm's value is the sum of the value of all the projects undertaken c. firm will grow through the addition of new projects d. positive net present value is added to the firm's net worth ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net present value

26. The internal rate of return does not take into account the a. explicit risk of the net cash flows b. magnitude of cash flows over the project's life c. net investment d. timing of cash flows over the entire life of a project ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 27. The net present value method assumes that cash flows are reinvested at the _________, whereas the internal rate of return method assumes that cash flows are reinvested at the _________. a. discount rate, required rate of return b. cost of capital, market rate of return c. firm's cost of capital, computed internal rate of return d. marginal cost of capital, discount rate ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: NPV vs. IRR: The reinvestment rate assumption 28. All of the following are reasons why a firm may face capital rationing except: a. reluctant to issue additional debt b. the discount rate is too high c. lacks the managerial resources d. restrictive covenants that limit borrowing

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital rationing and the capital budgeting decision

NAT: Reflective thinking

29. Which of the following would increase the net present value of a project? a. increase in the net investment b. use of straight line depreciation rather than MACRS c. decrease in the expected accounts payable d. decrease in the discount rate ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Net present value

30. The reason for a postaudit is to a. help financial managers reduce errors in cash flow estimation b. reduce the number of accepted risky projects c. reduce the number of projects submitted d. determine the correct required rate of return ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Reviewing and post-auditing an accepted project

NAT: Reflective thinking

31. A capital expenditure project has an expected 20 percent internal rate of return and a $10,000 net present value. It has one cash flow sign change. a. The discount rate used to calculate NPV is greater than 20 percent b. The project has another internal rate of return in addition to the 20 percent rate mentioned above c. In the internal rate of return calculation, the project's cash inflows are assumed to be reinvested at the firm's required rate of return d. None of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Net present value and internal rate of return

NAT: Reflective thinking

32. The value additivity principle indicates that, when a firm undertakes an independent project, the value of the firm is increased by the __________ from the project. a. present value of the cash inflows b. sum of the cash inflows and outflows c. net present value d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Advantages and disadvantages of the NPV method

NAT: Reflective thinking

33. When dealing with __________ cash flows, the __________ is computed by trial and error. a. uniform; internal rate of return b. perpetual; internal rate of return c. uneven; internal rate of return d. uneven; net present value ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital

TOP: Internal rate of return 34. The __________ is interpreted as the __________ for each dollar of initial investment. a. net present value; present value return b. profitability index; cash flow return c. profitability index; present value return d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Profitability index

35. The __________ of an investment is the period of time for the __________ to equal the initial cash outlay. a. profitability index; present value of the cash inflows b. payback period; cumulative cash inflows c. payback period; present value of the cash inflows d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback (PB) period

36. The profitability index would be __________ if the present value of the net cash flows (NCF) over the life of a project were __________. a. negative; less than zero b. negative; less than the net investment c. zero; equal to the net investment d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Profitability index

37. Which of the following investment decision rules (if any) assumes that the cash flows generated are reinvested over the life of the project at the firm's cost of capital? a. payback period b. internal rate of return c. accounting rate of return d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: NPV vs. IRR: The reinvestment rate assumption 38. The __________ approach takes into account both the magnitude and timing of cash flows over the entire life of a project in measuring its economic desirability. a. payback period b. accounting rate of return c. average rate of return d. internal rate of return ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Advantages/disadvantages of internal rate of return method 39. There are many reasons why a firm can earn above-normal profits. These reasons include all of the following except:

a. b. c. d.

access to superior labor or managerial talents superior access to financial resources at lower costs patent control of superior product designs ability of new firms to acquire necessary factors of production

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Sources of positive net present value projects

NAT: Reflective thinking

40. Real options in capital budgeting can be classified in all of the following ways except: a. abandonment option b. investment option c. purchasing power option d. shutdown options ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Real options in capital budgeting

NAT: Reflective thinking

41. Generally, the existence of a(n) __________ option reduces the downside risk of a project and should be considered in project analysis. a. designed-in b. abandonment c. investment timing d. output expansion ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Real options in capital budgeting

NAT: Reflective thinking

42. When evaluating international capital expenditure projects, the analyst may compute the present value of the net cash flows in the local currency and then __________. a. discount by one plus the spot rate (1+ S0) b. multiply by the forward exchange rate c. discount by the future exchange rate d. multiply by the spot exchange rate ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: International issues

43. Capital expenditures levels tend __________ (in real terms) during periods of relatively high inflation than during low inflation times. a. to be higher b. to be lower c. to be the same d. to depend on business risk ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Inflation and capital expenditures

NAT: Reflective thinking

44. The reasons that the amount and timing of the net cash flows to the foreign subsidiary and parent may differ include: a. subsidized loans b. differential tax rates

c. legal and political constraints on cash remittance d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: International issues

45. Entrepreneurial firms with a net worth of less than $1 million tend to prefer the __________ method for evaluating capital expenditures. a. NPV b. IRR c. Payback d. Profitability index ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Entrepreneurial finance issues

NAT: Reflective thinking

46. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm's cost of capital is 12 percent.

Determine the payback period for the project. a. 0.28 years b. 1.4 years c. 3.57 years d. 17.86 years ANS: C Solution: PB = $100,000/$28,000 = 3.57 years PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Payback

47. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm's cost of capital is 12 percent.

Determine the net present value for the project. a. $940 b. $100,940 c. $ 77,884 d. $ 40,000 ANS: A Solution: NPV = 28,000(PVIF0.12,5) - 100,000 = $28,000(3.605) - 100,000 = $940 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

48. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm's cost of capital is 12 percent.

Determine the internal rate of return for the project (to the nearest tenth of one percent). a. 12.0% b. 12.6% c. 3.6% d. 12.4%

ANS: D Solution: $100,000/$28,000 = 3.571 From Table IV, PVIFAr, 5 = 3.571, which falls between 3.605 (12%) and 3.517 (13%). r = 12.38% (calculator) or 12.4% (rounded) PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 49. The Atlantic Company plans to open a new branch office in a suburban area. The building will cost $200,000 and will be depreciated (on a straight-line basis) over a 20 year life to a $0 estimated salvage value. Equipment for the building will cost an additional $100,000. This equipment has a 20-year life and will be depreciated on a straight-line basis to a $0 estimated salvage value. The branch office is expected to generate additional before tax net income of $30,000 per year. The tax rate is 40 percent and the cost of capital is 12 percent. Compute the net present value for the project. a. $-63,523 b. $+246,477 c. $+53,523 d. $-53,523 ANS: D Solution: NPV = $300,000 / 20 = 15,000 $30,000 X .60 = 18,000 $33,000(PVIFA0.12,20) - $300,000 = $-53,523 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

50. An investment project requires a net investment of $100,000 and is expected to generate annual net cash inflows of $25,000 for 6 years. The firm's cost of capital is 12 percent. Determine the profitability index for this project. a. 1.50 b. 1.028 c. .028 d. .972 ANS: B Solution: PI = [$25,000(PVIFA0.12,6)]/$100,000 = [$25,000(4.111)]/$100,000 = 1.028 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Profitability index

51. A project requires a net investment of $450,000. It has a profitability index of 1.25 based on the firm's 12 percent cost of capital. Determine the net present value of the project. a. $ 112,500 b. $ 562,500 c. $1,012,500 d. $ 140,625 ANS: A

Solution: PI = PV of NCF/NINV = 1.25 = PV of NCF/$450,000 PV of NCF = $562,500 NPV = PV of NCF - NINV =$ 562,500 -$450,000 = $112,500 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Profitability index

52. What is the net present value of a project that requires a net investment of $76,000 and produces net cash flows of $22,000 per year for 7 years? Assume the cost of capital is 15 percent. a. $ 91,520 b. $ 15,520 c. $ 78,000 d. $167,474 ANS: B Solution: NPV = $22,000(4.160) - $76,000 = $15,520 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

53. Would you invest in a project that has a net investment of $14,600 and a single net cash flow of $24,900 in 5 years, if your required rate of return was 12 percent? a. Yes - the NPV is $862.90 b. No - the NPV is -$1,975.70 c. No - the NPV is -$481.70 d. Yes - the NPV is $165.70 ANS: C Solution: NPV = $24,900(0.567) - $14,600 = -$481.70 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

54. Sigma is thinking about purchasing a new clam digger for $14,000. The expected net cash flows resulting from the digger are $9,000 in year 1, $7,000 in the 2nd year, $5,000 in the 3rd year, and $3,000 in the 4th year. Should Sigma purchase this digger if its cost of capital is 12 percent? a. Yes, NPV = $3,176 b. Yes, NPV = $5,084 c. Yes, NPV = $16,605 d. Yes, NPV= $19,084 ANS: B Solution: NPV = $9,000(0.893) + $7,000(0.797) + $5,000(0.712) + $3,000(0.636) - $14,000 = $5,084 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

55. What is the internal rate of return for a project that has a net investment of $76,000 and net cash flows of $20,507 per year for 7 years? a. 16%

b. 17% c. 18.2% d. 19% ANS: D Solution: PVIFAr,7 = $76,000/$20,507 = 3.706 Therefore, IRR = 19% from Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 56. What is the internal rate of return for a project that has a net investment of $14,600 and a single net cash flow of $25,750 in 5 years? a. 10% b. 12% c. 15.3% d. 13.1% ANS: B Solution: PVIFr,5 = $14,600/$25,750 = 0.567 Therefore, IRR = 12% from Table II PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return; knowledge of capital budgeting and cost of capital TOP: Internal rate of return 57. What is the internal rate of return for a project that has a net investment of $150,000 and net cash flows of $40,000 for 5 years? a. between 10% and 11% b. between 9% and 10% c. between 11% and 12% d. between 12% and 13% ANS: A Solution: PVIFAr,5 = $150,000/$40,000 = 3.750, therefore, IRR is between 10% and 11% (from Table IV) PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 58. Using the profitability index, which of the following mutually exclusive projects should be accepted?

Project A: NPV = $6,000; NINV = $50,000 Project B: NPV = $10,000; NINV = $120,000 Project C: NPV = $8,000; NINV = $80,000 a. A b. B c. C d. all projects should be accepted ANS: A Solution:

PIA = $56/$50 = 1.12 PIB = $130/$120 = 1.08 PIC = $88/$80 = 1.1 Therefore, choose project A PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Profitability index

59. Turntec is considering replacing an automatic shuttle machine that has a book value of $2,000 and a $0 market value with a more efficient machine that will cost $24,000. The annual net cash flows from the new equipment are expected to be $6,000 for the next 6 years. What is the net present value of this project? Assume the firm's cost of capital is 12 percent and it's marginal tax rate is 40 percent. a. $666 b. $1,466 c. $1,866 d. - $134 ANS: B Solution: NPV = -$24,000 + $2000(.4) + $6,000(4.111) = $1,466 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

60. GoFlo is a small growing firm that is considering the purchase of another truck to serve GoFlo's expanding customer base. The new truck will cost $21,000 and should generate annual net cash flows of $6,000 over the truck's 5-year life. What is the payback period for this project? a. 3 years b. 4.2 years c. 3.5 years d. 3.3 years ANS: C Solution: PB = $21,000/$6,000 = 3.5 years PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Payback

61. Hydroponics is considering adding another greenhouse that would cost $95,000 and generate $20,000 in annual net cash flows over it's 8 year expected life. The greenhouse would be depreciated on a straight-line basis to zero and the salvage value is also expected to be zero. If the firm has a marginal tax rate of 40 percent, what is this project's internal rate of return? a. between 20 and 24% b. between 13 and 14% c. between 28 and 32% d. between 7 and 8% ANS: B Solution: PVIFAr,8 = $95,000/$20,000 = 4.75, which is between 13 and 14 percent in Table IV PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return; Knowledge of capital budgeting and cost of capital

TOP: Internal rate of return 62. Red Lake Mines, Inc. is considering adoption of a new project requiring a net investment of $10 million. The project is expected to generate 5 years of net cash inflows of $5 million per year. In the project's sixth, and final year, it is expected to have a net cash outflow of $1 million. What is the project's net present value, using a discount rate of 12 percent? a. about $8.52 million b. about $8.00 million c. about $7.52 million d. none of the above ANS: C Solution: NPV = - $10 + $5(3.605) - $1(0.507) = 7.52, or $7.5 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

63. Calculate the profitability index for a project that has a net present value equal to -$10,000. The project's net investment is $20,000, and the firm has a 40 percent marginal tax rate. a. -0.5 b. 0 c. 0.8 d. None of the above ANS: D Solution: PI = $10,000 / $20,000 = 0.5 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Net present value and profitability index

NAT: Analytic skills

64. A project requires a net investment of $100,000. At the firm's cost of capital of 10%, the project's profitability index is 1.15. Determine the net present value of the project. a. $15,000 b. $215,000 c. $115,000 d. none of the above/cannot be determined ANS: A Solution: PI = PV of NCF/NINV 1.15 = PV of NCF/$100,000 PV of NCF = $115,000 NPV = PV of NCF - NINV = $115,000 - $100,000 = $15,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Relationship between PI and NPV

NAT: Analytic skills

65. What is the NPV of a project that required a net investment of $500,00 and produced net cash flows of $150,000 per year for 5 years and $110,000 for the next 5 years? Assume the cost of capital is 14%. a. $211,080

b. $392,580 c. $588,710 d. $160,920 ANS: A Solution: NPV = -500,000 + 150,000(3.433) + 110,000 (5.216 - 3.433) = 211,080 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net Present Value

66. Kinetics is considering a project that has a NINV of $874,000 and generates net cash flows of $170,000 per year for 12 years. What is the NPV of this project if Kinetics cost of capital is 14%? a. $252,760 b. $110,840 c. $88,200 d. $47,570 ANS: C Solution: NPV = -$874,000 + $170,000(5.660) = $88,200 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: NPV

67. Using the profitability index, which of the following projects should be accepted?

Project M: Project N: Project O: a. b. c. d.

NPV = $60,000 NPV = $10,000 NPV = $2,000

NINV = $200,000 NINV = $30,000 NINV = $5,000

Project M Project N Project O All projects should be accepted

ANS: D Solution: PI-M = 260,000/200,000 = 1.3 PI-N = 40,000/30,000 = 1.33 PI-O = 7000/5000 = 1.4 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Profitability index

68. ZPS Models is considering a project that has a NINV of $564,000 and generates net cash flows of $105,000 per year for 10 years. What is the NPV of this project if ZPS has a cost of capital of 12.45%? a. $47,625 b. $18,503 c. $17,490 d. none of the above ANS: B Solution:

NPV = -$564,000 + $582,503 = $18,503 (by calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: NPV

69. Decode Genetics purchased lab equipment for $600,000 that will generate net cash flows of $130,000 per year for 10 years. What is the IRR for this project? a. 16.76% b. 17.26% c. 18.13% d. 17.76% ANS: B Solution: IRR=17.26 (by calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: IRR

70. Maplewood Creations is considering the purchase of a new truck to replace an old truck that has a book value of $2,500 and a market value of $800. The annual depreciation expense on the old truck was $500. The new truck, which will cost $29,000, will reduce operating costs $9,000 per year over it's 6 year economic life. The new truck has a 5-year MACRS life and an estimated salvage value at the end of 6 years of $2,000. If Maplewood has a 40 percent marginal tax rate and a cost of capital of 12 percent, what is the NPV of the new truck? Use the Depreciation schedule listed below: (5-Year depreciation Schedule: 20%, 32%, 19%, 12%, 12%, 5%) a. $1,517 b. $3,233 c. $29,037 d. $836 ANS: A Solution: NINV = $29,000 - $800 - ($2,500 - $800)(0.4) = $27,520 To determine the cash inflows: [(Savings - Book Value of new truck per year - Depreciation on old truck) X (1tax rate)] + depreciation

NCF1 = (9,000 - 5,800 - 500)(.6) + 5,300 = $6,920 NCF2 = (9,000 - 9,280 - 500)(.6) + 8,780 = $8,312 NCF3 = (9,000 - 5,510 - 500)(.6) + 5,010 = $6,804 NCF4 = (9,000 - 3,480 - 500)(.6) + 2,980 = $5,992 NCF5 = (9,000 - 3,480 - 500)(.6) + 2,980 = $5,992 NCF6 = (9,000 - 1,450)(.6) + 1,450 + 2,000(0.6) = $7,180 NPV @ 12% = $973.46 using a calculator PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

71. What is the net present value of a project that has a net investment of $148,000 and net cash flows of $25,000 in the first year, $45,000 in years 2-7 and a negative net cash flow of $27,000 in year 8?

Assume the cost of capital is 11 percent. a. $34,302 b. $74,847 c. $57,738 d. -$2,238

ANS: A Solution: NPV = $25,000(0.901) + $45,000(4.712 - 0.901) - $ 27,000(0.434) -$148,000 = $22,525 + $171,495 - $11,718 - $148,000 = $34,302 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

72. What is the internal rate of return for a project that has a net investment of $169,165 and net cash flows of $25,000 in the first year and 40,000 in years 2-7? a. 12.5% b. 13% c. 12% d. 13.5% ANS: C Solution: IRR = 12% (calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Internal rate of return

73. What is the internal rate of return for a project that has a net investment of $60,000 and the following net cash flows: Year 1 = $15,000; Year 2 = $20,000; Year 3 = $25,000; Year 4 = $30,000? a. 17.3% b. 16.7% c. 15.7% d. 16.3% ANS: D Solution: IRR = 16.3% (calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Internal rate of return

74. Road Hawk Inc. is adding a new production line that will cost $720,000. The line will be depreciated on a straight-line basis over a 7-year period and will generate net cash flows of $160,000 in each of the 7 years. At the end of the project, it is expected the line can be sold as scrap for $10,000. If the firm's marginal tax rate is 40% and it's required rate of return is 14 percent, what is the net present value of this project? a. $70,091 b. -$27,920 c. $64,091 d. -$31,520 ANS: D Solution: NPV= $-720,000 + $160,000(4.288) + $10,000(0.6)(0.400) = $-31,520 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

75. Consider a capital expenditure project that has forecasted revenues equal to $32,000 per year; cash expenses are estimated to be $29,000 per year. The cost of the project equipment is $23,000, and the equipment's estimated salvage value at the end of the project is $9,000. The equipment's $23,000 cost will be depreciated on a straight-line basis to $0 over a 10-year estimated economic life. Assume that the project requires an initial $7,000 working capital investment. The company's marginal tax rate is 30%. Calculate the project's net present value using a 12% discount rate. a. about -$10,610 b. about -$12,530 c. about -$ 9,954 d. about +$9,462 ANS: C Solution: NINV = $23,000 + $7,000 = $30,000 NCF1-9 = ($32,000 - $29,000 - $2,300)(1 - 0.3) + $2,300 = $2,790 NCF10 = $2,790 + $7,000 + 9,000(0.7) = $16,090 NPV = -$9,954 (using calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

76. Calculate the net present value for an investment project with the following cash flows using a 12 percent cost of capital: Year Net Cash Flow a. b. c. d.

0 $-100,000

1 $80,000

2 $80,000

3 $-30,000

$56,560 $30,000 $13,840 cannot be determined with information given

ANS: C Solution: NPV = NCFt - NINV = $80,000 (0.893) + 80,000 (0.797) - $30,000 (0.712) - $100,000 = $13,840 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Net present value

77. Indexx, a maker of disease-detection systems based on biotechnology is considering purchasing some diagnostic equipment that costs $380,000. Shipping and installation costs will be an additional $30,000. The equipment will be depreciated based on a 3-year MACRS life. Revenues from the new equipment should be $400,000 the first year and increase 15% each year over the expected 5-year economic life. Operating expenses should be $250,000 the first year and these expenses will increase 10% each year. At the end of 5 years the equipment will be obsolete and have no salvage value.

Should Indexx invest in this new equipment? Assume Indexx has a cost of capital of 15% and a marginal tax rate of 40%. Use the depreciation schedule listed below: (3 Year Depreciation Schedule: 33.33%, 44.45%, 14.81%, 7.41%) a. Yes, NPV = $175,573 b. Yes, NPV = $161,296 c. Yes, NPV = $456,406 d. No, NPV is negative

ANS: B Solution: NCF1 = (400,000 - 250,000 - 136,653)(.6) + 136,653 = $144,661 NCF2 = (460,000 - 275,000 - 182,245)(.6) + 182,245 = $183,898 NCF3 = (529,000 - 302,500 - 60, 721)(.6) + 60,721 = $160,188 NCF4 = (608,350 - 332,750 - 30, 381)(.6) + 30,381 = $177,512 NCF5 = (699,603 - 366,025)(.6) = $200,147 NPV = -$410,000 + $144,661(0.870) + $183,898(0.756) + $160,188(0.658) + $177,512(0.572) + $200,147(0.497) = $161,296 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: NPV calculation with uneven cash flows

NAT: Analytic skills

78. Ecogen is considering the purchase of some new equipment that will cost $340,000 installed. The equipment will produce a product that must be FDA approved and this will require at least a year. Net cash flow in Year 1 will be a negative $110,000 but is expected to be a positive $50,000 in Year 2. Net cash flows will be $150,000, $240,000, and $330,000 in the next 3 years. At the end of 5 years the equipment and the product will be obsolete. If the firm's marginal tax rate is 40% and their costs of capital is 15%, should they invest in the new equipment? a. Yes, NPV = $2,090 b. Yes, NPV = $12,390 c. No, NPV = -$63,210 d. No, NPV = -$12,210 ANS: A Solution: NPV = -$340,000 - $110,000(0.870) + $50,000(0.756) + $150,000(0.658) + $240,000(0.572) + $330,000(0.497) = $2,090 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: NPV calculation with uneven cash flows

NAT: Analytic skills

79. G-III Apparel is considering increasing the size of a warehouse. The cost of the expansion is $825,000 and the increase in inventories and accounts payable will be $410,000 and $360,000 respectively. G-III expects that the expansion will increase net cash flows by $150,000 a year for the next 5 years and $200,000 a year for years 6-12. G-III has a 14% cost of capital and a marginal tax rate of 35%. What is the NPV of the warehouse expansion? a. -$3,450 b. $60,050 c. $10,050 d. -$338,570 ANS: C Solution: NPV = -$825,000 - $410,000 + $360,000 + $150,000(3.433) + $200,000(5.216 - 3.433) + $50,000(0.270) = $10,050 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: NPV calculation with a deferred annuity

NAT: Analytic skills

80. Axa is replacing an old, fully depreciated extractor with a more efficient machine that will cost $265,000. The new extractor will be depreciated as a 7-year MACRS asset. With the more efficient production, Axa expects annual revenues to increase by $80,000, and annual operating expenses to increase by $25,000. If Axa expects to sell the machine at the beginning of year 6 for $40,000, determine the NPV of this project. Assume the firm's marginal tax rate is 40% and that the firm's cost of capital is 10%. Use the depreciation schedule listed below: (7-Yr Dep. Schedule: 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, 8.92%, 8.93%, 4.46%)

a. b. c. d.

-$46,283 -$42,855 -$40,773 -$38,105

ANS: A Solution: Year 1 2 3 4 5 5

NCF ($80,000 - $25,000 - $37,869)(1 - 0.4) + $37,869 = $48,148 ($80,000 - $25,000 - $64,899)(1 - 0.4) + $64,899 = $58,960 ($80,000 - $25,000 - $46,349)(1 - 0.4) + $46,349 = $51,540 ($80,000 - $25,000 - $33,099)(1 - 0.4) + $33,099 = $46,240 ($80,000 - $25,000 - $23,665)(1 - 0.4) + $23,665 = $42,466 After-tax salvage $40,000 + $7,648 = $47,648

Book value = $265,000 - $205,881 = $59,119 Loss on sale = $59,119 - $40,000 = $19,119 Tax savings on loss = $19,119(0.4) = $7,648 NPV = $-265,000 + $48,148(0.909) + $58,960(0.826) + $51,540(0.751) + $46,240(0.683) + $90,114(0.621) = -$46,283 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: NPV calculation with uneven cash flows

NAT: Analytic skills

81. What is the internal rate of return for a project that has a net investment of $370,000 and net cash flows of $60,000 in year 1, $75,000 in year 2, and $85,000 in years 3 through 8? a. 15.5% b. 13.6% c. 17.4% d. none of the above are correct ANS: B Solution: if r = 13% NINV = $-370,000 = $-370,000 53,100 60,000(0.885) = 58,725 75,000(0.783) = 266,135 85,000(4.799 - 1.668) = 7,960 NPV = $ r = 13% +

if r = 14% (0.877) (0.769) (4.639 - 1.647) NPV

$7,960 (14% - 13%) = 13.596 or 13.6% $7,960 + $5,385

= 52,620 = 57,675 = 254,320 = $- 5,385

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: IRR with deferred annuity

82. Rollerblade, a manufacturer of skating gear, plans to expand its operation in Brighton, England. The expansion will cost $18.5 million and is expected to generate annual net cash flows of 2.2 million pounds for a period of 15 years and nothing thereafter. The cost of capital for the project is 16%. Using the spot exchange rate of $1.60 per British pound, compute the net present value of the expansion project. a. -$6.235 million b. $2.458 million c. $1.124 million d. -$10.83 million ANS: C Solution: PVNCF = £2.2(PVIFA0.16,15) = £12.265 pounds PVNCFh = £12.265($1.60 /£) = $19.624 NPV = $19.624 - $18.5 = $1.124 (million) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: International issues

83. Zimmer, a manufacturer of modular rooms, plans to expand its operation in Landshut, Germany. The expansion will cost $14.5 million and is expected to generate annual net cash flows of DM4.5 million for a period of 12 years and then the operation will be sold for DM2 million. The cost of capital for the project is 14%. Using the spot exchange rate of $0.60 per DM, compute the NPV of this expansion project. a. $0.78 million b. $1.03 million c. $2.58 million d. $11.39 million ANS: B Solution: PVNCF = DM4.5(5.660) + DM2(0.208) = DM25.886 million PVNCFh = DM25.886($0.60 / DM) = $15.5316 NPV = $15.5316 - $14.5 = $1.0316 (million) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: International issues

84. A digital assembly system that costs $160,000 is expected to operate for 8 years. The estimated salvage value at the end of 8 years is $12,000. The system is expected to save the company $38,000 in labor costs before taxes and depreciation. The company will depreciate this system on a 5-year MACRS schedule. If the firm's cost of capital is 12% and its marginal tax rate is 35%, compute the NPV for the project. (Note: Requires MACRS tables) a. $4,045 b. $7,196 c. $20,873 d. $167,196 ANS: B Solution: Year

NCF

PVIF

PVNCF

1 2 3 4 5 6 7 8

($38,000 - $32,000)0.65 + $32,000 = $35,900 ($38,000 - $51,200)0.65 + $51,200 = $42,620 ($38,000 - $30,720)0.65 + $30,720 = $35,452 ($38,000 - $18,432)0.65 + $18,432 = $31,151 ($38,000 - $18,432)0.65 + $18,432 = $31,151 ($38,000 - $9,216)0.65 + $9,216 = $27,925 ($38,000 - $0)0.65 + $0 = $24,700 ($38,000 - $0)0.65 + $12,000(0.65) = $32,500

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

.893 .797 .712 .636 .567 .507 .452 .404

$ 32,059 $ 33,968 $ 25,242 $ 19,812 $ 17,663 $ 14,158 $ 11,164 $ 13,130 $ 167,196 $-160,000 NPV = $ 7,196

NAT: Analytic skills TOP: Net present value

85. TexMex is considering replacing its tortilla machine with a new model that sells for $46,000 including the cost of installation. The old machine has been fully depreciated and has a $0 salvage value. The new machine will be depreciated as a 3-year MACRS asset. Revenues are expected to increase $18,000 per year over the 5 year life of the new machine. At the end of 5 years the new machine is expected to have no salvage value. What is the IRR for this project if TexMex has a required rate of return of 14% and a marginal tax rate of 40%. Operating costs are not expected to increase from the current level of $8,000 per year. a. 21.0% b. 14.0% c. 19.3% d. 5.7% ANS: C Solution: Year 1 2 3 4 5

NCF ($18,000 - $15,332)(0.60) + $15,332 = $16,933 ($18,000 - $20,447)(0.60) + $20,447 = $18,979 ($18,000 - $6,813)(0.60) + $6,813 = $13,525 ($18,000 - $3,409)(0.60) + $3,409 = $12,164 ($18,000 - $0)(0.60) + $0 = $10,800

By calculator, the IRR = 19.27% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Internal rate of return

86. Colex wishes to bid on a contract that is expected to yield after-tax net cash flows of $25,000 in year 1, $30,000 in year 2, and $35,000 per year in years 3 - 8. To obtain the contract, Colex will need to invest $110,0000 to reconfigure a packaging system, $20,000 (after-tax) to retrain current employees, and $15,000 (after-tax) on an environmental impact study that is required to be completed on acceptance of the contract. What is the project's internal rate of return ? a. 16.7% b. 14.1% c. 16.2% d. 14.9% ANS: D Solution:

NINV = $110,000 + $20,000 + $15,000 = $145,000 NCF1 = $25,000 NCF2 = $30,000 NCF3-8 = $35,000 IRR = 14.9% by calculator PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Internal rate of return

87. Which of the following statements about comparing capital budget techniques is/are correct?

I. The payback period is easy to understand and helps the firm identify how long it will be unable to use the initial investment for other projects.

II. Mutually exclusive projects allow a firm to do other like projects (mutually exclusive) simultaneously as long as the budget restraints are met. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital rationing and the capital budgeting decision

NAT: Reflective thinking

88. Which of the following statements about comparing the techniques of net present value (npv) and internal rate of return (irr) is/are correct?

I. The net present value assumes that all cash flows are reinvested at the cost of capital and is therefore realistic.

II. The internal rate of return is stated as a percent and is therefore easy to communicate to decision-makers who may not understand the fine points of finance. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Net present value and internal rate of return

NAT: Reflective thinking

89. What is the net present value of the following project if the required rate of return is 15%? The initial investment is $150,000 Years Cash Flows 1 $30,000 2 $80,000 3 $100,000 4 $200,000 a. b. c. d.

$203,690 $180,665 $150,000 $116,681

ANS: D PTS: 1 NAT: Analytic skills

OBJ: Type: E. Prob LOC: Knowledge of capital budgeting and cash flows

TOP: Net Present Value 90. Should the following project be accepted if the cost of capital is 12%?

Initial Investment is $50,000 Years Cash Flows 1 $25,000 2 $35,000 3 $55,000 a. b. c. d.

Yes, because the internal rate of return is 10.5% which is less than 12%.

Yes, because the internal rate of return is 35% which is more than 12%.

No, because the internal rate of return is 8.7% which is less than 12%.

Yes, because the internal rate of return is 48% which is more than 12%.

ANS: D PTS: 1 NAT: Analytic skills TOP: Internal rate of return

OBJ: Type: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

91. In comparing the techniques of net present value and internal rate of return: a. The npv and irr techniques will generate the same accept-reject decision provided the projects have conventional cash flows. b. The differences between the underlying assumptions of npv and irr can cause them to rank projects differently. c. Both a and b d. Neither a nor b ANS: C PTS: 1 OBJ: Type: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Net Present Value versus Internal Rate of Return: The reinvestment rate assumption 92. In considering the payback period: a. The maximum period allowed by a firm is a specific time period based on objective criteria. b. It considers the time value of money in determining the maximum allowable time period. c. It gives some indication of a project’s desirability from a liquidity viewpoint. d. It is based on cash flows both during and after the payback period.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback period

93. In considering the payback method, a. It is a method of determining the financial exposure of a firm for a project. b. It is a complicated but accurate capital budgeting method. c. Both a and b are correct. d. Neither a nor b is correct.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback Period

94. The payback method has all of the following advantages EXCEPT: a. It considers the time value of money b. It determines a firm’s financial exposure c. It is easy to calculate d. It determines if the project under consideration will be able to replace the start-up costs.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback Period

95. A weakness of the payback period is that it disregards: a. Projects with shorter payback periods b. Cash flows during the payback period c. Start-up costs d. The time value of money ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Payback period

ESSAY 1. List the advantages and disadvantages of the payback method.

ANS: The advantages of the payback method are: 1. It is easy and inexpensive to use.

2. It provides a crude measure of project risk.

3. It provides a measure of project liquidity.

The disadvantages of the payback method are: 1. There is no objective decision criterion.

2. It gives equal weight to all cash flows within the payback period, regardless of when they occur during the period. It ignores the time value of money.

3. It ignores cash flows occurring after the payback period.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Payback period 2. Why is the net present value method of evaluating projects better than the internal rate of return method?

ANS: The net present value method is better for the following reasons: 1. The internal rate of return method can produce multiple internal rates of return which cannot be compared to the firm’s cost of capital in determining a project’s acceptability.

2. The net present value assumes that cash flows are reinvested at the firm’s cost of capital, whereas the internal rate of return method assumes that these cash flows are reinvested at the computed internal rate of return. The cost of capital is considered a more realistic reinvestment rate than the computed internal rate of return.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Net present value and internal rate of return 3. Explain why the internal rate of return method is more popular than the net present value method.

What are some potential problems with relying on the IRR method?

ANS:

The internal rate of return method is more popular because some people feel more comfortable dealing with the concept of a project’s percentage rate of return than with its dollar amount of net present value. The internal rate of return takes into account both the timing and magnitude of cash flows over the entire life of the project in measuring the project’s economic desirability.

In spite of this, it is possible to have multiple internal rates of return. Net present value will yield only one internal rate of return. The reinvestment rate of the internal rate of return method is less realistic PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Internal rate of return 4. How does the profitability index differ from the net present value and when would each method be preferred?

ANS: The profitability index is the benefit-cost ratio, the ratio of the present value of expected net cash flows over the life of a project to the net investment. When dealing with mutually exclusive investments, conflicts may arise between the net present value and the profitability index criteria.

When a conflict arises, the final decision is based on other factors. If there is no capital rationing, the net present value approach is preferred because it will select the projects that are expected to generate the largest total dollar increase in the firm’s wealth and thus maximize shareholder wealth. If the firm must do capital rationing, and capital budgeting id being done for only one period, the profitability index approach may be preferred because it will indicate which projects will maximize the returns per dollar of investment.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Profitability Index: Decision rule 5. In working with capital budgeting, what does a post-audit do?

ANS: A post-audit consists of comparing actual cash flows from an accepted project with projected cash flows that were estimated when the project was adopted. A project review should be concerned with identifying systematic biases or errors in cash flow estimation on the part of individuals, department, plants, or divisions and attempting to determine why these biases or errors exist. A good post-audit can help a company’s decision makers better evaluate investment proposals submitted in the future.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Reviewing and post-auditing an accepted project

Chapter 11—CAPITAL BUDGETING AND RISK MULTIPLE CHOICE 1. The discount rate used in calculating the certainty equivalent net present value is the a. risk-adjusted discount rate b. cost of capital c. risk-free rate d. cost of equity capital ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 2. The certainty equivalent factors used to adjust the cash flows for risk range from a. -1 to + 1 b. 0 to infinity c. +.01 to + .99 d. 0 to + 1.0 ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 3. The basic capital budgeting decision models, that is, NPV and IRR, handle risk by a. ignoring it b. assuming all cash flows are known with certainty c. assuming all projects are of average risk and evaluating them based on expected values d. using risk-adjusted discount rates to evaluate projects ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Computing the risk-adjusted net present value 4. All of the following are advantages of the NPV-payback approach to risk analysis except a. it is easy and inexpensive to apply b. it considers a project's liquidity c. it explicitly considers the variability of a project's return d. it is consistent with the notion that risk increases with futurity ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: NPV/payback approach 5. The subjective approach to determining risk-adjusted discount rates a. uses the risk-free rate for average-risk projects b. explicitly considers the probability distribution of a project's cash flows c. always leads to the correct investment decisions d. groups projects into risk classes and evaluates all projects in a particular risk class at the same risk- adjusted discount rate ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted discount rate approach 6. The hurdle rate approach a. is an improvement over the risk-adjusted discount rate approach because it provides for an objective basis to determine risk premiums for individual projects b. is a modification of the internal rate of return approach c. is inconsistent with the principle of project risk balancing d. is a method used with the certainty equivalent approach.

ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Computing the risk-adjusted net present value

7. Simulation techniques are a. cheap to apply b. widely used c. mostly beneficial for large projects d. identical to sensitivity analysis ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Simulation analysis 8. The use of sensitivity analysis requires that a. a model of a project's cash flows be developed b. probability distributions of the determinants of a project's cash flows be estimated c. the firms have access to a very large computer d. the firm is greatly interested in the portfolio risk reduction characteristics of a project ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Sensitivity analysis 9. Project C has been classified into risk class II by the analyst of a major firm. The risk premium required for projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%.

If the project has an estimated return of 20%, the analyst would recommend a. accepting project C b. rejecting project C c. reestimating the risk premiums for class II projects d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted discount rate approach 10. Total project risk is a. the contribution a project makes to the risk of the firm b. measured by the correlation coefficient c. the chance that a project will perform different from expectations d. measured by the project's beta ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Total project risk versus portfolio risk 11. A firm's leveraged beta will always be _____ its unleveraged beta. a. less than b. greater than c. the same as d. could be all of the above ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: The equity and debt case 12. The _____ the amount of debt in a firm's capital structure, the _____ will be the firm's beta. a. larger, larger b. smaller, larger

c. larger, smaller d. smaller, smaller ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: The equity and debt case 13. The risk-adjusted discount rate approach is preferable to the weighted cost of capital approach when a. all projects have the same risk characteristics b. the risk-free rate is known with certainty c. the projects under consideration have different risk characteristics d. the firm is unlevered ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Computing the risk-adjusted net present value 14. A major problem with using the risk-adjusted discount rate approach is the determination of a. the beta value for the firm b. the firm's weighted cost of capital c. the firm's required rate of return d. beta values for individual projects ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Computing the risk-adjusted net present value 15. Which of the following techniques can be used to analyze total project risk? a. net present value/payback approach b. risk-adjusted discount rate approach c. simulation analysis d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Adjusting for total project risk 16. The net present value/payback approach is a useful approach when a. screening projects characterized by rapid technological advances b. cash flow estimates are known with certainty c. the more risky cash flows occur during the startup period d. None of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Net present value/payback approach

NAT: Reflective thinking

17. In a simulation analysis, a model is simulated on a computer program and run through several iterations. The results of these iterations are used to a. plot a required rate of return value profile b. compute a mean and a standard deviation of returns c. provide the decision maker with a measure of beta risk d. plot the coefficient of variation of the annual net cash flows ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Simulation analysis

18. Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the _____ is to changes in a particular variable. a. probability b. return distribution c. net present value d. standard deviation ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Sensitivity analysis

19. When analyzing a sensitivity curve, the _____ the slope, the more sensitive the net present value is to a change in the computed variable. a. more negative b. steeper c. more general d. smaller ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Sensitivity analysis

20. A major disadvantage of the risk-adjusted discount rate approach is that it a. can lead to selecting only above-average risk projects b. provides the decision maker with a range of numbers c. can lead to selecting only below-average risk projects d. is difficult to estimate the appropriate risk premium for a project ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Risk-adjusted discount rate approach

21. The certainty equivalent approach adjusts the _____ for risk in the _____ of the net present value equation. a. net cash flows, numerator b. risk-free rate, numerator c. required return, numerator d. net cash flows, denominator ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 22. When evaluating a capital expenditure to be made in a foreign country, the parent firm must be concerned with the a. exchange rate risk b. cash flows that can be expected to be received by the parent c. greater uncertainty associated with tax rates in the host country d. all the above ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: International issues: Special elements of capital budgeting 23. The _____ approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures. a. net present value

b. internal rate of return c. risk-adjusted discount rate d. certainty equivalent ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Summary

24. The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is the a. sensitivity analysis method b. simulation approach c. net present value/payback method d. risk-adjusted discount rate approach ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Summary

25. The risk-adjusted discount rate approach is used in the analysis of projects for which __________ is the applicable risk measure. a. total project risk b. beta (systematic) risk c. unsystematic risk d. both total project and beta risk ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Risk-adjusted discount rate approach

26. The certainty equivalent factors used in capital budgeting analysis are equal to the __________ divided by __________ . a. certain return; risky return b. risky return; certain return c. certain return; beta d. beta, risky return ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 27. With the __________ approach, the decision maker adjusts separately each period's cash flows to account for the specific risk of those cash flows. a. risk-adjusted discount rate b. NPV/payback c. certainty equivalent d. economic life ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 28. With the risk adjusted discount rate approach, in the context of total risk, the discount rates used in evaluating cash flows are determined __________ . a. objectively b. subjectively c. using regression analysis d. objectively and by using regression analysis

ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted discount rate approach 29. The __________ of a firm is a weighted average of the __________ of the individual assets in the firm. a. systematic risk; systematic risk b. unsystematic risk; unsystematic risk c. total risk; total risk d. systematic risk, total risk ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; understand risk and return TOP: Adjusting for beta risk in capital budgeting 30. The risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project is _____. a. sensitivity analysis b. simultaneous equations c. scenario analysis d. RADR analysis ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Scenario analysis

31. A project has an expected net present value of $50,000 with a standard deviation of the net present value of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a negative NPV? a. 99.38% b. 0.62% c. 34.5% d. 49.38% ANS: B Solution: z = (0 - $50,000)/$20,000 = - 2.50 From Table V, p(z < -2.5) = .0062 or 0.62% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of risk and return TOP: Simulation analysis 32. A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a net present value greater than $60,000? a. 1915% b. 69.15% c. 0.13% d. 30.85% ANS: D Solution: z = ($60,000 - $50,000)/$20,000 = +0.50 From Table V p(z >+0.5) = 0.3085 or 30.85% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of risk and return TOP: Simulation Analysis

33. A simulation analysis for a new acquisition has indicated that the expected NPV is $50 million with a standard deviation of $40 million. Assume that NPV is normally distributed. What is the probability that the project will be unacceptable? a. 89.44% b. 10.56% c. 39.44% d. 21.19% ANS: B Solution: z = (0 - $50,000)/$40,000 = -1.25 From Table V, p(z < -1.25) = .1056 or 10.56% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Simulation Analysis 34. The DMT Company is financed entirely with equity. DMT has a beta of 1.20 and the current risk-free rate is 9.5 percent. If the expected market return is 14 percent, what rate of return should DMT require on a project of average risk? a. 14.9% b. 15.4% c. 14.0% d. 12.0% ANS: A Solution: ke = 0.095 + 1.20(0.14 - 0.095) = 0.149 or 14.9% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Project beta risk - all equity case 35. Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent. If Faris' tax rate is 40 percent, estimate the levered beta for the new product division? a. 2.44 b. 1.14 c. 2.74 d. 3.88 ANS: C Solution: u = 1.6/[1+.6(0.4/0.6)] = 1.14 l = 1.14[1+.6(0.7/0.3)] = 2.74 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Project beta risk - debt and equity case

36. Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30 percent equity. The levered beta for this division has been estimated to be 2.02. What will be Technico's weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent? a. 14.77% b. 10.33% c. 18.1% d. 1.03% ANS: B Solution: ke = 0.08 + 2.02(0.05) = 0.181 k* = 0.7(0.07) + 0.3(0.181) = 0.1033 or 10.33% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Weighted | risk-adjusted cost of capital calculation 37. Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted discount rate for its can division of 17 percent. A planned expansion in the can division requires a net investment of $170,000 and results in expected cash inflows of $42,000 a year for seven years. Should Calco invest in this expansion? a. Yes, NPV = $10,096 b. Yes, NPV = $ 9,896 c. No, NPV = -$5,276 d. No, NPV = -$9,896 ANS: C Solution: NPV = $42,000(3.922) - $170,000 = -$5,276 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Computing risk-adjusted NPV 38. SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions of the firm's total assets: Division Electric & Gas Bus transportation Real estate Recreation

Beta

% of Assets

0.85 0.95 1.40 1.15

60 10 25 5

What is the firm's weighted average beta? a. 1.01 b. 1.53 c. 0.93 d. 1.13 ANS: A Solution: Beta = 0.6(0.85) + 0.10(0.95) + 0.25(1.40) + 0.05(1.15) = 1.01 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Weighted beta calculation

39. SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportion of the firm's total assets: Division Electric & Gas Bus transportation Real estate Recreation

Beta

% of Assets

0.85 0.95 1.40 1.15

60 10 25 5

The risk-free rate is 8 percent and the market risk premium is 5 percent. If SCAN is considering a residential development, what should the firm use as its cost of equity in evaluating this project? a. 13.05% b. 16.20% c. 12.25% d. 15.00% ANS: D Solution: ke = 0.08 + 1.40(0.05) = 0.15 or 15% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Risk-adjusted cost of capital 40. The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.6. The current risk-free rate is 9.5 percent and the expected market return is 16 percent. What rate of return should Chris-Kraft require on a project of average risk? a. 25.6% b. 14.9% c. 10.4% d. 19.9% ANS: D Solution: ke = 0.095 + 1.6(0.16 - 0.095) = 0.199 or 19.9% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Risk adjusted cost of capital calculation 41. The net present value of a project is normally distributed with an expected value of $52,000 and a standard deviation of $31,515. Determine the probability that the project will have a net present value of less than zero. a. 1.65% b. 95.1% c. 4.95% d. cannot be determined ANS: C Solution: P(NPV < $0) = P ( Z < ($0 - $52,000)/$31,515) = P ( Z < - 1.65) = 4.95% from Table V PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Scenario analysis

42. IKON is financed entirely with equity and its beta is 1.31. If the current risk-free rate is 6.25% and the expected market return is 12.8%, what is IKON's required rate of return on a project of average risk? a. 8.58% b. 14.83% c. 17.65% d. 12.81% ANS: B Solution: ke = 6.25 + 1.31(12.8 - 6.25) = 14.83% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Understand risk and return TOP: Beta risk

NAT: Analytic skills

43. The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.25. The current risk-free rate is 7 percent and the expected market return is 15 percent. Chris-Kraft is considering an investment project with a risk that matches the firm's average risk, requires a net investment of $70,000, and has net cash flows of $18,000 per year for 8 years. Should Chris-Kraft invest in the project? a. Yes, NPV = $5,726 b. Yes, NPV = $75,726 c. No, NPV = -$10,934 d. No, NPV = -$5,726 ANS: A Solution: ke = 0.07 + 1.25(0.15 - 0.07) = 0.17 NPV = $18,000(4.207) - $70,000 = $5,726 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted NPV 44. Quick Flick is considering two investments. Both require a net investment of $120,000 and have the following net cash flows: Year

Project X

Project Y

1 2 3 4 5

$50,000 40,000 30,000 25,000 20,000

$25,000 45,000 50,000 60,000 70,000

Quick uses a combination of the net present value approach and the payback approach to evaluate investment alternatives. The firm uses a discount rate of 14 percent and requires that all projects have a payback period no longer than 3 years. Which investment or investments should Quick accept? a. only Project X b. only Project Y c. both projects X and Y d. reject both projects ANS: C Solution: Year

NCF:X

PVIF

PVCF:X

NCF:Y

PVCF:Y

1 2 3 4 5

$50,000 40,000 30,000 25,000 20,000

.877 .769 .675 .592 .519

$ 43,850 30,760 20,250 14,800 10,380 $120,040

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

$25,000 45,000 50,000 60,000 70,000

$ 21,925 34,605 33,750 35,520 36,330 $162,130

NAT: Analytic skills TOP: NPV/payback approach

45. Billy Bob is considering building a water slide park that will require a net investment of $200,000 and yield the following net cash flows: Year

Net Cash Flows

Cert. Equiv. Factor

1 2 3 4 5

$120,000 90,000 60,000 30,000 10,000

.90 .80 .65 .50 .30

If the risk-free rate is 8 percent and the market risk premium is 6 percent, what is the certainty equivalent NPV for this project? a. $12,805 b. $ 5,746 c. $ 3,703 d. $11,025 ANS: B Solution: Year 1 2 3 4 5

CE Flow

PVIF

PVNCF

$108,000 72,000 39,000 15,000 3,000

0.926 0.857 0.794 0.735 0.681

$100,008 61,704 30,966 11,025 2,043 $205,746 200,000 $ 5,746

PVNCF = Less: NINV C.E.NPV

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent NPV 46. The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The initial outlay required is $22 million. Net cash flows over the 4-year life cycle and the corresponding certainty-equivalents of the new model are as follows: Year

Net Cash Flow

Certainty-equivalent

1 2 3 4

$15 million 13 million 11 million 9 million

0.90 0.75 0.55 0.30

The firm's cost of capital is 14% and the risk-free rate is 6%. Bull uses the certainty-equivalent approach in evaluating above-average risk investments such as this one. What is the project's certainty-equivalent NPV? a. $20,083,000 b. $ 6,628,400 c. $13,905,000 d. $ 3,019,400 ANS: B Solution: NPV = $13,500,000(0.943) + $9,750,000(0.89) + $ 6,050,000(0.84) + $2,700,000(0.792) - $22,000,000 = $6,628,400 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent NPV 47. DKA uses the certainty equivalent approach to deal with total project risk and is considering a project with the following: Year

Expec. NCF

Certainty Equivalent Factor

0 1 2 3 4

-$60,000 20,000 20,000 25,000 30,000

1.0 0.95 0.90 0.80 0.65

What is the certainty equivalent NPV for this project if the risk-free rate is 8% and the required return on the market portfolio is 15%? a. $3,233 b. $17,743 c. - $15,243 d. $13,233 ANS: A Solution: Year

Cert. Equiv. CF

PVIF

PVCF

0 1 2 3 4

-$60,000 19,000 18,000 20,000 19,500

1.000 .926 .857 .794 .735

-$60,000 17,594 15,426 15,880 14,333 $ 3,233

Certainty Equivalent NPV =

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent NPV calculation 48. Determine the coefficient of variation for the following annual cash in flows from an investment project: Cash Flow ($000)

Probability

$2,000

.10

2,500 3,000 3,500 4,000

a. b. c. d.

.20 .30 .20 .20

$624.50 125.8 0.201 cannot be determined

ANS: C Solution: R = $2,000 (0.10) + $2,500 (0.20) + $3,000 (0.30) + $3,500 (0.20) + $4,000 (0.20) = $3,100  = [(2000 - 3100)2 (.10) + (2500 - 3100)2 (.20) + (3000 - 3100)2 (.30) + (3500 - 3100)2 (.20) + (4000 - 3100)(.20)].5 = (390,000).5 = $624.50 v = $624.50/$3100 = 0.201 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return; Finance applications in spreadsheets TOP: Coefficient of variation 49. Given the following cash flows and certainty equivalent factors for an investment project, determine the certainty equivalent net present value. The firm's cost of capital is 14% and the risk-free rate is 6%.

a. b. c. d.

Year

Cash Flow

Certainty-Equivalent Factor

0 1 2 3

$-100,000 60,000 60,000 60,000

1.00 0.90 0.75 0.55

$32,000 $18,692 $4,238 cannot be determined

ANS: B Solution:

Year(t)

Cash Flow(NCFt)

0 1 2 3

$-100,000 60,000 60,000 60,000

C.E. Factor(t) 1.00 .90 .75 .55

C.E.

P.V. of PVIF0.06,t

$-100,000 54,000 45,000 33,000

1.000 .943 .890 .840

Certainty equivalent NPV =

Cash Flows $-100,000 50,922 40,050 27,720 + $18,692

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent NPV

50. M-tel is financed entirely with equity and the firm's stock has a beta of 0.85. M-tel is considering investing in a project that is expected to have a beta of 1.3. The project requires an initial outlay of $6 million and is expected to generate after-tax net cash flows of $1.3 million each year for 8 years.

Calculate the NPV of the project. Assume the risk-free rate is 7% and the expected market return is 14%. (Note: Problem requires either calculator use or interpolation from the tables. The suggested solutions use calculator accuracy.) a. $249,685 b. -$371,484 c. $238,700 d. -$352,800 ANS: B Solution: ke = 7% + 1.3(14% - 7%) = 16.1% NPV = -$371,484 (calculator accuracy) PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted NPV 51. MedChem has a capital structure of 60% equity and 40% debt and a current beta of 1.2. MedChem is considering an investment project in a new line of business that has an expected internal rate of return of 16%. The typical firm already in the line of business that MedChem is considering expanding into has a beta of 1.5 and a capital structure that has 55% debt and 45% equity. The marginal tax rate for all these firms, including MedChem, is 40%. If the current risk-free rate is 7% and the expected market risk premium is 8%, should MedChem expand into the new line? Assume that MedChem will retain its current capital structure. a. expand if after-tax cost of debt is 11.5% or less b. expand if after-tax cost of debt is 15% or less c. expand if after-tax cost of debt is 10.4% or less d. do not expand ANS: B Solution: üu = 1.5/[1+.6(55/45)] = .8654 ül = .8654[1+.6(40/60)] = 1.21 ke = 7 + 1.21(8) = 16.68% IRR = 16% = 0.6(16.68%) + 0.4(ki) ki = 15 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand risk and return TOP: Beta risk

NAT: Analytic skills

52. American Biodyne (AB) is considering expanding into a new line of business. The expansion will require an investment of $500,000 in new equipment. This equipment which will cost another $300,000 to install, will be depreciated on a straight-line basis over an 8-year period to an estimated salvage value of zero. If the expansion project is accepted, working capital will increase by $100,000 immediately. Revenues for the first 3 years are forecasted at $650,000 per year and at $800,000 in years 4-8. Operating costs exclusive of depreciation are expected to be $310,000 per year for 3 years and increase to $400,000 per year for the following 5 years. AB has a marginal tax rate of 40% and its required rate of return for the project under consideration is 16%. If AB assumes that the new equipment will have an actual market value of $50,000 at the end of the 8th year, should the expansion be undertaken? a. Yes, NPV = $275,114

b. Yes, NPV = $265,964 c. Yes, NPV = $302,934 d. Yes, NPV = $272,434 ANS: A Solution: NINV = $500,000 + $300,000 + $100,000 = $900,000 NCF1-3 = ($650,000 - $310,000 - $100,000)(1 - 0.4) + $100,000 = $244,000 NCF4-7 = ($800,000 - $400,000 - $100,000)(1 - 0.4) + $100,000 = $280,000 NCF8 = $280,000 + $100,000 + $50,000(1 - 0.4) = $410,000 NPV = $-900,000 + $244,000(2.246) + $280,000(4.039 - 2.246) + $410,000(0.305) = $275,114 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk-adjusted NPV 53. All of the following are correct statements about a project’s total risk EXCEPT: a. Undiversified investors are concerned about the company’s future outlook. b. It becomes the relevant risk when the project’s returns are correlated to the returns from the firm as a whole. c. Total project risk can be measured by calculating standard deviation d. Total project risk is irrelevant when forecasting a company’s chance of bankruptcy.

ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Total Project Risk

54. Many firms combine net present value and payback when analyzing project risk. Which of the following statements is/are correct?

I. Both payback and net present value consider the frequency of cash flows.

II. Both payback and net present can be adjusted for risk. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Computing risk-adjusted NPV 55. The certainty equivalent approach is a risk evaluation technique. Which of the following statements is/are correct?

I. Certainty equivalents adjust the cash flows in the numerator of the NPV equation.

II. Using the RADR involves adjustments to the denominator of the NPV equation. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 56. Rolling in Dough Cookie Corporation is trying to determine its certainty equivalent NPV. What is the CNPV if the cost of capital is 12% and the initial investment is $19,000 (rounded)?

Year Equivalents 1 2 3 50% a. b. c. d.

Cash Flows

Certainty

$15 000 $15 000 $ 8 000

90% 60%

$2,575.25 $3,431.33 $5,261.38 $4,215.15

ANS: B PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent NPV calculation 57. Which of the following statements is correct about adjusting for beta risk in capital budgeting? a. It measures unsystematic risk. b. It is a guaranteed measure of the success of the project. c. The beta concept can be used to determine RADR. d. It evaluates the efficiency of the management team.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Beta risk

NAT: Reflective thinking

58. Portfolio risk is also known as: a. total project risk b. beta risk c. market risk d. scenario risk ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Total risk versus portfolio risk

59. All of the following techniques are used to measure total project risk EXCEPT: a. simulation analysis b. profitability index c. certainty equivalent approach d. risk adjusted discount rate ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Adjusting for total project risk

60. A weakness of the net present value/payback method is: a. It is a complicated calculation b. It is subjective c. It is directly related to the variability of returns from a project d. Because it recognizes the riskiness of various projects, it can develop multiple outcomes.

ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Net present value/ payback approach

61. The type of analysis that models some event and requires that estimates be made of the probability distribution of each cash flow element is:

a. b. c. d.

scenario sensitivity simulation net present value/payback approach

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Simulation analysis

62. What item has made sensitivity analysis simple and inexpensive? a. computer accounting software b. computer spreadsheet software c. computer webinars d. computer video and presentation software ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Sensitivity analysis

63. All of the following are methods of adjusting a project for total risk EXCEPT: a. sensitivity analysis b. carpe diem approach c. certainty equivalent approach d. simulation analysis ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Summary 64. The risk of an investment project is defined in terms of the potential ____________ of its returns. a. certainty b. size c. variability d. timing ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Summary 65. _____________________ are needed for sensitivity analysis and have made the application simple and inexpensive. a. risk tolerance tables b. financial statements c. financial calculators d. computer spreadsheets ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Sensitivity analysis 66. Determine the pure project beta of a project that has 45% debt and 55% equity. The beta for the company is 1.6 and a tax rate of 40%. a. 1.82 b. 1.82 c. 1.07 d. 2.07 ANS: C

PTS: 1

OBJ: TYPE: E. Prob

NAT: Analytic skills LOC: Understand risk and return TOP: Adjusting for beta risk in capital budgeting: The equity and debt case ESSAY 1. What is the reason companies utilize the certainty equivalent approach in evaluating projects?

ANS: 1. It can adjust the cash flows to account for risk.

2. Each cash flow can be adjusted separately.

3. It provides an unambiguous basis for making a decision. It utilizes net present value which is a clear method of determining a project’s acceptability.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Certainty equivalent approach 2. What are the weaknesses of the net present value/payback approach?

ANS: 1. The choice of which payback criterion should be applied is purely subjective and not directly related to the variability of returns from the project.

2. A single payback cutoff does not allow for the fact that some investments have fairly certain cash flows far into the future, whereas others do not.

3. Some projects are more risky at start-up and the payback criterion fails to recognize this.

4. The method may cause the firm to reject some actually acceptable projects.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of cash flows and cost of capital TOP: Net present value/payback approach 3. How can beta, a measure of systematic risk of a portfolio of securities, be used to judge the risk of a firm?

ANS: Just as beta of a portfolio of securities can be computed as the weighted average of the individual security betas, a firm may be considered as a portfolio of assets, each having its own beta. From this perspective, the systematic risk of the firm is simply the weighted average of the systematic risk of the individual assets.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Adjusting for beta risk in capital budgeting 4. How and when should firms consider employing additional risk analysis techniques in judging the suitability of large projects prior to implementation?

ANS:

The decision to employ some risk analysis technique to evaluate an investment project depends on the project’s size and the additional cost of applying such a technique as compared with the perceived benefits. For small projects, only the simpler risk adjustment techniques should be used; for major projects that have above or below-normal risk, it is worthwhile to analyze the project’s risk as precisely as possible. Failure to fully analyze the risk of a large project could result in bad investment decisions and even substantial losses.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Summary 5. What are the primary advantages and disadvantages of applying simulation to capital budgeting risk analysis?

ANS: The simulation approach explicitly recognizes all of the interactions among the variables that influence a project’s net present value. It provides both a mean net present value and a standard deviation that can help the decision maker analyze trade-offs between risk and expected return. Unfortunately it can take considerable time and effort to gather the information necessary for each of the input variables and to correctly formulate the model. This limits the feasibility of simulation to very large projects.

In addition, the simulation assume that the values of the input variables are independent of one another. If not, then the interaction must be incorporated into the model, introducing even more complexity.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Simulation analysis

Chapter 12—THE COST OF CAPITAL MULTIPLE CHOICE 1. The Institutional Brokers' Estimate Service (IBES) summarizes analysts' _______. a. short-term earnings forecasts b. long-term earnings growth rates c. bankruptcy forecasts d. short-term earnings forecasts and long-term earnings growth rates ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Issues in implementation

2. Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk common stock investments over the years have averaged (arithmetically) _______ percentage points _______ than the returns on Treasury bills. a. 6 to 8, higher b. 1 to 2, lower c. 3 to 4, higher d. 8 to 9, higher ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Capital asset pricing model approach 3. The cost of equity capital for non-dividend paying stocks can be determined by a. using the Capital Asset Pricing Model

b. estimating ke for comparable dividend-paying stocks in their industry c. forecasting the liquidation proceeds from the sale of the company's assets. d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their industry ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk premium on debt & other approaches for estimating...

4. For a company that is not planning to change its target capital structure, the proportions of debt and equity used in calculating the weighted cost of capital should be based on the current _______ weights of the individual components. a. book value b. market value c. replacement value d. accounting value ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the weighted cost of capital schedule

NAT: Reflective thinking

5. The cost of capital is a. the rate of return required by investors in the firm's securities b. the minimum rate of return required on new investments of high risk undertaken by the firm c. approximately 10 percent for most firms d. concerned with plant and equipment only ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

6. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million will be _______ the marginal cost of capital for amounts over $700 million. a. less than b. equal to c. greater than d. cannot be determined from the information given ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the weighted marginal cost of capital schedule 7. The CAPM assumes that the only risk of concern to the investor is _______, which is measured by _______. a. Unsystematic risk, beta b. Systematic risk, the return to the market portfolio c. Systematic risk, beta d. Unsystematic risk, the return to the market portfolio ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capital asset pricing model approach | p. 462

8. If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects a. its cost of capital will rise b. the average risk premium for the firm will decline c. the risk-free rate will increase as more risk is added d. its cost of capital will fall ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Divisional costs of capital

9. The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the components in the firm's _______ capital structure. a. historical average b. long-range target c. current d. industry average ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The problem of lumpy capital

NAT: Reflective thinking

10. For firms subject to the 34% marginal tax rate, the after-tax cost of _______ is roughly two-thirds the cost of preferred stock. a. retained earnings b. new common stock c. long-term debt d. retained earnings and new common stock ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of debt

11. There are four major components that determine the risk premium. They include all the following except a. interest rate risk b. business risk c. reinvestment rate risk d. financial risk ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Nature of risk premiums 12. The required rate of return on any security consists of a a. risk premium plus an expected inflation rate b. risk free rate plus a risk premium c. inflation rate plus a marketability premium d. risk free rate plus an inflation premium ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Nature of risk premiums

13. All of the following are true EXCEPT: a. The claims of preferred stockholders on the firm's earnings are junior to those of debtholders. b. The risk of recapitalization increases a firm's required rate of return.

c. Long-term state government securities are always less risky than corporate long-term securities of the same maturity. d. The cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Relative costs of capital

14. Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost by the _____ proportion for that financing source. a. weighted capital structure b. target capital structure c. economic capital structure d. divisional capital structure ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the weighted cost of capital structure

NAT: Reflective thinking

15. If a preferred stock is callable, then the calculation of the cost of preferred stock financing is a. similar to that for bonds b. equal to Dp/Pn c. equal to Dp less flotation costs d. less than Dp/Pn ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of preferred stock

16. The constant growth valuation model approach to calculating the cost of equity assumes that a. earnings and dividends grow at a constant rate, but stock price growth is indeterminate b. the growth rate is greater than or equal to ke c. dividends are constant d. earnings, dividends, and stock price will grow at a constant rate ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Dividend valuation model approach

NAT: Reflective thinking

17. The total return to stockholders, ke, is composed of the a. opportunity cost plus a risk premium b. dividend yield plus the price appreciation of the security c. opportunity cost plus an inflation premium d. dividend yield minus the risk premium ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Dividend valuation model approach

NAT: Reflective thinking

18. If a firm is losing money then the after-tax cost of debt is a. equal to kd (1 - T) b. found by trial and error c. equal to the pretax cost of debt d. equal to the yield to first call date ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of debt

19. The historic beta of a firm is of little use as a forecast of the firm's future systematic risk characteristics when a. the firm is growing at a rate of 7-10 percent a year b. the firm is expanding an existing product line c. the firm is expanding into a new product line d. all of these answers are correct ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: The capital asset pricing model approach 20. All of the following methods may be used to determine the cost of equity capital (ke) for a non-dividend-paying stock except a. the risk premium on debt approach b. the Capital Asset Pricing Model approach c. comparing with similar dividend-paying stocks in the industry d. the simulation with growth expectations approach ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk premium on debt & other approaches for estimating...

21. The cost of external equity is greater than the cost of internal equity because a. it decreases the earnings per share b. it increases the market price of the stock c. of the flotation costs d. dividends are increased ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Reflective thinking

22. Retained earnings are a cheaper source of funds than the sale of new equity because a. retention defers the payment of taxable dividends to shareholders b. there are no flotation costs c. new shares are usually priced below current market price d. all the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Reflective thinking

23. Historic average capital costs are _______ new (marginal) resource allocation decisions. a. not relevant for making b. very useful when making c. necessary for making d. the relevant costs for making ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Marginal costs

24. Which of the following is not a typical source of debt funds for a small firm? a. investment banking firms b. commercial finance companies

c. Small Business Administration d. leasing companies ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Entrepreneurial finance issues: The cost of capital

NAT: Reflective thinking

25. If a firm will use only equity funds during the current capital budgeting period then the _______ is the correct capital cost to use for computing the cost of funds for the firm. a. cost of equity capital b. weighted cost of funds c. historical cost of funds d. all of these answers are correct ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The problem of lumpy capital

NAT: Reflective thinking

26. The optimal capital budget is determined by comparing the expected project returns to the company's a. computed break points b. cost of equity schedule c. marginal cost of capital schedule d. optimal opportunity curve ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the optimal capital budget

NAT: Reflective thinking

27. The cost of depreciation-generated funds is equal to a. the cost of equity capital b. zero, because depreciation is a non-cash expense c. the investment opportunity cost d. the weighted cost of capital ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of depreciation-generated funds

NAT: Reflective thinking

28. __________ refers to the variability in the firm's operating earnings. a. Business risk b. Financial risk c. Marketability risk d. Interest rate risk ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Nature of risk premiums 29. The major components that determine the risk premium on a specific security at any point in time include all of the following except a. business risk b. financial risk c. interest rate risk d. real rate of return risk ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Nature of risk premiums 30. Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and government securities. a. common stock, preferred stock, corporate debt, long-term government debt b. corporate debt, long-term government debt, preferred stock, common stock c. long-term government debt, corporate debt, preferred stock, common stock d. corporate debt, preferred stock, long-term government debt, common stock ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Relative costs of capital 31. Rank in ascending order (lowest to highest) investors' required rates of return on the various types of corporate securities. a. preferred stock, corporate debt, common stock b. common stock, preferred stock, corporate debt c. preferred stock, common stock, corporate debt d. corporate debt, preferred stock, common stock ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Relative costs of capital

32. Which of the following statements (if any) is (are) true concerning companies that do not pay dividends? a. The cost of equity capital can be estimated using the Capital Asset Pricing Model. b. The cost of equity capital is equal to the growth short-term rate of earnings per share. c. The dividend capitalization model can be used to determine an accurate cost of equity capital. d. The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry.

ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Risk premium on debt & other approaches for estimating...

33. The optimal capital budget is indicated by the point at which the __________ and the __________ intersect. a. depreciation schedule; investment opportunity schedule b. investment opportunity curve; marginal cost of capital curve c. investment opportunity curve; average cost of capital curve d. efficient portfolio curve; marginal cost of capital curve ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the optimal capital budget

NAT: Reflective thinking

34. During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than Japanese firms. During 1990 this disadvantage may have disappeared due to: a. higher exports to the U.S. b. higher real interest rates in Japan c. larger shareholder interest

d. higher Japanese stock market ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates

NAT: Multicultural understanding TOP: International issues

35. If a firm sells assets, generating cash flows, the cost of these funds is ______. a. the firm's cost of equity b. the firm's cost of cash flows c. the firm's weighted cost of capital d. zero ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of depreciation generated funds

NAT: Reflective thinking

36. Small firms are reluctant to obtain capital through the sale of common stock because of: a. potential loss of voting control b. high issuance costs c. high cost of debt d. both the potential loss of voting control and the high issuance costs ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function TOP: Entrepreneurial finance issues

NAT: Reflective thinking

37. Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is planning to place privately with a large insurance company. Assume that the company has a 40% marginal tax rate. This long-term debt issue will yield 12% to the insurance company. a. 4.8% b. 7.2% c. 12.0% d. 10.6% ANS: B Solution: ki = kd(1 - T) = 12%( 1- 0.40) = 7.2% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: After-tax cost of debt calculation

NAT: Analytic skills

38. Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share.

Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%. a. 13.0% b. 7.8% c. 8.12% d. 13.54% ANS: D Solution: kp = $3.25/($25 - $1) = 13.54% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of preferred calculation

39. The Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity capital for the firm (using the CAPM). a. 14.1% b. 7.6% c. 6.5% d. 13.0% ANS: A Solution: ke = rf + (km - rf) = 6.5% + 0.80(16% - 6.5%) = 14.1% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity (CAPM)

40. The following financial information is available on Rawls Manufacturing Company: Current per share market price Current (t = 0) per share dividend Expected long-term growth rate

$48.00 $3.50 5.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%). a. 12.3% b. 13.4% c. 13.0% d. 12.7% ANS: D Solution: ke = $3.50(1.05)/$48 + 0.05 = 0.1266 (or 12.7%) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of internal equity - constant growth dividend...

NAT: Analytic skills

41. The following financial information is available on Rawls Manufacturing Company: Current per share market price Beta Expected rate of return on market Risk-free rate

$48.00 1.1 12.0% 6.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%). a. 12.9% b. 12.6% c. 13.0% d. 11.8% ANS: B Solution: ke = rf + (km- rf) = 0.06 + 1.1(0.12 - 0.06) = 0.126 = 12.6%

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity - CAPM approach

NAT: Analytic skills

42. The following financial information is available on Rawls Manufacturing Company: Current per share market price Current per share dividend Current per share earnings Beta Expected rate of return on market Risk-free rate Expected long-term growth rate

$48.00 $ 3.50 $ 6.00 1.1 12.0% 6.0% 5.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of external equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%). a. 12.7% b. 14.4% c. 12.6% d. 11.4% ANS: D Solution: ke' = (D1/Pnet) + g = [$3.50(1.05)/$44] + 0.05 = 0.1335 or 13.4% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity - constant growth dividend...

NAT: Analytic skills

43. Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ke = 16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%.

(Compute answer to nearest .1%). a. 14.3% b. 12.6% c. 14.6% d. 11.9% ANS: B Solution: ka = 0.40 x 12.5%(1 - 0.4) + 0.60 x 16.0% = 12.6% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skill TOP: Weighted cost of capital

44. What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years. a. 9.6% b. 9.9% c. 10.0% d. 10.6% ANS: C

Solution: Try kp = 10% $9.60(8.514) + $100(0.149) = $96.63 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of preferred stock - finite life

NAT: Analytic skills

45. What is the cost of equity for East Roon, if the firm is expected to always pay a constant dividend of $2.22? The firm's common stock is presently selling for $18.50. a. 8.3% b. 12.0% c. 10.2% d. cannot be determined from the information given ANS: B Solution: ke = $2.22/$18.50 = 0.12 or 12% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of common equity - zero growth

NAT: Analytic skills

46. According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9 percent and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of equity capital? a. 17.45% b. 8.36% c. 9.55% d. 16.2% ANS: A Solution: ke = 7.9% + 1.15(8.3%) = 17.45% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of common equity - CAPM

NAT: Analytic skills

47. Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7 percent a year into the foreseeable future. What is NA's cost of external equity if its stock can be sold to net $46 a share? a. 10.9% b. 11.2% c. 7.2% d. 21.0% ANS: B Solution: ke = $1.80(1.07)/$46 + 0.07 = 0.112 or 11.2% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of common equity - constant growth

NAT: Analytic skills

48. A firm with a 40 percent marginal tax rate has a capital structure of $60,000,000 in debt and $140,000,000 in equity. What is the firm's weighted cost of capital if the marginal pretax cost of debt is 12 percent, the firm's average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5 percent? a. 13.75% b. 11.59% c. 12.31% d. 10.45% ANS: C Solution: ka = 0.3(0.12)(1 - 0.4) + 0.7(0.145) = 0.1231 or 12.31% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital calculation

NAT: Analytic skills

49. Crickentree has a target capital structure of 30 percent debt and 70 percent equity. If the firm expects to have a net income of $1.7 million and a dividend payout ratio of 40 percent, what will be its equity break point? a. $2,428,571 b. $1,457,143 c. $3,400,000 d. $ 971,429 ANS: B Solution: x = $1.7(1 - 0.4)/0.7 = $1.457 or $1,457,143 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Break point calculation

50. Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm's marginal tax rate is 40 percent. a. 6.0% b. 7.2% c. 7.8% d. 6.6% ANS: D Solution: (try 11%) ki = 11%(0.6) = 6.6% $928 = $100(7.191) + $1000(0.209)  $928 so kd = 11% ki = 11%(0.6) = 6.6% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of debt

51. Easy Slider recently sold a 15 year $1,000 face value bond at a discount for $700 that net the firm $692 after flotation costs. The low coupon bond has a 6% coupon with interest paid semiannually. If Easy Slider has a marginal tax rate of 40 percent, what is its after-tax cost of debt for these bonds? a. 10.0% b. 6.0%

c. 9.2% d. 7.8% ANS: B Solution: (Try 5% semiannually ): $692 = $30(15.373) + $1,000(0.231) = $692 Therefore kd = 10% and ki = 10%(1 - 0.4) = 6% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of debt

52. Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To finance its capital budget for next year, the firm will sell $50 million of 11 percent debentures at par and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7 percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40 percent, what is its weighted cost of capital for the coming year? a. 9.64% b. 8.63% c. 9.84% d. 11.67% ANS: A Solution: ke = $1.40/$30 + 0.07 = 0.1167 ka = 0.6(0.1167) + 0.4(0.11)(1 - 0.4) = 0.0964 or 9.64% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Weighted cost of capital

53. Wellington Gas has a target capital structure of 50 percent common equity, 40 percent debt, and 10 percent preferred stock. The cost of retained earnings is 16 percent, and the cost of new equity (external) is 16.7 percent. Wellington can sell debentures that will have an after-tax cost of 8.3 percent and the after-tax cost of preferred stock will be 11.9 percent. What is the marginal cost of capital before and after the break point? a. 12.51% and 12.86% b. 11.18% and 11.53% c. 14.23% and 14.68% d. 12.51% and 11.53% ANS: A Solution: ka1 = 0.5(0.16) + 0.4(0.083) + 0.1(0.119) = 0.1251 ka2 = 0.5(0.167) + 0.4(0.083) + 0.1(0.119) = 0.1286 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Weighted cost of capital

54. GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30 percent, a marginal tax rate of 35 percent, and a dividend payout ratio of 40 percent. GQ has no preferred stock. What is GQ's break point for equity? a. $634,286 b. $962,000 c. $412,286

d. $288,600 ANS: C Solution: Retained earnings = $740,000(1 - 0.35)(1 - 0.4) = $288,600 Break point =$288,600/0.7 = $412,286 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Break point determination

55. Groves, Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate of about 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The expected market rate of return is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of equity for Groves? a. 19.6% b. 13.5% c. 15.4% d. 6.1% ANS: C Solution: ke = 0.093 + 1.45(0.135 - 0.093) = 0.154 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity - CAPM

56. PDQ Inc. has a weighted cost of capital of 14.6 percent and has an opportunity to invest in the following average risk projects: Project 1 2 3

Cost $10,000 $21,000 $18,500

Annual Cost Flow $1,992.43 $4,526.84 $4,580.34

Project life 10 years 8 years 7 years

In which projects should PDQ invest? Assume no capital rationing. a. 1 & 2 b. 2 & 3 c. 1 & 3 d. cannot be determined from the information provided ANS: C Solution: IRR1 = $10,000/$1,992.43 = 5.019 so IRR = 15% IRR2 = $21,000/$4,526.84 = 4.639 so IRR = 14% IRR3 = $18,500/$4,580.34 = 4.039 so IRR = 16% Invest in projects 1 and 3 because their IRR is greater than 14.6% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Calculation of optimal capital budget

NAT: Analytic skills

57. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be retired in 20 years, what is the cost of the preferred issue? a. 10.37%

b. 10.50% c. 10.23% d. 9.75% ANS: B Solution: 10.5 % (by calculator) PTS: 1 OBJ: TYPE: E. Prob.

LOC: knowledge of capital budgeting and cost of capital TOP: Cost of finite maturity preferred stock

NAT: Analytic skills

58. Witin's stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1 million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs are 8%? a. 13.49% b. 10.87% c. 13.21% d. 13.17% ANS: A Solution: ke = 1.00(1.10) + .10 = .1349 or 13.49% 31.51 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity

59. Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of $12.3 million and an annual dividend of $0.12 per share, what is the expected equity break point?

There are 12 million shares outstanding. a. $18,923,076 b. $16,707,692 c. $10,061,538 d. $ 2,215,385 ANS: B Solution: Payout = 12,000(.12) = $1,440,000 BP = (12.3 - 1.44)/.65 = $16,707,692 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Break point for equity

60. Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt?

Assume 40% tax rate. a. 4.96% b. 8.30% c. 4.99% d. 3.32% ANS: C Solution:

8.31(1-.4) = 4.986 or 4.99% (by calculator) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of debt

61. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The 5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is 6.10% and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax rate is 40%. a. 9.48% b. 17.1% c. 14.9% d. cannot determined from the information provided ANS: B Solution: ke = 6.10 + 1.25(8.8) = 17.1% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity

62. Sharp's current capital structure of 60 percent equity, 35 percent debt, and 5 percent preferred stock is considered optimal. This year Sharp expects to have earnings after tax of $3.6 million and to pay out $600,000 in dividends. Sharp can also raise up to $2 million in long-term debt at a pretax interest rate of 10.6 percent (all debt over $2 million will cost 11.4% pretax), and sell preferred stock at a cost of 11.5 percent. Sharp's marginal tax rate is 40 percent. The current value of Sharp's common stock is $36 and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing at an annual compound rate of 8 percent a year and are expected to continue growing at that rate. New shares can be sold to net the firm $34.50. Sharp has an opportunity to invest in the following capital projects. Which one(s) should be accepted?

Project 1 2 3 a. b. c. d.

Cost $3.0 million $2.5 million $2.0 million

Annual Cash Flow $552,893 $693,481 $345,220

1 and 2 1 and 3 1, 2, and 3 cannot be determined from the information provided

ANS: A Solution: Equity break point = $3,000,000/0.6 = $5,000,000 Debt break point = $2,000,000/0.35 = $5,714,286 ke = $2.15/$36 + 0.08 = 0.140 ki = 0.106(1 - 0.4) = 0.0636 k'e = $2.15/$34.50 + 0.08 = 0.142 ka1 = 0.6(0.140) + 0.35(0.0636) + 0.05(0.115) = 0.112 ka2 = 0.6(0.142) + 0.35(0.0636) + 0.05(0.115) = 0.113 ka3 = 0.6(.142) + 0.35(0.114)(0.6) + 0.05(0.115) = 0.115 IRR1 = $3,000,000/$552,893 = 5.426 or 13% IRR2 = $2,500,000/$693,481 = 3.605 or 12%

Project Life 10 years 5 years 10 years

IRR3 = $2,000,000/$345,220 = 5.793 or 11.4% (by calculator) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital and optimal capital structure

NAT: Analytic skills

63. Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: Project 1 2 3 4

Net Investment $3,000,000 $1,500,000 $2,000,000 $1,600,000

IRR 13.5% 18.0% 12.6% 16.0%

FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10 percent a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and be sold at par. If FOT has a marginal tax rate of 40 percent, in which projects should it invest? a. 1, 2, 3, & 4 b. 2 c. 1, 2, and 4 d. 2 and 4 ANS: C Solution: Break point for common equity = $2,000,000/0.7 = $2,857,143 Second equity break point = $4,000,000/0.7 = $5,714,286 Debt break point = $2,000,000/0.3 = $6,666,667 ke = $1.05/$22 + 0.10 = 0.148 k'e1 = $1.05/$19.80 + 0.10 = 0.153 k'e2 = $1.05/$18.70 + 0.10 = 0.156 ka1 = 0.7(0.148) + 0.3(0.10)0.6 = 0.122 ka2 = 0.7(0.153) + 0.3(0.10)0.6 = 0.125 ka3 = 0.7(0.156) + 0.3(0.10)0.6 = 0.127 ka4 = 0.7(0.156) + 0.3(0.12)0.6 = 0.131 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital and optimal capital structure

NAT: Analytic skills

64. Temple Company's common stock dividends have grown over the past 5-year period from $0.60 per share to $0.89 (today). Assume that Temple's dividends are expected to grow at this rate for the foreseeable future. Temple's stock is currently selling for $12 per share. New common stock can be sold to net the company $11 per share. Determine the costs of internal and external equity to Temple. a. 18.1%; 18.9% b. 15.9%; 16.6% c. 16.2%; 16.9% d. 15.9%; 18.9%

ANS: C Solution: $0.89 = $0.60 (FVIFg, 5 ) g = 8.2% by calculator or interpolation ke = $0.96/$12 + 0.082 = 0.162 or 16.2% k'e = $0.96/$11 + 0.082 = 0.169 or 16.9% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity capital

65. Whipple Industries, Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration: Required Investment $2 million 3 million 1 million 4 million 1 million 3 million 5 million

Project A B C D E F G

Expected Rate of Return 20.0% 15.0 13.5 13.0 12.5 12.0 11.5

The firm's marginal cost of capital schedule is as follows: Amount of Funds Raised $0 - $6 million $6 million - $12 million $12 million - $18 million Over $18 million

Cost 12.0% 12.5% 13.5% 15.0%

Determine Whipple's optimal capital budget (in dollars) for the coming year. a. $11 million b. $10 million c. $5 million d. $14 million ANS: A Solution:

Project

Required Investment

Cumulative Investment

Expected Rate of Return

Marginal Cost of Capital

A B C D E F G

$2 million 3 million 1 million 4 million 1 million 3 million 5 million

$2 million 5 million 6 million 10 million 11 million 14 million 19 million

20.0% 15.0 13.5 13.0 12.5 12.0 11.5

12.0% 12.0 12.0 12.5 12.5 12.5 and 13.5 13.5 and 15.0

Optimal Capital budget: $11 million (Projects A,B,C.D,E) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Optimal capital budget

66. American Dental Laser is selling a 10 year $1,000 face value bond with a 8% coupon rate. Interest is paid annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the pretax cost of debt for these bonds. a. 11.1% b. 11.3% c. 11.5% d. 11.8% ANS: B Solution: $810 = $80(PVIFAkd,10) + $1000(PVIFkd,10) try 11%: $80(5.889) + $1000(0.352) = $823.12 try 12%: $80(5.650) + $1000(0.322) = $774.00 kd = 11% +

$13.12 (12% - 11%) = 11.3% $13.12 + $36

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt--deep discount bond

NAT: Analytic skills

67. Mid-States Utility Company just issued at $3.20 cumulative preferred stock at a price to the public of $30 a share. The flotation costs were $1.50 a share and the issue will be retired in 20 years at its $30 par value. What is the cost of this preferred issue? a. 11.3% b. 10.3% c. 10.7% d. 11.6% ANS: A Solution: $28.50 = $3.20(PVIFAkp,20) + $30(PVIFkp,20) try 11%: $3.20(7.963) + $30(0.124) = $29.20 try 12%: $3.20(7.469) + $30(0.104) =$27.02

kp = 11% +

$0.70 $0.70 + $1.48

(12% - 11%) = 11.3%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of preferred stock

68. Wright Express(WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%. a. 14.9% b. 12.4% c. 13.4% d. 16.0% ANS: C

Solution: try 12%: $120(5.650) + $10000(.322) = $1,000 try 13%: $120(5.426) + $1000(0.295) = $946.12 kd = 12% +

$20 $20 + $33.88

(13% - 12%) = 12.4%

ke = 7% + $1.20(14.5% - 7%) = 16% ka = 0.3(12.4%)(1 - 0.4) + 0.7(16%) = 13.4% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Weighted cost of capital

69. California Best (CB), a sport shoe store, expects an operating income of $2.3 million this year. CB has no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7% and the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market, what is the firm's cost of capital? Assume that CB has a marginal tax rate of 40%. a. 8.3% b. 16.96% c. 9.96% d. 15.3% ANS: B Solution: ka = ke = 7% + 1.2(8.3%) = 16.96% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of equity

70. Columbia Gas Company's(CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%. a. 10.9% b. 13.6% c. 19.6% d. 16.9% ANS: A Solution: kd = 10%(1 - 0.4) = 6% ke = $1.6(1.08)/$31 + 0.08 = .136 or 13.6% ka = 0.35(6%) + 0.65(13.6%) = 10.9% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Weighted cost of capital

71. Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital structure change? a. Yes, cost of capital decreases by 2.52%

b. Yes, cost of capital decreases 1.67%. c. No, stock price would decrease due to increased risk d. No, cost of capital increases by 0.85%.

ANS: B Solution: Old ke = 4.2 + 1.1(8.5) = 13.55% = ka New ke = 4.2 + 1.2(8.5) = 14.4% New ka = .7(14.4) + .3(6) = 11.88% Stock price is maximized where the cost of capital is minimized.

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of capital

72. Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The cost of retained earnings is 14% and the cost of new equity is 15.5%. Sadaplast expects to have a net income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%.

Sadaplast has a dividend payout ratio of 25%. What is Sadaplast's cost of capital between the first and second break points? a. 12.25% b. 11.27% c. 11.75% d. 12.73% ANS: C Solution: RE = .75($85 million) = $63.75 million BPe = $63.75 million / 0.65 = $98.077 million BPd = $25 million / 0.30 = $83.333 million BPd' = $45 million / .30 = $150 million ka = 0.65(0.14) + 0.30(0.07) + 0.05(0.11) = 0.1175 or 11.75% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Weighted cost of capital

73. Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of capital. A partial balance sheet is shown below: Current liabilities Long-term debt Common stock at $1 par Paid in capital Retained earnings Total liabilities and stockholders' equity a. b. c. d.

13.4% 13.1% 11.6% 12.7%

ANS: D

$

300,000 1,000,000 100,000 900,000 3,000,000 $5,300,000

Solution: Capital structure: Debt = Market value of Equity: 100,000 shares($24) = Total

$1,000,000 2,400,000 $3,400,000

Capital structure: Debt = $1/$3.4 = 29.41% Equity=2.4/3.4 = 70.59% ka = 0.2941(7.2%) + 0.7059(15.0%) = 12.71% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure and cost of capital

NAT: Analytic skills

74. Mahlo is planing to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2 and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is 4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is $2.10. Should Mahlo complete the diversification into the bakery industry? a. No, stock price drops about $11.70 b. Yes, stock price increases about $9.40 c. Yes, stock price increases about $1.80 d. No, stock price drops about $9.40 ANS: A Solution: Current ke = 0.04 + 1.4(0.09) = 0.166 or 16.6% P0 = $2.10(1.12) / (0.166 - 0.12) = $51.13 New ke = 0.04 + 1.2(0.09) = 0.148 or 14.8% New P0 = $2.10(1.09) / (0.148 - 0.09) = $39.47 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cost of capital

75. Which of the following statements regarding the cost of capital is/are correct?

I. The weighted cost of capital is the discount rate used when computing the net present value.

II. The after-tax cost of capital is weighted by the proportions of the capital components in the firm’s long-range target capital structure. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Weighted cost of capital

76. The cost of debt must account for all of the following inputs EXCEPT: a. Bond ratings. b. Issuance costs. c. flotation costs. d. The tax rate.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of debt

77. There are two primary ways that capital is raised. Which of the following statements is/are correct?

I. Capital is raised internally by using retained earnings.

II. a. b. c. d.

Capital is raised externally by selling fixed assets.

I only II only Both I and II Neither I nor II

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of equity capital

78. Investors can form earnings growth expectations from various sources, including a. potential sales growth. b. current earnings and retention rates. c. assumed product development. d. investors’ required rate of return.

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand the role of the finance function

NAT: Reflective thinking TOP: Issues in implementation

79. What is the weighted average cost of capital for Mud Bug Corporation?

Source of Capital Capital Components Long Term Debt $60,000 Preferred Stock $15,000 Common Stock $75,000 a. b. c. d.

Cost 5.6% 10.6% 13.0%

6.9% 8.5% 10.2% 9.8%

ANS: D PTS: 1 NAT: Analytic skills TOP: Weighted cost of capital

OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

80. Zappin’ Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3 and the firm is in the 35% tax bracket.

Year 2004 2003 2002 2001

Dividend $1.55 $1.40 $1.35 $1.32

a. 15.71% b. 9.11% c. 12.56% d. 10.72% ANS: C PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of internal equity - constant growth dividend...

81. The cost of internal equity is cheaper than the cost of external equity. Which of the following statements is/are correct?

I. External equity may incur expenses which are deducted from the capital received for the sale of the security.

II. Corporations generally discount the price of the securities that are sold to the public in order to raise capital. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Reflective thinking

82. What is the cost of preferred stock if the stock is selling for $208, the dividend is $35 and flotation costs are 5% of the selling price? a. 17.7% b. 25.2% c. 12.5% d. 10.8% ANS: A PTS: 1 NAT: Analytic skills TOP: Cost of preferred calculation

OBJ: TYPE: E. Prob.

LOC: Cost of capital

83. What would be the weighted average cost of capital for Limp Linguini Noodle Makers, Inc. under the following conditions: *The capital structure is 40% debt and 60% equity *The before-tax cost of debt (which includes flotation costs) is 20% and the firm is in the 40% tax bracket. *The firm’s beta is 1.7 *The risk-free rate is 7% and the market risk premium is 6% a. b. c. d.

15.12% 18.7% 17.2% 12%

ANS: A Determine the cost of equity: 1.7(6%) + 7% = 17.2% Determine the cost of debt: 20% X .60 = 12 Determine the weighted cost of capital: 17.2(.60) + 12(.40) = 15.12% PTS: 1 OBJ: TYPE: C. Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Computing the component costs of capital

NAT: Analytic skills

84. A firm has a beta of 1.2. The return in the market is 14% and the risk-free rate is 6%. The estimated cost of common stock equity is: a. 6% b. 7.2% c. 15.6% d. 14% ANS: C

Solution: 1.2 (14% - 6%) + 6% = 15.6% PTS: 1 OBJ: TYPE: E. Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Computing the component costs of capital

NAT: Analytic skills

85. The optimal capital budget occurs at the point where two curves intersect. Which of the following is one of those curves?

I. Weighted marginal cost of capital curve II. Investment opportunity curve a. b. c. d.

I only II only Both I and II Neither I nor II

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the optimal capital budget

NAT: Reflective thinking

86. The cost of common stock equity may be estimated by using which of the following? a. Earnings curve b. Dupont analysis c. Capital asset pricing model d. Price/Earnings ratio ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Reflective thinking

87. A firm is determining its cost of common stock equity. It last paid a divided of $.52, the dividends are growing at 5%, flotation costs are $2 per share and the firm will net $72 per share upon the sale of the stock. What is the firm’s cost of common equity? a. 3.49% b. 8.22% c. 6.11% d. 5.76% ANS: D Solution: $.52 (1 + .05) = $.55 (.55/72) + .05 = 5.75% PTS: 1 OBJ: TYPE: E. Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Analytic skills

88. Surfin’ Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00.

It is estimated that Surfin’ Bubba will have a growth rate in earnings of 10% into the foreseeable future. If Surfin’ Bubba plans to raise new capital for expansion, what is the cost of new equity if flotation costs are 8% of the price. a. 13.49% b. 11.57% c. 12.21%

d. 10.87% ANS: A Solution: 1.00 X 1.10 = $1.10

1.10 (34.25 x .92)

+ .10 = 13.49%

PTS: 1 OBJ: TYPE: E. Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital

NAT: Analytic skills

89. What is Bodacious Bodywear’s weighted average cost of capital under the following conditions: * The firm has 30% debt, 10% preferred stock, and 60% equity *The cost of common equity is 14% and the cost of preferred stock is 9% * The firm’s debt has a before-tax cost of debt of 10% (including flotation costs) * The firm is in the 40% tax bracket a. 11.1% b. 8.5% c. 12.3% d. 10.5% ANS: A Solution: (.60 X 14%) + (.10 X 9%) + (10% X .6 X .30) = 11.1% PTS: 1 OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Computing the component costs of capital

NAT: Analytic skills

90. In determining the cost of debt, several factors must be considered. All of the following are those factors EXCEPT: a. the firm’s before-tax cost of debt b. the firm’s tax rate c. flotation costs d. the firm’s growth rate of dividends ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cost of debt

ESSAY 1. In considering the SML concept, the required returns for any individual security are dependent on certain values. List and discuss those values.

ANS: 1. The risk-free rate: The 3-month or 6-month Treasury Bill rate is generally used for this value.

2. The expected market return: This is the return that investors expect to earn on stocks with a beta of 1.0.

3. The beta of the corporation: Beta is normally estimated by using historic values reflecting the relationship between a security’s returns and the market returns.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return TOP: Capital asset pricing model (CAPM) approach 2. What are the reasons that the cost of external equity is greater than the cost of internal equity?

ANS: 1. External equity has issuance costs associated with new shares. These costs are generally significant enough that they cannot be ignored.

2. The price of the new shares being sold to the public is normally set to an amount less than the market price of the stock before the announcement of the new issue.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of external equity capital 3. Firms can raise capital in two ways. Why is it that internal funding does not have a zero cost?

ANS: Firms using internal funding, or retained earnings, incur an opportunity cost. When funds are generated through the earnings of the firm, either managers can pay out funds as dividends to common stockholders, or the funds can be retained and reinvested in the firm. If the funds are paid out to stockholders, they could reinvest the funds elsewhere to earn an appropriate return, given the risk of the investment. If managers decide to retain earnings and reinvest them in the firm, there must be investment opportunities in a firm offering a return equivalent to the returns available to stockholders in alternative investments on a risk-adjusted basis.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of internal equity capital 4. How is the marginal cost of the various component capital sources determined?

ANS: The marginal cost of funds is the cost of the next increments of capital raised by the firm. When computing the marginal cost of the various component capital sources, companies typically estimate the component costs they anticipate encountering, or paying, during the coming year. If capital costs change significantly during the year, it may be necessary to recompute the new capital costs and use the new estimates when evaluating projects from that time forward, PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Computing the component costs of capital; Marginal costs 5. What is the investment opportunity curve and how is it accomplished?

ANS:

The investment opportunity curve is the graph which illustrates the comparison between the expected project return to the company’s marginal cost of capital schedule. It is accomplished by first plotting the returns expected from the proposed capital expenditure projects against the cumulative funds required. The optimal capital budget is indicated by the point at which the investment opportunity curve and the marginal cost of capital curve intersect.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Determining the optimal capital budget

Chapter 13—CAPITAL STRUCTURE CONCEPTS MULTIPLE CHOICE 1. In analyzing the value of the firm as a function of capital structure, the present value of the tax shield benefit is offset by the present value of the expected __________, resulting in an interior optimal capital structure. a. financial distress costs b. agency costs c. holding costs d. financial distress costs and agency costs ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure with a corporate income tax | financial...

2. The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based on a(n) ______ process. a. reinvestment b. capital asset pricing model c. arbitraging d. compound interest ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure without a corporate income tax

NAT: Reflective thinking

3. Two prominent finance researchers (Modigliani and Miller) showed that a. the firm's optimal capital structure consists of approximately equal proportions of debt and equity b. the value of the firm is independent of its capital structure in perfect capital markets with no income taxes c. the firm's cost of capital is minimized when its capital structure consists of approximately equal proportions of debt and equity d. the firm's cost of capital is maximized when its capital structure consists of approximately equal proportions of debt and equity ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure without a corporate income tax

NAT: Reflective thinking

4. Perfect capital markets imply the following: a. there are no transactions costs for buying and selling securities b. relevant information is unavailable for individuals

c. all investors can borrow and lend at the same rate d. a single investor can influence security prices ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Capital structure theory

5. With an optimal capital structure a. overall capital costs are minimized b. the net present value of new projects is minimized c. financial leverage is minimized d. the weighted cost of capital is maximized ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

6. Holding all other things equal, as the relative amount of debt in the capital structure of the firm increases, the cost of equity capital will a. increase b. decrease c. remain unchanged; there is no relationship between the two d. initially rise rapidly, then increase slowly beyond some point ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

7. As more debt is added to the capital structure of a firm, the cost of debt capital a. initially rises slowly, then falls beyond some point b. increases at a steady rate throughout the entire range c. beyond some point, becomes greater than the cost of equity d. initially rises slowly, then increases rapidly beyond some point ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

8. Which of the following statements is true regarding the relationship between the firm's cost of debt and its capital structure (as measured by the debt ratio)? a. The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk. b. The precise relationship between the cost of debt and the debt ratio is simple to determine. c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

9. Which of the following statements is (are) true concerning the relationship between the firm's cost of equity and its capital structure (as measured by the debt ratio)? a. The exact relationship between the cost of equity and the debt ratio is difficult to determine. b. The range of debt ratios where the cost of equity begins to increase rapidly varies by firm and industry depending on the firm's age.

c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

10. The amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm defines the firm's a. financial structure b. capital structure c. target capital structure d. optimal financial structure ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

11. The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm is known as the a. optimal corporate structure b. target financial structure c. optimal capital structure d. optimal degree of combined leverage ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure decisions & maxim. of shareholder...

NAT: Reflective thinking

12. The optimal capital structure is determined by several factors including all of the following except: a. corporate capital gains b. business risk c. potential bankruptcy risk d. agency costs ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure decisions & maxim. of shareholder...

NAT: Reflective thinking

13. One of the primary assumptions of capital structure analysis is that the level and variability of ______ is not expected to change as changes in capital structure are contemplated. a. net income b. earnings before taxes c. operating income d. debt ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Assumptions of capital structure analysis

NAT: Reflective thinking

14. Generally the ______ a firm's business risk, the ______ the amount of financial leverage that will be used in the optimal capital structure. a. greater, greater b. smaller, less c. greater, less d. smaller, greater

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Effect of financial leverage on stockholders returns

15. All of the following factors influence a firm's business risk except: a. degree of operating leverage b. variability of interest rates c. variability of operating costs d. variability of selling prices ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Business risk

16. Operating leverage involves the use of a. equity and debt in equal proportions b. market power c. debt d. assets having fixed costs ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Business risk

17. The use of fixed cost sources of funds, such as debt and preferred stock affect a firm's ______. a. financial risk b. degree of operating leverage c. market power d. business risk ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Financial risk and financial leverage

18. The use of fixed-cost financing sources is referred to as the use of a. operating leverage b. a leveraged buyout c. financial leverage d. combined leverage ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Financial risk and financial leverage

19. The objective of capital structure management is to find the capital mix that leads to a. maximization of earnings per share b. shareholder wealth maximization c. maximization of net income d. maximization of the current period's dividends ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Effect of financial leverage on stockholder returns and risk 20. Financial leverage benefits shareholders when the a. return on assets is greater than the cost of debt b. return on equity is greater than the cost of debt c. return on investments is less than the weighted cost of capital d. return on equity is less than the cost of debt ANS: A

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand risk and return TOP: Effect of financial leverage on stockholder returns and risk 21. Modigliani and Miller show that the value of a firm is ______ capital structure given perfect capital markets and no corporate income taxes. a. maximized by having no debt in the b. independent of c. maximized by having an optimal d. dependent on the ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure without a corporate income tax

NAT: Reflective thinking

22. Due to both financial distress and agency costs, a firm should have a capital structure that a. contains all debt b. contains all equity c. contains both debt and equity d. contains only long-term debt ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure with corporate income tax | bankruptcy...

23. Agency costs a. increase as the debt/total assets ratio decreases b. affect the present value of the tax shield c. decrease as financial distress increases d. reduce the market value of the levered firm ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Agency costs

24. Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place restrictions on which of the following activities? a. the sale of assets b. payment of dividends c. the issuance of additional debt d. all of the above are typical protective covenants ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Agency costs

25. As the proportion of debt in the capital structure increases, investors require a ______ return and the value of existing debt will ______. a. higher, increase b. higher, decrease c. lower, increase d. lower, decrease ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

26. Investors' required returns and the cost of equity capital ______ as the relative amount of debt used to finance the firm ______. a. increase, increases b. increase, decreases c. remain constant, increases d. remain constant, decreases ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

27. Studies of capital structure changes have found that actions that increase leverage have generally been associated with ______ stock returns and actions that decrease leverage are associated with ______ stock returns. a. negative, positive b. negative, no change in c. positive, negative d. no change in, negative ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Signaling effects

28. The managerial implications of capital structure theory include all of the following except: a. capital structure changes transmit important information to investors b. changes in capital structure result in changes in the market value of the firm's equity c. optimal capital structure is influenced heavily by the business risk facing the firm d. tax shield benefits from equity lead to increased firm value ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Managerial implications of capital structure theory

NAT: Reflective thinking

29. The increased variability in earnings per share due to the firm's use of debt is a definition of ______. a. combined leverage b. agency risk c. financial risk d. operating risk ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Financial risk and financial leverage

30. In determining the capital structure for an international firm, the managerial objective is to a. minimize exchange rate risk b. minimize the risk of expropriation c. minimize the overall cost of capital d. minimize available local low-cost financing ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: International issues: Capital structure

NAT: Multicultural understanding

31. __________ represents the permanent sources of the firm's financing. a. Financial structure b. Capital structure c. Equity structure

d. Cost structure ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

32. The optimal capital structure of a firm is a function of the __________. a. business risk of the firm b. tax structure c. business risk of the firm and the tax structure d. the variability of sales volumes ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure decisions & maxim. of shareholder...

NAT: Reflective thinking

33. The less a firm's business risk, the __________ the amount of __________ that will be used in the optimal capital structure, holding constant all other relevant factors. a. less; financial leverage b. more; financial leverage c. less; equity capital d. more; debt capital ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Business risk

34. The market value of a levered firm can be represented by the following equation: Market value of levered firm = Market value of unlevered firm __________ Present value of tax shield __________ Present value of financial distress costs __________ Present value of agency costs a. minus; plus; plus b. plus; plus; plus c. plus; minus; minus d. minus, plus, minus ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The value maximizing capital structure

NAT: Reflective thinking

35. The optimal capital structure is a function of __________. a. corporate income taxes b. financial distress costs c. agency costs d. corporate income taxes, financial distress costs, and agency costs ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: The cost of capital and the optimal capital structure

NAT: Reflective thinking

36. According to the "pecking order theory," firms prefer to issue __________ securities first and then issue __________ securities as a last resort. a. equity, debt b. debt, convertible debt c. debt, equity d. equity, convertible debt ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: The pecking order theory

37. __________ refers to the argument that officers and managers have access to information about the expected future earnings of the firm that is not available to outside investors. a. Insider trading b. Asymmetric information c. Signaling effect d. Pecking order theory ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Signaling effects

38. A survey of Fortune 500 firms indicate that they prefer internal financing (retained earnings) to external financing. This preference is known as __________. a. financial slack b. the pecking order theory c. capital structure theory d. asymmetric capital ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The pecking order theory

39. A firm with highly liquid assets plus unused debt capacity is said to have _____. a. arbitrage structural capacity b. the optimal capital structure c. financial slack d. optimal financial structure ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: The pecking order theory

40. The management of Graphicopy is trying to determine how much debt they should have in their capital structure. If they sell $500,000 in perpetual bonds with a 9 percent coupon, what would be the present value of the tax shield? Assume the marginal tax rate is 35%. a. $15,750 b. $29,250 c. $175,000 d. $45,000 ANS: C Solution: PV tax shield = ($500,000)(0.35) = $175,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Tax shield calculation

41. What is the annual tax shield to a firm that has a capital structure consisting of $100 million of debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%? a. $9.0 million b. $5.4 million c. $9.36 million d. $3.6 million ANS: D

Solution: Tax shield = 0.09($100)(0.4) = $3.6 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Tax shield

42. What is the present value of the tax shield to a firm that has a capital structure consisting of $100 million of perpetual debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%? a. $72 million b. $40 million c. $60 million d. $3.6 million ANS: B Solution: PV tax shield = $100(0.4) = $40 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Present value of tax shield

43. Calculate the market value of Lotle Group, a firm with total assets of $80 million and $30 million of perpetual debt in its capital structure. The firm's cost of equity is 14% and the cost of debt is 9%. Lotle expects annual, perpetual net operating income (EBIT) of $9 million and a marginal tax rate of 40%. a. $30 million b. $61.3 million c. $57 million d. $64.3 million ANS: C Solution: Income available to stockholders= ($9.0 - $2.7)(1 - 0.40) = $3.78 million Value = $2.7/0.09 + $3.78/0.14 = $57 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Valuation and capital structure

NAT: Analytic skills

44. What is the annual tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%? a. $2.125 million b. $1.87 million c. $0.85 million d. $0.744 million ANS: D Solution: Tax shield = 0.085($25 million)(0.35) = $0.744 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Tax shield

45. What is the present value of the tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on perpetual debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%? a. $8.75 million b. $12.25 million c. $0.85 million d. $0.744 million ANS: A Solution: PV tax shield = $25 million(0.35) = $8.75 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Present value of tax shield

46. Calculate the market value of a firm with total assets of $60 million and a net worth of $35 million.

The firm's cost of equity is 15% and the cost of perpetual debt is 8%. The firm has a perpetual net operating income (EBIT) of $4.5 million and a marginal tax rate of 35%. a. $41.67 million b. $30.00 million c. $35.83 million d. $30.83 million ANS: C Solution: Income available to stockholders = ($4.5 - $2.0)(1 - 0.35) = $1.625 Value = $2.0/0.08 + $1.625/0.15 = $35.83 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Valuation and capital structure

NAT: Analytic skills

47. What is the market value of Barings, a firm with total assets of $100 million and $30 million in perpetual debt in its capital structure. Barings' cost of equity is 15% and its cost of debt is 10%.

Expected perpetual net operating income (EBIT) will be $17 million and the marginal tax rate is 40%. a. $86.0 million b. $104.0 million c. $98.0 million d. $92.7 million ANS: A Solution: Income available to stockholders = (17 - 3)(1 - .4) = $8.4 Value = $8.4/.15 + 3/.10 = $86 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Valuation and capital structure

NAT: Analytic skills

48. Calculate the market value of a firm with total assets of $105 million and $50 million of 10% perpetual debt in the capital structure. The firm's cost of equity is 14% on the $55 million in equity in the capital structure. The perpetual EBIT is expected to be $9 million and the marginal tax rate is 40%. a. $88.6 million b. $67.1 million c. $114.3 million

d. $78.6 million ANS: B Solution: Income available to stockholders = ($9 - 5)(.6) = $2.4 Value = $2.4/.14 + 5/.10 = $67.1 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Valuation and capital structure

NAT: Analytic skills

49. RoTek has a capital structure of $300,000 in equity and $300,000 in perpetual debt. The firm's cost of equity is 14 percent and its cost of debt is 9 percent. If the firm has an expected, perpetual net operating income of $120,000 and a marginal tax rate of 40 percent, what is the market value of RoTek? Assume all net income is paid out as dividends. a. $698,571 b. $814,286 c. $818,571 d. $55,800 ANS: A Solution: Interest = $300,000(0.09) = $27,000 Net income = ($120,000 - $27,000)(1 - 0.40) = $55,800 Market value = $55,800/0.14 + $27,000/0.09 = $698,571 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Capital structure and valuation

NAT: Analytic skills

50. Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost information: Debt/assets

kd

ke

.30 .40 .50 .60 .70

.10 .105 .11 .117 .13

.125 .13 .135 .142 .155

Based on this information, what capital structure (debt/asset ratio) should management accept?

Assume the marginal tax rate is 40%. a. 40% has lowest cost of capital b. 50% has lowest cost of capital c. 60% has lowest cost of capital d. 70% has lowest cost of capital ANS: C Solution: Debt/assets .30 .40 .50 .60

0.3(0.10)(0.6) + 0.7(0.125) = 0.1055 0.4(0.105)(0.6) + 0.6(0.13) = 0.1032 0.5(0.11)(0.6) + 0.5(0.135) = 0.1005 0.6(0.117)(0.6) + 0.4(0.142) = 0.0989

.70

0.7(0.13)(0.6) + 0.3(0.155) = 0.1011

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of capital and optimal capital structure

NAT: Analytic skills

51. Seduak has estimated the costs of debt and equity capital for various proportions of debt in its capital structure: % of Debt

Cost of Debt

Cost of Equity

0% 10 20 30 40 50 60

5.4% 5.4 5.8 6.3 7.0 8.2

13.0% 13.3 13.8 14.4 15.2 16.0 17.0

Based on these estimates, determine Seduak's optimal capital structure. a. 30% debt b. 40% debt c. 50% debt d. 60 % debt ANS: C Solution: k10 = 0.10(0.054) + 0.90(0.133) = 0.1251 k20 = 0.20(0.054) + 0.80(0.138) = 0.1212 k30 = 0.30(0.058) + 0.70(0.144) = 0.1182 k40 = 0.40(0.063) + 0.60(0.152) = 0.1164 k50 = 0.50(0.07) + 0.50(0.16) = 0.115 k60 = 0.60(0.082) + 0.40(0.17) = 0.1172 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of capital and capital structure

NAT: Analytic skills

52. Technico has determined that its optimal capital structure is 40% debt, at which point its weighted cost of capital, ka, is 13.7%. Due to financial problems, the firm has decided to raise the proportion of debt to 50%, which will increase its weighted cost of capital to 14.4%. What is the effect on the stock price of Technico? The current dividend is $1.60 and the long-term growth rate of dividends is expected to be 8.5%. a. Decrease $3.65 b. Decrease $3.96 c. Increase $3.65 d. Increase $3.96 ANS: B Solution: P0 = $1.60(1.085)/(0.137 - 0.085) = $33.38 P0 = $1.60(1.085)/(0.144 - 0.085) = $29.42 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Valuation

53. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure: % of Debt

Cost of Debt

Cost of Equity

35 40 45 50

5.4% 5.6 5.9 6.4

13.8% 14.0 14.3 14.7

Based on these estimates, determine Biotec's optimal capital structure. a. 35% debt b. 40% debt c. 45% debt d. 50% debt ANS: C Solution: k35 = 0.35(0.054) + 0.65(0.138) = 0.1086 k40 = 0.40(0.056) + 0.60(0.140) = 0.1064 k45 = 0.45(0.059) + 0.55(0.143) = 0.1052 k50 = 0.50(0.064) + 0.50(0.147) = 0.1055 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of capital and optimal capital structure

NAT: Analytic skills

54. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure: % of Debt

Cost of Debt

Cost of Equity

35 40 45 50

5.4% 5.6 5.9 6.4

13.8% 14.0 14.3 14.7

If Biotec pays a current dividend of $1.00 and expects dividends to grow at a constant rate of 7%, what is Biotec's stock price if it obtains its optimal capital structure? a. $14.66 b. $30.40 c. $30.14 d. $29.40 ANS: A Solution: P0 = 1.00(1.07)/(0.143 - 0.07) = $30.40 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Valuation

55. Triad Labs has total assets of $120 million and $40 million of debt in its capital structure. Its current cost of equity is 13% and its cost of debt is 8.5%. Triad is considering increasing its debt to $70 million and purchasing its own stock with proceeds from the sale of $30 million in debt with a cost of 9.5%, reducing equity to $50 million. The cost of equity will increase to 14.5%. Net operating income (EBIT) will remain at $12 million. If Triad has a marginal tax rate of 40%, should the firm increase its debt? Assume that both debt and EBIT are perpetual.

a. b. c. d.

No, the value of the firm decreases $15.9 million No, the value of the firm decreases $30.0 million Yes, the value of the firm increases $14.1 million Yes, the value of the firm increases $30.0 million

ANS: C Solution: Income available = (12 - 3.4)(.6) = $5.16 Value = $5.16/.13 + 3.4/.085 = $79.7 million Income available (after new debt) = (12 - 3.4 - 2.85)(.6) = $3.45 Value = 3.45/.145 + 3.4/.085 + 2.85/.095 = $93.8 million PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Valuation and capital structure

NAT: Analytic skills

56. The airline industry is extremely price competitive, as well as having huge fixed costs and very low variable costs. This is an example of: a. low asset performance b. high profitability c. high operating leverage d. low fixed threshold ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Financial challenge 57. The capital structure decision attempts to minimize ________________ which maximizes the value of the firm. a. leverage costs b. the cost of capital c. labor costs d. compensation packages ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure decisions and maximization of shareholder wealth 58. The greater the variability of costs , the greater the business risk of the firm. This is reflected in the: a. selling price b. cost of inputs used to produce a firm’s output c. sales volume d. existence of market power ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Business risk

59. The process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit is called: a. option pricing b. diversification c. arbitrage d. margining ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking

TOP: Capital structure without a corporate income tax 60. Arbitrage transactions are: a. risky b. illegal c. speculative d. risk-free ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure without a corporate income tax

NAT: Reflective thinking

61. The tax deductibility of interest payments provides the firm with a: a. market advantage b. learning curve c. tax shield d. safeguard against auditing ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure with a corporate income tax

NAT: Reflective thinking

62. In considering a firm’s capital structure, the firm should increase its ___________ which will maximize its value a. stock outstanding b. earnings c. cash flow from investing d. debt ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure with a corporate income tax

NAT: Reflective thinking

63. With financial leverage, a change in EBIT results in a change in: a. fixed costs b. EPS c. financial risk d. EBT ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Financial risk and financial leverage

NAT: Reflective thinking

ESSAY 1. How do signaling effects impact the firm’s capital structure decision?

ANS: When a firm issues new securities, the event can be viewed as providing a signal to the marketplace regarding the future prospects of the firm. New common equity offerings generally have a negative impact on the stock’s market price, whereas new debt offerings generally have no impact on the stock price. Repurchases of common stock have led to positive stock returns.

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: Signaling effects

2. What is the pecking order theory with regard to managerial preferences for financing alternatives?

ANS: The pecking order theory indicates that firms prefer internal financing (namely, retained earnings) to external financing (new security issues). This preference is based on two considerations. First, because of floatation costs of new security issues, internal financing is less costly than external financing. Second, internal financing avoids the discipline and monitoring that occurs when new securities are sold publicly. Companies are reluctant to make major changes in dividend payments and only gradually adjust dividend payout ratios to reflect their investment opportunities and thereby avoid the issuance of new securities.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Capital structure theory 3. There are many factors that influence a firm’s business risk. List them.

ANS: The factors that influence a firm’s business risk are: 1. The variability of sales volumes over the business cycle.

2. The variability of selling prices.

3. The variability of costs.

4. The existence of market power.

5. The extent of product diversification.

6. The level and rate of growth.

7. The degree of operating leverage.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Business risk 4. Explain how industry effects need to be considered in the capital structure decision.

ANS: Given the corporate income tax, financial distress costs, and agency costs, an optimal capital structure consisting of both debt and equity is shown to exist. Determination of the optimal capital structure involves balancing the present value of the tax shield accruing from debt financing against the present value of the expected financial distress costs and the agency costs associated with debt financing.

In general, the studies of industry effects in capital structure tend to conclude that there is an optimal capital structure for individual firms. Firms may deviate from their optimal leverage targets, over time they appear to take actions that close the gap between actual and target capital structure ratios.

The market rewards firms that achieve their optimal capital structure.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Other considerations in the capital structure decision; Summary

Chapter 14—CAPITAL STRUCTURE MANAGEMENT IN PRACTICE MULTIPLE CHOICE 1. Raw material and direct labor costs are examples of a. fixed costs

b. overhead costs c. variable costs d. capital costs ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Short run costs

2. When fixed operating costs are incurred by the firm, a change in ______ is magnified into a relatively larger change in earnings before interest and taxes. a. overhead expenses b. interest charges c. labor costs d. sales revenue ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Measurement of operating and financial leverage

NAT: Reflective thinking

3. When fixed capital costs are incurred by the firm, a change in ______ is magnified into a larger change in earnings per share. a. earnings before interest and taxes b. overhead expenses c. interest charges d. preferred dividends ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of financial leverage

4. The percentage change in a firm's EBIT that results in a 1% change in sales or output is known as the a. degree of combined leverage b. degree of financial leverage c. degree of operating leverage d. degree of business risk ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of operating leverage

5. The total variability of the firm's EPS associated with a change in sales is an indication of combined leverage and is best measured by a. DOL b. DFL c. DOL + DFL d. DOL x DFL ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Reflective thinking

6. In the analysis of financial leverage, all of the following are referred to as fixed charges except: a. bond interest b. common stock dividends c. bank interest d. preferred stock dividends ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of financial leverage

7. The degree of combined leverage is defined as the percentage change in earnings per share resulting from a given percentage change in a. operating costs b. interest charges c. common stock dividends d. sales (or output) ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Reflective thinking

8. The degree of combined leverage is equal to the degree of operating leverage _____ the degree of financial leverage. a. added to b. divided by c. multiplied by d. subtracted from ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Reflective thinking

9. Rent, insurance, and the salaries of top management are examples of: a. fixed costs b. capital costs c. variable costs d. fluctuating costs ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Short run costs

10. A firm that employs relatively large amounts of labor- saving equipment in its operations will have a relatively ______ degree of operating leverage. a. low b. constant c. insignificant d. high ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of operating leverage

11. A firm that employs a relatively large proportion of debt and preferred stock in its capital structure will have a relatively ______ degree of financial leverage. a. low b. high c. insignificant d. constant ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of financial leverage

12. The degree of combined leverage is equal to the _____ multiplied by the ______. a. degree of operating leverage, variable cost ratio b. degree of financial leverage, variable cost ratio

c. degree of operating leverage, degree of financial leverage d. degree of operating leverage, fixed cost ratio ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Reflective thinking

13. A firm is considering the purchase of assets that will increase its fixed operating costs. The firm should decrease the proportion of ______ it employs in its capital structure if it wants to maintain its existing degree of combined leverage. a. debt b. warrants c. common stock d. common stock and warrants ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Reflective thinking

14. To balance the operating and financial risks that are so variable for a multinational company, Nestle allows its foreign operating subsidiaries ________ operational flexibility and follows a ________ financing strategy. a. decentralized, centralized b. centralized, centralized c. centralized, decentralized d. decentralized, decentralized ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: International issues

15. The degree of financial leverage is defined as the percentage change in a. EBIT resulting from a given percentage change in sales b. EPS resulting from a given percentage changes in sales c. EBIT resulting from a given percentage change in EPS d. EPS resulting from a given percentage change in EBIT ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of financial leverage

16. An analytical technique called ______ can be used to help determine when debt financing is advantageous and when equity financing is advantageous. a. DFL-EPS analysis b. EBIT-EPS analysis c. DCL-EPS analysis d. DOL-EBIT analysis ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: EBIT-EPS analysis

17. Cash insolvency analysis evaluates the adequacy of a firm's cash position in a a. bankruptcy proceeding b. non-normal environment c. highly competitive environment d. recessionary environment ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital

TOP: Cash insolvency analysis

18. Financial leverage causes a firm's __________ to change at a rate greater than the change in ______________. a. EBIT; EPS b. EPS; EBIT c. EBIT; sales d. sales; EBIT ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Degree of financial leverage

19. In EBIT-EPS analysis, the indifference point is found at the point where __________ for the two alternative financing plans are equal. a. EBIT b. EPS c. stock prices d. DOL ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: EBIT-EPS analysis

20. A firm which has a 2.5 DOL (degree of operating leverage) would find that an 8% increase in EBIT would result from a _____ increase in sales. a. 3.2% b. 5.4% c. 20.0% d. 2.0% ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: DOL

21. A negative DOL indicates the percentage _____ in operating losses that occurs as the result of a 1% increase in output. a. increase b. reduction c. change d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: DOL

22. A DFL (degree of financial leverage) of 3.0 indicates that a 27% increase in EPS is the result of a _____ increase in EBIT. a. 81% b. 3% c. 9% d. 6% ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: DFL

23. The use of increasing amounts of combined leverage _____ the risk of financial distress. a. decreases b. increases

c. has no effect on d. creates diversity in ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: DCL

24. A firm is said to be _____ if it is unable to meet its current obligations. a. cash insolvent b. bankrupt c. free cash challenged d. technically insolvent ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Cash insolvency analysis

25. Illinois Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC's degree of operating leverage at a sales level of $9 million? a. 1.60 b. 1.875 c. 3.0 d. 1.26 ANS: B Solution: DOL = [($9,000,000 - 0.7($9,000,000)]/[$9,000,000 - 0.7($9,000,000) - $1,260,000] = 1.875 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of operating leverage calculation

NAT: Analytic skills

26. Illinois Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC's degree of financial leverage at an EBIT level of $1,440,000. a. 1.20 b. 1.875 c. 3.0 d. 1.60 ANS: D Solution: DFL = $1,440,000/[$1,440,000 - 0.08($3,000,000) - $150,000/(1 - 0.5)] = 1.60 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of financial leverage calculation

NAT: Analytic skills

27. Illinois Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC's degree of combined leverage at a sales level of $10 million? a. 2.00 b. 1.72 c. 2.50 d. 1.25 ANS: C Solution: DCL = ($10,000,000 - 0.70($10,000,000)/[($10,000,000 - 0.7($10,000,000 - $1,260,000 - 0.08($3,000,000) - ($150,000)/(1 - 0.5)] DCL = 2.50 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage calculation

NAT: Analytic skills

28. Suppose that ITC's degree of combined leverage (DCL) is 3.00 at a sales volume of $9 million.

Determine ITC's percentage change in earnings per share (EPS) if forecasted sales increase by 20 percent to $10,800,000. a. 60% b. 50% c. 32% d. 30% ANS: A Solution: % change EPS = 3.00(20%) = 60% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage analysis

NAT: Analytic skills

29. The Lincoln Mint produces various types of one ounce silver commemorative medals for sale to collectors. The cost of producing and selling a given medal is as follows: Fixed costs: Design and preparation of dies Promotion and selling expenses Administrative overhead Total Variable costs: Silver blanks Striking medals Mailing expenses Total Projected selling price:

$ 8,000 25,000 7,000 $40,000 $

6.00 0.50 3.50 $ 10.00 $ 14.00

What is the degree of operating leverage at an output level of 15,000 units?

a. b. c. d.

0.0 1.0 3.0 cannot be determined from the information provided

ANS: C Solution: DOL = [($14 - $10)(15,000)]/[($14 - $10)(15,000) - $40,000] = 3.0 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of operating leverage calculation

NAT: Analytic skills

30. Last year Avator's operating income (EBIT) increased by 22 percent while its dollar sales increased by 15%. What is Avator's degree of operating leverage (DOL)? a. 0.68 b. 2.0 c. 1.47 d. 0.32 ANS: C Solution: DOL = 22% / 15% = 1.47 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of operating leverage

31. Kermit's Hardware's (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.

The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH's degree of operating leverage. a. 14.81 b. 5.19 c. 12.95 d. 4.54 ANS: C Solution: VC = $32.2(0.30) = 9.66 EBIT = $32.2 - $20.8 - $9.66 = $1.74 DOL = ($32.2 - $9.66)/$1.74 = 12.95 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of operating leverage

32. Kermit's Hardware's (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.

The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH's degree of financial leverage. a. 1.22 b. 2.07 c. 1.09 d. 1.04 ANS: B

Solution: EBIT = $32.2 - $20.8 - $9.66 = $1.74 DFL = $1.74/($1.74 - $0.9) = 2.07 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of financial leverage

33. Kermit's Hardware's (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.

The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH's degree of combined leverage. a. 26.8 b. 5.5 c. 29.1 d. 4.7 ANS: A Solution: DCL = 12.95 x 2.07 = 26.8 Check: DCL = ($32.2 - $9.66)/($1.74 - $0.9) = 26.83 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Analytic skills

34. Weis Products has fixed operating costs of $20 million and a variable cost ratio of 0.55. Weis has 4 million common shares outstanding and a marginal tax rate of 45%. What is Weis's degree of operating leverage at an expected sales level of $150 million. a. 1.00 b. 1.74 c. 1.42 d. 1.32 ANS: C Solution: EBIT = $150 - $20 - 0.55($150) = $47.5 DOL = ($150 - 0.55(150))/47.5 = 1.42 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of operating leverage

35. Kenzel has an EPS of $4.20 and sales are $9 million. If the firm has a degree of operating leverage of 4.0 and a degree of financial leverage of 5.2, forecast EPS if the firm expects a 4% sales decline. a. $0.71 b. $3.49 c. $4.03 d. $3.33 ANS: A Solution: DCL = 4.0 x 5.2 = 20.8 EPS decline = 4%(20.8) = 83.2% Forecasted EPS = $4.20(1 - 0.832) = $0.7056 PTS: 1

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage 36. Leigh Fibers expects its operating income over the coming year to equal $2.5 million with a standard deviation of $800,000. Leigh must pay interest charges of $1.2 million next year and preferred dividends of $300,000. Leigh's marginal tax rate is 35%. What is the probability that Leigh will have negative EPS next year if its operating income is expected to be normally distributed? (Problem requires normal distribution table) a. 14.7% b. 5.2% c. 10.6% d. 15.7% ANS: A Solution: Loss level = $1,200,000 + $300,000/(1 - 0.35) = $1,661,538 z = ($1,661,538 - $2,500,000)/$800,000 = -1.048 From Table V, p = 14.7% PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Financial risk analysis

37. Chemex has a cash and marketable securities balance of $200 million. Management expects free cash flows of $320 million during the coming year. If management is considering a restructuring of its capital structure that would add an additional $350 million of annual fixed financial charges, what is the expected cash balance at the end of the year? a. -$30 million b. $170 million c. $230 million d. $470 million ANS: B Solution: CB = $200 + $320 - $350 = $170 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cash insolvency analysis

38. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares) and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans.

Plan A: Plan B:

Equity financing. Under this plan, an additional 2.5 million shares of common stock will be sold at $15 each.

Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.

What is the EBIT-EPS indifference point? Assume a 40 percent marginal tax rate. a. $33.9 million b. $30.75 million c. $37.0 million d. $12.9 million ANS: B Solution: [(EBIT - $12 - $3.75)(1 - 0.40)]/10 = [(EBIT - $12)(1 - 0.40)]/(10 + 2.5)

EBIT = $30.75 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Indifference point calculation

NAT: Analytic skills

39. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares) and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans.

Plan A: Plan B:

Equity financing. Under this plan, an additional 2.5 million shares of common stock will be sold at $15 each.

Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.

What happens to the EBIT indifference point if the interest rate on the new debt decreases and the common stock price remains constant? a. the indifference point increases b. the indifference point decreases c. the indifference point does not change d. cannot be determined from the information provided ANS: B Solution: No calculations needed PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: analytic skills TOP: Indifference point analysis

40. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two companies differ in their capital structures, as shown below:

Debt (10%) Common equity No. shares outstanding

Jefferson $200 million $300 million 15 million

Jackson $100 million $400 million 20 million

Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jefferson at an EBIT level of $50 million? a. $-1.20 b. $ 1.20 c. $ 2.20 d. $ 3.33 ANS: B Solution: EBT = $50 - $20 = $30 EAT = $30(1 - 0.4) = $18 EPS = $18,000,000/15,000,000 = $1.20 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Indifference point analysis

41. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two companies differ in their capital structures, as shown below:

Jefferson $200 million $300 million 15 million

Debt (10%) Common equity No. shares outstanding

Jackson $100 million $400 million 20 million

Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jackson at an EBIT level of $50 million? a. $1.50 b. $1.20 c. $2.00 d. $2.50 ANS: B Solution: EBT = $50 - $10 = $40 EAT = $40(1 - 0.4) = $24 EPS = $24,000,000/20,000,000 = $1.20 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Indifference point analysis

42. Onex expects to have an EBIT of $240,000 with a standard deviation of $90,000. The distribution of operating income is approximately normal. What is the probability that Onex will have an EBIT that is below $0? a. 0.47% b. 2.67% c. 0.38% d. 2.25% ANS: C Solution: z = ($0 - $240,000)/$90,000 = -2.67

From Table V, p = 0.38%

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Risk calculation from normal table

NAT: Analytic skills

43. Alace is an all equity firm with 10 million shares outstanding that is evaluating two alternative financing plans. With the first plan, Alace will sell 1 million shares of common stock at $15 each.

Under the second plan, the firm would sell $15 million of 12 percent long-term debt. If Alace has a marginal tax rate of 35 percent, what is the EBIT-EPS indifference point? a. $12.9 million b. $19.8 million c. $11.7 million d. $18.0 million ANS: B Solution: (EBIT - $1.8)(1 - 0.35)/10 = (EBIT - 0)(1 - 0.35)/(10 + 1) EBIT = $19.8 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Indifference point calculation

NAT: Analytic skills

44. Knight Moves is considering two alternative financing plans. The firm is expected to operate at the $75 million EBIT level. Under Plan D (debt financing) EPS is expected to be $2.25, and under Plan E (equity financing) EPS is expected to be $1.82. If the market is expected to assign a P/E ratio of 12 to the debt plan and 15 to the equity plan, which plan should Knight pursue? a. debt b. equity c. indifferent between the two alternatives d. neither is satisfactory ANS: B Solution: Debt Plan Price = 12($2.25) = $27.00 Equity Plan Price = 15($1.82) = $27.30 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Effect of financial leverage on stock prices

NAT: Analytic skills

45. Dagger Company has a current capital structure consisting of $60 million in long-term debt with an interest rate of 9% and $60 million in common equity (12 million shares). The firm is considering an expansion plan costing $23 million. The expansion plan can be financed with additional long-term debt at a 12% interest rate or the sale of new common stock at $8 per share. The firm's marginal tax rate is 40%. Determine the indifference level of EBIT for the two financing plans. a. -$30.24 million b. $18.36 million c. $30.24 million d. $19.68 million ANS: D Solution: (EBIT - $8.16) (1 - 0.40) 12

=

(EBIT - $5.4) (1 - 0.40) 14.875

EBIT* = $19.68 (million) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Indifference point calculation

NAT: Analytic skills

46. The Ames Company has an expected EBIT of $16 million with a standard deviation of $8 million. The indifference point between a debt financing alternative and a common stock financing alternative was computed to be $12 million. Determine the probability that the equity financing alternative will be superior to the debt financing alternative (i.e., have a higher EPS). (Problem requires normal distribution table.) a. 50.0% b. 30.85% c. 69.15% d. cannot be computed ANS: B Solution: The probability that the equity financing alternative will result in a higher EPS is equal to the probability that the EBIT level will be less than $12 million, or z = ($12.0 - $16.0)/$8.0 = -0.50

The probability of a value less than 0.50 standard deviations to the left of the mean is 0.3085 or 30.85%, from Table V. PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Indifference point risk analysis

NAT: Analytic skills

47. Centex, a producer of telephone systems for small businesses, has current sales of $43 million and variable operating costs of $27.95 million. Centex expects to increase sales in the coming year by 15% while keeping fixed operating costs constant at $9.1 million. What is the DOL for Centex? a. 3.3 b. 2.5 c. 7.2 d. 1.0 ANS: B Solution: DOL =

(8.2075 - 5.95)/5.95 (49.45 - 43)/43

=

0.3794 = 2.53 0.15

EBIT0 = 43 - 27.95 - 9.1 = $5.95 EBIT1 = 49.45 - 49.45(.65) - 9.1 = $8.2075 Variable cost ratio = 27.95/43 = .65 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of operating leverage

48. TCA Cable has fixed operating cost of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 in bonds outstanding with a coupon interest rate of 12%. TCA has 1.0 million common shares and 1,000,000 shares of $1.75 preferred stock outstanding. Total revenues for TCA Cable are $14.2 million. If TCA has a marginal tax rate of 40%, what is its degree of combined leverage? a. 2.1 b. 1.0 c. 1.9 d. 2.5 ANS: D Solution: DCL =

14.2 - 4.26 [7.34 - 0.48 - 1.75/(1-0.4)]

=

9.94 3.944

= 2.52

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Analytic skills

49. Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of combined leverage of 3.4. What is Borkstran's degree of financial leverage? a. 1.20 b. 0.73 c. 2.29 d. 0.84

ANS: A Solution: DOL = (7.8 - 4.68)/1.1 = 2.84 DFL = DCL/DOL = 3.4/2.84 = 1.20 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of financial leverage

50. Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree of operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to increase 15%, what will be the EPS forecast? a. $2.61 b. $4.60 c. $5.81 d. $3.68 ANS: C Solution: DCL = 1.87(2.91) = 5.44 % change in EPS = 5.44(15) = 81.6 Forecasted EPS = 3.20(1.816) = $5.81 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Analytic skills

51. Last year Alpine Growers experienced a 34% increase in earnings per share on 11% increase in sales.

If management knows that Alpine's DOL is 1.5, what is its DFL? a. 3.09 b. 2.06 c. 3.55 d. 1.67 ANS: B Solution: DCL = 34/11 = 3.09 DFL = 3.09/1.5 = 2.06 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of financial leverage

52. If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm's DOL. During the same period the firm saw its EBIT increase only 8%. a. 1.50 b. 3.38 c. 1.34 d. 0.67 ANS: D Solution: D0L = 8%/12% = 0.67 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of operating leverage

53. Given the following financial data for Boston Technology, compute the firm's degree of combined leverage. Assume a marginal tax rate of 40%.

Sales Fixed costs Variable costs EBIT Interest Shares outstanding a. b. c. d.

19x5

19x6

$700,000 175,000 406,000 119,000 42,000 100,000

$760,000 190,000 448,000 122,000 46,000 102,000

0.29 -0.38 -0.15 0.38

ANS: B Solution: 19x5 19x6 $119,000 $122,000 EBIT 42,000 46,000 I 77,000 76,000 EBT 30,800 30,400 T $ 46,200 $ 45,600 EAT $0.462 $0.447 EPS DCL = [($0.447 - $0.462)/$0.462]/[($760,000 - $700,000)/$700,000] = -0.38 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Analytic skills

54. ASG expects next year's operating income (EBIT) to equal $22 million, with a standard deviation of $16 million. The coefficient of variation of operating income is equal to 0.73. Interest expenses will be $9 million next year and debt retirement will require a principal payment of $2.5 million. ASG's marginal tax rate is 40%. If EBIT is normally distributed, what is the probability that ASG will have a negative EPS next year? a. 20.9% b. 25.5% c. 23.3% d. 25.8% ANS: A Solution: z = ($9.0 - $22.0)/16.0 = -0.81 From Table V, at z = - 0.81; p = 0.2090 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Financial risk analysis

55. Sulzar's capital structure consists only of common stock (20 million shares), but the firm is planning a major expansion which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital through the sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first mortgage bonds that would have a coupon rate of 9%. If Sulzar has a marginal tax rate of 40%, calculate the EBIT-EPS indifference point. a. $45 million b. $36 million c. $5 million d. $9 million ANS: A Solution: [(EBIT - $9.0)(0.60)]/20 = [(EBIT - 0 )(.60)]/25 EBIT* = $45 (million) PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: EBIT-EPS analysis

56. Given the following financial data for Cosmos, compute the firm's degree of combined leverage.

Sales Fixed costs Variable costs EBIT Interest EPS a. b. c. d.

20x5

20x6

$780,000 195,000 460,200 124,800 46,800 $0.42

$874,000 218,500 524,400 131,100 52,400 $0.51

$0.42 8.37 -2.15 1.78

ANS: D Solution: DCL = [($0.51 - $0.42)/$0.42]/[($874,000 - $780,000)/$780,000] = 1.78 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Degree of combined leverage

NAT: Analytic skills

57. Given the following financial data for Cosmos, compute the firm's degree of financial leverage.

Sales Fixed costs Variable costs EBIT Interest EPS a. 23.81 b. 4.24 c. 0.42

$780,000 195,000 460,200 124,800 46,800 $0.42

$874,000 218,500 524,400 131,100 52,400 $0.51

d. 2.18 ANS: B Solution: DFL = [($0.51 - $0.42)/$0.42]/[($131,100 - $124,800)/$124,800] = 4.24 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Degree of financial leverage

58. Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share.

Higgins also has a $20 million mortgage bond outstanding that has an 11 percent coupon rate. Higgins is considering two alternatives to financing a major expansion. Plan A is to sell $10 million of additional long-term debt with a 12.5 percent coupon. Plan B is to sell 200,000 shares of common stock at $30 per share and $4 million in long-term debt with a 11.25 percent coupon. What is the EBIT indifference level between these two alternatives? Assume the marginal tax rate is 40 percent. a. $1,374,000 b. $11,450,000 c. $4,554,000 d. $2,650,000 ANS: B Solution: (EBIT - $3.45)(0.6)/2 = (EBIT - $2.65)(0.6)/2.2 EBIT* = $11.45 million PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Indifference point calculation

NAT: Analytic skills

59. Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of operating income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability that it will have an operating income that is below $0? a. 4.27% b. 1.46% c. 0.02% d. 2.4% ANS: B Solution: z = ($0 - $240,000)/$110,000 = -2.18; From Table V, p = 1.46% PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Risk calculation from normal table

NAT: Analytic skills

60. Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of common stock at $15 each and $6 million of 13 percent long-term debt. If Midwest has a marginal tax rate of 40 percent, what is the EBIT-EPS indifference point for this plant? a. $702,000 b. $234,000 c. $2,234,000 d. $1,170,000

ANS: D Solution: (EBIT - $780,000)(0.6)/200,000 = .6EBIT/600,000 EBIT* = $1,170,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: knowledge of capital budgeting and cost of capital TOP: Indifference point calculation

NAT: Analytic skills

61. Jocko Inc. has a capital structure that consists of 60% common equity (2.0 million shares), 30% long-term debt ($10 million with 12% coupon), and 10% preferred stock ($50 par value with $4.75 dividend). The company is planning a major plant expansion and is undecided between the following two financing plans: 1) Equity financing: Sale of 400,000 shares of common at $10 each.

2) Debt financing: Sale of $4 million of 12.5 percent long-term bonds.

Calculate the EBIT-EPS indifference point. Assume the marginal tax rate is 40%. a. $4.253 million b. $3.051 million c. $3.654 million d. $4.728 million ANS: A Solution: Total current capitalization = $10,000,000 debt/0.3 = $33,333,333 Preferred stock = 0.10 x $33,333,333 = $3,333,333 Preferred shares = $3,333,333/$50 = 66,667 Preferred dividends = 66,667 x $4.75 = $316,668.25 (EBIT - 1.7)(.6) - .317 2

=

(EBIT - 1.2)(.6) - .317 2.4

EBIT* = $4,727,779 or $4.728 million PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Indifference point

62. River Rafts has determined that its expected EBIT for the coming year is $8.3 million. The EBIT is approximately normally distributed with a standard deviation of $5.1 million. If River Rafts has $1.9 million in annual interest payments, what is the probability that the firm will have negative earnings? a. 4.65% b. 10.47% c. 5.16% d. 35.20% ANS: B Solution: z = $1.9 - $8.3 = -1.255 $5.1

p = 10.47%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Financial risk analysis (Requires use of normal table.)

NAT: Analytic skills

63. Twin City Printing is considering two financial alternatives for financing a major expansion program.

Under either alternative EBIT is expected to be $15.6 million. Currently the firm's capital structure consists of 4 million shares of common stock and $35 million in 11% long-term bonds. Under the debt financing alternative $10 million in 12% long-term bonds will be sold and under the equity financing alternative the firm would sell 500,000 shares of common stock. The P/E under the debt alternative would be 15 and the P/E under the equity alternative would be 16. The firm's marginal tax rate is 40%.

Which alternative would produce the higher stock price? a. debt--stock price of $23.75 b. debt--stock price of $32.29 c. equity--stock price of $25.07 d. equity--stock price of $33.28 ANS: C Solution:

EBIT I EBT Taxes EAT

Equity

Debt

$15.60 3.85 11.75 4.70 $ 7.05

$15.60 5.05 10.55 4.22 $ 6.33

EPS = $7.05/4.5 = $1.567 Price 16 x $1.567 = $25.07

$6.33/4 = $1.583 15 x $1.583 = $23.75

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Financial leverage and stock price

NAT: Analytic skills

64. Sitco has a total of $12 million in cash and marketable securities. Free cash flows during the coming year are expected to be $47 million with a standard deviation of $31 million. Assume that Sitco's free cash flows are approximately normally distributed. What is the probability that Sitco will run out of cash during the coming year? a. 29.98% b. 34.83% c. 97.13% d. 2.87% ANS: D Solution: z = $0 - $59 = -1.90 $31

p = 2.87%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Cash insolvency analysis (Requires use of normal table.)

NAT: Analytic skills

65. Crown Data(CD) has a current capital structure that consists of $120 million in common equity (15 million shares) and $80 million in long-term debt with an average interest rate of 11 percent. CD is considering an expansion project that will cost $22 million. The project will be financed either by issuing long-term debt at a cost of 12.5 percent, or the sale of new common stock at $35 per share. The firm's marginal tax rate is 40%. What is the EBIT indifference point between the two financing options. a. $71.5 million

b. $77.2 million c. $68.3 million d. $ 1.0 million ANS: B Solution: (EBIT - 11.55)(1 - 0.4) 15

= (EBIT - 8.8)(1 - 0.4)

15.62857143

EBIT* = $77.2 million PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: EBIT indifference point

66. In considering EBIT-EPS analysis, which of the following statements is/are correct? a. If the expected earnings are above the indifference point, the debt option is preferred. b. If the expected earnings are below the indifference point, the equity option is preferred. c. Both statements a and b are correct. d. Neither statement a nor b is correct.

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: EBIT-EPS analysis

67. What type of security is used to purchase a target company in a leveraged buy-out? a. common stock b. dividends c. debt d. retained earnings ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Financial challenge

68. A change in EBIT is magnified into a larger change in EPS. This means that financial leverage is using ________________ as its fulcrum. a. short-term costs b. fixed costs c. variable costs d. retained earnings ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Measurement of operating and financial leverage

NAT: Reflective thinking

69. In using Nestle Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to acquired fixed assets comes from: a. debt b. federal funds c. tax breaks d. equity from the parent company ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: International issues

70. Some companies use debt or preferred stock financing instead of common stock financing. The purpose is:

a. b. c. d.

to retain control to facilitate record-keeping to maintain privacy to prevent audit problems

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Retention of control

71. There are three categories of costs: fixed costs, variable costs and semi-variable costs. Which of the following is a semi-variable cost? a. depreciation b. labor costs c. raw materials d. management salaries ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Leverage and the income statement

NAT: Reflective thinkikng

ESSAY 1. What are the effects of leverage on shareholder wealth and the cost of capital?

ANS: Firms are limited in the amount of combined leverage that can be used by the firm to increase EPS and shareholder wealth. Excessive amounts of financial leverage can cause the market value of the firm to decline and the cost of capital to increase. As the risk of financial distress increases, investors will require a higher rate of return on funds supplied to the firm. This increase will result in the firm having to pay a higher cost for funds, which will offset the returns gained from the combined leverage. The end result is a decline in the market value of the firm and a rise in its cost of capital.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Effect of financial leverage on stock prices 2. Explain the difference between short-run costs and long-run costs.

ANS: Short run costs vary directly with the level of sales, whereas other costs remain constant regardless of sales. Costs that are closely tied to sales are called variable costs and those costs that are independent of sales are fixed costs. It is with these short-run costs that a firm can determine its breakeven point.

Long-run costs are always variable costs because a firm can change the size of its physical facilities and the number of management personnel in response to changes in the level of sales.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Short run costs 3. Why does a firm use operating and financial leverage? In what ways does it help the firm, in what ways does it hurt the firm?

ANS:

A firm uses operating and financial leverfage in the hope of earning returns in excess of the fixed costos of its assets and liabilities. This will increase the returns to common stockholders. However, it also increases the variability or risk of these returns. Leverage magnifies shareholders’ potential losses as well as potential gains. Leverage concepts highlight the risk-return trade-off of various types of financial decisions.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Operating and financial leverage 4. List the five steps developed to assest financial managers in making capital structure decisions.

ANS: The steps are: 1. Compute the expected level of EBIT after the expansion 2. Estimate the variability of this level of operating earnings.

3. Compute the indifference point between the two financing alternatives 4. Analyze these estimates in the context of the risk the firm is willing to assume.

5. Examine the market evidence to determine whether the proposed capital structure is too risky.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: EBIT-EPS analysis and capital structure decisions

Chapter 15—DIVIDEND POLICY MULTIPLE CHOICE 1. The dividend clientele effect concept was originally developed by a. Myron Gordon b. Merton Miller and Franco Modigliani c. Milton Friedman d. Paul Samuelson ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Shareholder preferences

2. Dividend reinvestment plans involve the purchase of a. newly issued stock b. existing stock c. letter stock d. both newly issued and existing stock ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Dividend reinvestment plans

3. Most states limit dividend policy by requiring a. that dividends may not be paid unless the firm generates net earnings during the most recent year b. that dividends may only be paid out of retained earnings c. that dividends may not be paid when the firm is insolvent d. the firm’s capital to be used to pay dividends ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand stocks and bonds

TOP: Legal constraints

4. The following factors influence a firm's ability and/or willingness to pay dividends: a. liquidity b. borrowing capacity and access to capital markets c. earnings stability d. all of the above ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Determinants of dividend policy

5. In the theoretical world of Miller and Modigliani a. a firm should pay out 100 percent of earnings as dividends to maximize shareholder wealth b. the marginal tax rates facing investors are the most important single determinant of dividend policy c. dividends are important only for their informational content d. dividends reduce investors’ uncertainty ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Informational content

6. Finance researcher Myron Gordon argues that a. risk-averse shareholders may prefer some dividends over the promise of future capital gains if the interest rate is expected to decline b. dividends reduce uncertainty, and thus the payment of dividends will increase the firm's value c. the clientele effect has no influence on share value d. the existence of transaction costs has no impact on the dividend decision ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arguments for the relevance of dividends

7. The passive residual dividend policy asserts that a. dividends should be paid out only if the firm does not have enough acceptable investment projects to utilize all earnings internally. b. dividends should be paid only when the firm has ready access to new equity markets c. retained earnings, being the residual earnings of the firm, should always be paid out to existing stockholders d. investment policy and dividend policy decisions should always be made independently ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Passive residual policy

8. The passive residual dividend policy seems to be inconsistent with a. a world having significant transactions costs associated with new stock issues b. a stable dividend policy c. a policy of paying only stock dividends d. a share-repurchase policy ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Dividend policies

9. Many firms try to maintain a stable dividend policy a. because of the informational content of dividend changes

b. in order to satisfy investors who rely on dividends as a primary source of income c. in order to remain as eligible investments for many financial institutions d. all of the above ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stable dollar dividend policy

10. The record date in the normal dividend payment procedure is a. the same day as the declaration date b. the same day as the ex-dividend date c. the date when the firm makes a list from its stock transfer books of shareholders eligible to receive the dividend d. one day prior to the payment date ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: How dividends are paid

11. A passive residual dividend policy suggests that the firm will: a. pay the same dollar amount of dividends every year b. pay the same percentage of earnings in dividends every year c. pay a dividend only after all viable investment projects have been exhausted d. omit a dividend in the next period ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand investments and dividends

NAT: Reflective thinking TOP: Passive residual policy

12. Which phrase below best summarizes the arguments supporting a stable dollar dividend policy? a. earnings stability b. beta c. capital structure d. informational content ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stable dollar dividend policy

13. In a large, widely-held corporation, the financial manager should consider all of the following in establishing a dividend policy EXCEPT: a. individual shareholder preferences b. cash flow needs c. informational content of dividends d. investment opportunities ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Determinants of dividend policy

14. Which of the following is not a direct result of a stock dividend? a. the number of shares outstanding is increased b. the market price of each outstanding share is increased c. the amounts shown in the firm's capital accounts are redistributed d. the per-share price of the stock goes up ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock dividends and stock splits

15. Firms carry out share repurchase agreements in a number of ways, including all of the following EXCEPT:

a. b. c. d.

buy from shareholders through a tender offer buy outstanding shares in the open market buy treasury shares negotiate a purchase privately from large holders, particularly institutions

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Procedures for repurchasing shares

16. Rank in chronological sequence the payment date, ex-dividend date, declaration date, and record date. a. record date, declaration date, ex-dividend date, payment date b. declaration date, record date, ex-dividend date, payment date c. declaration date, record date, payment date, ex- dividend date d. declaration date, ex-dividend date, record date, payment date ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: How dividends are paid

17. Firms with the _______ earnings growth tend to have the ________ dividend payout ratio. a. highest, highest b. highest, lowest c. lowest, lowest d. lowest, highest ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Growth prospects

18. The value of a firm is influenced by three types of financial decisions including all of the following EXCEPT: a. dividend decisions b. financing decisions c. investment decisions d. par value decisions ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

19. The capital impairment restriction, a legal constraint on dividend payments, states that a. only the current year's earnings may be used for dividend payments b. dividends may not be paid out of stockholder's equity c. a firm's permanent capital cannot be used to make dividend payments d. a firm’s capital surplus can be used to make dividend payments ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Legal constraints

20. A legal constraint that dividends must be paid out of a firm's present and past net earnings is known as the _______ restriction. a. net earnings b. net operating earnings c. initial investment d. earned capital ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Legal constraints

21. Restrictive covenants are contained in all of the following except

a. b. c. d.

preferred stock agreements lease contracts bond indentures agency restrictions

ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Restrictive covenants

22. Dividend payments reduce all of the following balance sheet items except a. cash b. fixed assets c. stockholder's equity d. retained earnings ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds TOP: "How dividends are paid" & other general discussion

NAT: Reflective thinking

23. A firm with stable earnings is usually more willing to a. retain more earnings b. have a higher dividend payout ratio c. have a sinking fund agreement d. seek aggressive growth ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Earnings stability

24. All of the following are alternative dividend policies EXCEPT: a. constant payout b. stable dollar c. constant earnings d. passive residual ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Dividend policies

25. In order for a stock to qualify for inclusion on the "legal lists," a firm must a. register with the Securities Exchange Commission (SEC) b. have assets in excess of $500,000 c. have 10 continuous profitable quarters d. have a record of continuous and stable dividends ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stable dollar dividend policy

26. A stock dividend will not affect which of the following balance sheet items. a. total assets b. retained earnings c. contributed capital in excess of par d. common stock at par ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock dividends and stock splits

27. One reason why small business concerns have very low dividend payout ratios is that a. the firm usually is low on cash

b. the firm needs funds for taxes c. the firm needs the funds to finance growth d. the small firm prefers stock offerings ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Entrepreneurial finance: Dividend policy

28. Dividend payments from foreign subsidiaries represent a. a movement from a weak to a stronger currency b. the primary means of transferring funds to the parent company c. a way to avoid taxes d. the effects of exchange risk ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Multicultural understanding LOC: Understand stocks and bonds TOP: International issues: Dividend policies for multinational firms 29. On the ex-dividend date, the a. seller of the stock is entitled to the dividend b. buyer has 4 business days to register his/her purchase c. buyer of the stock is entitled to the dividend d. corporation records all security owners ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: How dividends are paid

30. Under dividend reinvestment plans, shareholders can automatically a. reduce their taxable income b. increase their cash inflows c. use dividends to purchase additional shares d. transfer from retained earnings accounts to equity accounts.

ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Dividend reinvestment plans

31. The net effect of a stock dividend is to a. increase the firm's total stockholders' equity b. increase the number of shares outstanding c. increase total dividends d. increase stock prices ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock dividends and stock splits

32. The fundamental question in dividend policy is a. the tax consideration b. the amount of growth the firm considers optimal c. not violating any restrictive covenants d. determining what portion of earnings will be paid out ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Determinants of dividend policy

33. The dividend _______ states that investors will tend to be attracted to firms that have dividend policies consistent with the investor's objectives a. "clientele effect"

b. "informational content" c. signal d. passive residual theory ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Shareholder preferences

34. From an accounting standpoint, stock splits are accomplished by a. increasing the number of shares authorized b. increasing par value of existing shares c. reducing the par value of existing shares d. reducing the number of shares, and increasing the price of each share ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock dividends and stock splits

35. According to the __________ dividend policy, a firm that has more funds than it needs should pay a cash dividend to shareholders. a. constant payout ratio b. stable dollar c. passive residual d. reinvestment ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Share repurchases as dividend decisions

36. As part of a share repurchase program by a company, a tender offer involves the __________. a. purchase of stock on the open market b. purchase of stock directly from its stockholders c. private negotiation of purchases from large institutions, such as insurance companies d. planning for many positive-NPV investments ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Procedures for repurchasing shares

37. Dividend policy can affect the value of the firm for which of the following reasons? a. personal taxes b. flotation costs c. shareholder transaction costs d. all of these answers are correct ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arguments for the relevance of dividends

38. According to Miller and Modigliani, it is __________ that really determines a firm's value. a. investment policy b. dividend policy c. payout ratio d. transaction costs ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arguments for the irrelevance of dividends

39. All of the following are dividend policies EXCEPT: a. stockholders want dividends and they want them to be consistent b. stockholders prefer the delay of the payment of dividends if there is a corresponding

increase in capital gains. c. stockholders of small firms favor a dividend policy of retention. d. stockholders who prefer a high dividend payout are unwilling to pay extra for the stock of companies that provide a higher yield mostly because they are living on a fixed income.

ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Shareholders preferences

40. The theoretical post-stock dividend price is equal to the pre-stock dividend price __________. a. multiplied by 1 minus the percentage stock dividend rate b. multiplied by 1 plus the percentage stock dividend rate c. divided by 1 minus the percentage stock dividend rate d. divided by 1 plus the percentage stock dividend rate ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Stock dividends and stock splits

41. Under the Revenue Reconciliation Act of 1993, the tax-paying individual investor may prefer low dividends and higher expected capital gains because __________. a. the top marginal rate is lower on dividend income than on capital gains b. the taxes on capital gains can be deferred c. capital gains are more certain than share repurchases d. the tax on capital gains is 28% ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Tax considerations

42. All of the following are arguments for the relevance of dividends except: a. existence of issuance costs b. reduction of agency costs c. protection against dilution d. risk aversion ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arguments for the relevance of dividends

43. In considering the arguments for the relevance of dividends, which of the following statements is/are correct?

I. Shareholders who are risk averse may prefer some dividends over the promise of future capital gains.

II. Flotation costs on new stock sales make dividend payout more desirable, rather than issuing new stock. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Arguments for the relevance of dividends

44. A firm that employs a constant payout ratio dividend policy pays _____. a. a constant (fixed) dollar dividend b. out a certain percentage of each year's earnings c. a constant quarterly dividend d. low payout ratios if the company has low growth rates

ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Other dividend payment policies

45. When a firm purchases its own stock in the open market, the repurchased shares become known as _____. a. treasury stock b. preferred stock c. option stock d. reinvestment stock ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Procedures for repurchasing shares

46. When a firm initiates the repurchase of stock through a tender offer, it is giving the shareholders: a. treasury stock notification b. a put option c. a call option d. a futures option ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Procedures for repurchasing stock

47. A foreign subsidiary with good access to capital within the host country, tends to pay _____ dividends to the parent than subsidiaries with poor access to local capital. a. smaller b. larger c. no d. none of these answers is correct; dividends are not related to availability of capital ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Multicultural understanding TOP: International issues

48. All of the following are advantages of share repurchase as a dividend decision EXCEPT:: a. effectively converts dividend income into capital gains income b. provide firm with greater financial flexibility in timing the payment of returns to shareholders. c. all current shareholders are able to sell their shares at a higher price d. they represent a signal to investors that the company expects higher earnings in the future ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Share repurchases as dividend decisions

49. The Percolator Company has the following capital structure: Common stock ($5 par, 250,000 shares) Contributed capital in excess of par Retained earnings

$1,250,000 $5,000,000 $4,000,000

The company declares a 10 percent stock dividend. The pre-stock dividend market price of the company's stock is $50. Determine the balance in the retained earnings account after the stock dividend. a. $4,000,000 b. $1,375,000 c. $2,750,000 d. $1,250,000

ANS: C Solution: New shares = 0.10 (250,000) = 25,000 Amount transferred from R/E = 25,000($50) = $1,250,000 New R/E balance = $4,000,000 - $1,250,000 = $2,750,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends 50. The Percolator Company has the following capital structure: Common stock ($5 par, 250,000 shares) Contributed capital in excess of par Retained earnings

$1,250,000 $5,000,000 $4,000,000

The company declares a 10 percent stock dividend. The pre-stock dividend market price of the company's stock is $50. Determine the balance in the common stock account after the stock dividend. a. $1,250,000 b. $1,375,000 c. $125,000 d. $2,500,000 ANS: B Solution: New C/S at par = 25,000 ($5) = $125,000 New C/S balance =$1,250,000 + $125,000 = $1,375,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends 51. The Wagner Company tries to follow a pure "residual" dividend policy. Earnings and dividends last year were $100 million and $20 million respectively. Anticipated earnings for this year are $80 million. The company is financed completely with common equity. The required rate of return on retained earnings is 15 percent and the cost of new equity is 16 percent. If Wagner has $70 million of investment projects having expected returns greater than 15 percent, determine the total amount of dividends Wagner should pay. a. None b. $10 million c. $20 million in dividends and raise needed investment funds externally d. $80 million in dividends and raise needed investment funds externally ANS: B Solution: Residual = Earnings - Investment = $80 million - $70 million = $10 million PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Residual dividend policy

52. The Wagner Company tries to follow a pure "residual" dividend policy. Earnings and dividends last year were $100 million and $20 million respectively. Anticipated earnings for this year are $80 million. The company is financed completely with common equity. The required rate of return on retained earnings is 15 percent while the cost of new equity is 16 percent. If Wagner has $90 million of investment projects having expected returns greater than 16 percent, determine Wagner's dividend and investment policies. a. Pay out $20 million in dividends and raise $30 million externally b. Pay no dividends and invest only in the first $80 million in projects. c. Pay out $10 million in dividends and raise $20 million externally d. Pay no dividends and raise $10 million externally ANS: D Solution: There is no residual because investment needs exceed earnings. Hence the firm must raise additional funds externally and pay no dividend.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Residual dividend policy 53. Last year, Quality's earnings per share were $2.34 and it paid a dividend of $1.10. What was Quality's dividend payout ratio? a. 21.2% b. 42.7% c. 47% d. 53% ANS: C Solution: Payout ratio = $1.10 /$ 2.34 = 0.47 or 47% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Payout ratio calculation 54. The Earth Shoe Company, whose stock has a market value of $20, has the following common equity accounts on its balance sheet: Common stock ($1 par, 1,000,000 shares) Contributed capital in excess of par Retained earnings Total Common stockholders' equity

$ 1,000,000 $14,000,000 $52,000,000 $67,000,000

If the firm declares a 5% stock dividend, what will be the retained earnings figure after the dividend is paid? a. $1,000,000 b. $51,000,000 c. $14,950,000 d. $5,000,000 ANS: B Solution: Number new shares = (1,000,000)(0.05) = 50,000 From R.E. = 50,000($20) = $1,000,000 New R.E. = $51,000,000 PTS: 1

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Understand stocks and bonds

TOP: Stock dividends

55. HiTec is growing fast and wishes to retain all its earnings to finance future growth. Instead of a cash dividend, HiTec declares a 10 percent stock dividend. If the price per share of HiTec stock is $30 before the ex-dividend date, what will be the price on the ex-dividend date? a. $27.27 b. $27.94 c. $33.00 d. $27.00 ANS: A Solution: Post-dividend price = $30/1.10 = $27.27 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Reflective thinking LOC: Understand stocks and bonds TOP: Stock dividends 56. Saturn Corporation has just declared a 25 percent stock dividend. The stock was selling for $18 before the stock dividend. The stock will pay a quarterly cash dividend of 8 cents per share after the stock dividend. If the 8-cent dividend is maintained over the next year what is the post-stock dividend yield? a. 2.13% b. 2.22% c. 0.56% d. 1.44% ANS: B Solution: Post-dividend price = $18/1.25 = $14.40 Yield = $0.32/$14.40 = 2.22% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends and dividend yield calculations 57. Last year, Toluca Engineering paid a $0.25 dividend per share each quarter. If Toluca announces both a 5 percent stock dividend and an increase in the quarterly dividend to $0.27, what is the effective rate of the dividend increase? a. 13.0% b. 8.0% c. 11.2% d. 13.4% ANS: D Solution: Percent increase = [$0.27(1.05) - $0.25]/$0.25 = 0.134 or 13.4% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends and dividend yield calculations 58. Grabill Aerospace Company has just declared a 15% stock dividend. Immediately prior to the stock dividend, the stock was selling for $23 and had a P/E ratio of 14. Calculate the post-stock dividend price of Grabill's stock. a. $26.45 b. $20.00 c. $26.22 d. $20.18

ANS: B Solution: Post-stock dividend price = 23/1.15 = $20 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividend 59. Heintz Corp. has just declared a 10% stock dividend. The company's pre-stock dividend common stockholders' equity was as follows: Common stock ($0.50 par, 10,000,000 shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$ 5,000,000 $ 48,000,000 $ 97,500,000 $150,500,000

If the common stock of Heintz was selling at $32 a share prior to the stock dividend, what will the retained earnings be after the stock dividend is distributed? a. $ 65,500,000 b. $118,500,000 c. $ 66,000,000 d. $ 97,500,000 ANS: A Solution: New shares = 10,000,000(0.10) = 1,000,000 R.E. = $97,500,000 - $32(1,000,000) = $65,500,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividend 60. Sorsi has declared a 15% stock dividend. If the stock was selling for $34 before the ex-dividend date, what should its price be on the ex-dividend date? a. $34.00 b. $29.57 c. $28.90 d. $30.91 ANS: B Solution: Price = $34/1.15 = $29.57 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends 61. Haulsee Inc. paid a quarterly dividend of $0.12 and has announced both a 10% stock dividend and an increase in the quarterly dividend to $0.14. What is the effective rate of the dividend increase? a. 26.7% b. 18.3% c. 28.3% d. 15.7% ANS: C Solution: Percentage increase = [($0.14)(1.10) - .12]/.12

= .283 or 28.3% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend yield 62. Badger Tool and Die Company has 100,000 shares outstanding and plans to pay $1.00 per share in dividends each quarter next year. Badger has a capital budget of $700,000 for next year and plans to maintain its present debt ratio of 0.30. If earnings are expected to be $7.20 per share, how much external equity must Badger raise? a. $210,000 b. $490,000 c. $170,000 d. none ANS: C Solution: Earnings - dividends = R.E .= $720,000 - $400,000 = $320,000 Equity needed = $700,000(0.7) = $490,000 External equity = $490,000 - $320,000 = $170,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend policy and investment needs 63. Cycle Out has 1,000,000 shares outstanding and currently has annual earnings per share of $5.20. If Cycle's stock price is $62.40, what would be the expected stock price if Cycle repurchases 50,000 shares? a. $65.52 b. $65.68 c. $75.72 d. Cannot be determined from the information provided ANS: B Solution: New EPS = $5,200,000/950,000 = $5.4737 Current P/E = $62.40/$5.20 = 12 times New stock price = $5.4737(12) = $65.68; or Price = $62.40/0.95 = $65.68 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Share repurchases 64. Cafe de Oro earns $4.25 per share and has a dividend payout ratio of 0.40. If Cafe de Oro has a capital budget of $200,000 and 70,000 shares outstanding, what are the annual dividends per share? a. $1.70 b. $1.39 c. $2.55 d. $4.00 ANS: A Solution: DPS = $4.25(0.4) = $1.70 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend calculation (problem has superfluous information)

65. The Altern Music Co. earns $4.25 per share, has 70,000 shares outstanding, and a capital budget of $200,000. If Altern Music raises all of its funds internally and follows the "passive residual policy", what are the annual dividends per share? a. $1.70 b. $1.39 c. $2.55 d. $2.81 ANS: B Solution: Earnings = 70,000 ($4.25) = $297,500 DPS = ($297,500 - $200,000)/70,000 = $1.39 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Passive residual dividend policy 66. WPI Inc. has the following current equity accounts on its balance sheet: Common stock ($2.50 par, 500,000 shares) Contributed capital in excess of par Retained earnings Total

$ 1,250,000 $10,000,000 $15,540,000 $26,790,000

If WPI earned $3.20 per share this year, what is the maximum dividend per share that WPI may pay if the state capital impairment provisions are limited to the par value and the contributed capital in excess of par accounts? a. $3.20 b. $31.08 c. $34.28 d. $15.54 ANS: B Solution: DPS = $15,540,000/500,000 = $31.08 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Legal restrictions on dividends calculation 67. Nova earned $7.20 per share and maintains a stable payout ratio of 60 percent. Nova has 1,000,000 shares outstanding and a capital budget of $5 million. If Nova maintains a debt ratio of 0.50, what were the dividends per share? a. $4.32 b. $2.88 c. $2.20 d. cannot be determined from the information provided ANS: A Solution: DPS = $7.20(0.6) = $4.32 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend payment calculation (w/superfluous info in prob.)

68. Excelsior Company's capital structure is as follows:

Common stock ($2 par value, 2,000,000 shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$ 4,000,000 16,000,000 23,000,000 $43,000,000

The current market price of the firm's common stock is $30. If the firm declares a 10% stock dividend, determine the balance in the contributed capital in excess of par and retained earnings accounts. a. $22,000,000; $17,000,000 b. $21,600,000; $17,000,000 c. $21,600,000; $23,000,000 d. $17,000,000; $21,600,000 ANS: B Solution: Number of new shares = 0.10 (2,000,000) = 200,000 Amount transferred from R/E = 200,000 x $30 = $6,000,000 New R/E balance = $23,000,000 - $6,000,000 = $17,000,000 New C/S balance = $4,000,000 + 200,000 x $2 = $4,400,000 New Contributed capital in excess of par balance = $16,000,000 + $21,600,000 New Total C/S Equity $43,000,000 (no change)

($6,000,000- $400,000) =

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends 69. Peterson Company expects earnings per share and dividends per share to be $4.50 and $2.50 respectively next year. Peterson currently has 5,000,000 shares of common stock outstanding. The company's capital budget for next year is projected to be $25,000,000. Peterson plans to maintain its present debt ratio (debt to total assets) at 40% next year. (Assume that Peterson's capital structure includes only common equity and debt and that these will be the only sources of funds to finance capital budgeting projects next year.) Determine how much external equity the company must raise to finance its capital budget. a. $15,000,000 b. 0 c. $5,000,000 d. cannot be determined ANS: C Solution: R/E = ($4.50 - $2.50) x 5,000,000 shares = $10,000,000 Equity portion of capital budget = 0.60 x $25,000,000 = $15,000,000 External equity needed = $15,000,000 - $10,000,000 = $5,000,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividends and investment policy 70. Kaneb Services, Inc. has just declared a 3 for 2 stock split. The company's pre-split common stockholders' equity was as follows: Common stock($1.25 par, 2,000,000 shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$ 2,500,000 $ 17,500,000 182,100,000 $202,100,000

If the pre-split price of common stock was $42, what will be the amount of retained earnings after the split? a. $140,100,000 b. $139,200,000 c. $182,100,000 d. $141,350,000 ANS: C Solution: In a stock split retained earnings do not change PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understanding stocks and bonds TOP: Stock split

NAT: Analytic skills

71. Kaneb Services, Inc. has just declared a 3 for 2 stock split. If the pre-split price of common stock was $42 a share, what will be the post-split price per share (assuming no other changes occur). a. $31.50 b. $26.25 c. $25.15 d. $28.00 ANS: D Solution: Post-split price = 2($42)/3 = $28 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: Stock split

NAT: Analytic skills

72. The Barden Corporation has the following equity accounts on its balance sheet: Common Stock ($1.25 par, 3,000,000 shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$

3,750,000 24,250,000 153,600,000 $181,600,000

What is the maximum amount of dividends per share that may be paid by the Barden Corp. if the capital impairment provisions of state law are limited to the par value and the capital in excess of par accounts? a. $59.28 b. $51.20 c. $60.53 d. $ 8.08 ANS: B Solution: DPS = $153.6/3 = $51.20 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Capital investment restriction 73. Interim Systems has 1.5 million shares outstanding. This year Interim will have operating income (EBIT) of $18.2 million, interest expenses of $2.4 million, depreciation expenses of $3.1 million.

What will the dividend per share be if Interim's dividend payout ratio is 40%? Assume a marginal tax rate of 40%.

a. b. c. d.

$2.53 $3.39 $2.03 $6.32

ANS: A Solution: DPS = [($18.2 - $2.4)(0.6)(0.4)]/1.5 = $2.528 or $2.53 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend calculations 74. Zycad has operating earnings (EBIT) of $8.6 million and annual interest expenses are $1.5 million.

Zycad wishes to maintain its annual dividend of $1.00 per share on the 1,900,000 shares outstanding.

The firm has a bond issue outstanding that requires the retirement of $3 million (face value) of the issue each year through purchases of the bonds in the market. What is the maximum dividend per share that may be paid if the current market price of the bonds is $85? Assume the marginal tax rate is 40% and that earnings are the only source of funds that can be used to pay the dividend and retire the bonds. a. $0.66 b. $0.16 c. $1.37 d. $0.90 ANS: D Solution: Earnings available for dividends ($8.6 - $1.5)(0.6) - $3(0.85) = $1.71 million DPS = $1.71/1.9 = $0.90 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend policy with restrictive covenants 75. Omega Sports has the following equity accounts on its balance sheet: Common stock ($0.50 par, 900,000 shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$

450,000 5,580,000 21,204,000 $27,234,000

The current market price of the firm's shares is $20. If the firm declares a 10 percent stock dividend and a cash dividend of $0.10 per share, the retained earning account would change to __________ . a. $21,060,000 b. $19,305,000 c. $25,335,000 d. $19,404,000 ANS: B Solution: RE = $21,204,000 - 90,000($20) - 990,000($0.10) = $19,305,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividends

76. Zimmer Corp. has just declared a 5 for 4 stock split. If the pre-split price of common stock was $36 a share, what will be the post-split price per share (assuming no other changes occur)? a. $30.00 b. $27,00 c. $28.80 d. $32.00 ANS: C Solution: Price = 4(36)/5 = $28.80 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: Stock split

NAT: Analytic skills

77. Leigh Fibers has 6 million shares outstanding. This year Leigh will have operating income (EBIT) of $36.4 million, interest expenses of $5.8 million, and depreciation expenses of $6.2 million. What will be Leigh's dividend per share if the company has a payout ratio of 30%? Assume a marginal tax rate of 40%. a. $0.92 b. $0.73 c. $1.09 d. $0.61 ANS: A Solution: EAT = ($36.4 - $5.8)(1 - 0.40) = $18.36 (million) DPS = $18.36(0.30)/6 = $0.918 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend calculation 78. If Sulzer has 10 million shares outstanding, operating income (EBIT) of $42.4 million, and interest expenses of $6.8 million, what is Sulzer's dividend payout ratio, given that the dividend per share is $0.80? Assume a marginal tax rate of 40%. a. 56.3% b. 31.5% c. 50.4% d. 37.5% ANS: D Solution: EAT = ($42.4 - $6.8)(1 - 0.40) = $21.36 EPS = 21.36/10 = $2.136 Dividend payout ratio = $0.80/$2.136 = .3745 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Dividend payout ratio 79. Wrenn Corp. has 5.6 million shares outstanding, interest expenses of $4.4 million, and depreciation expenses of $3.7 million. What is Wrenn's operating income if the dividend per share is $0.80 and the dividend payout ratio is 35%? Assume a marginal tax rate of 40%. a. $15.89 million b. $25.73 million c. $21.33 million d. $29.43 million

ANS: B Solution: Dividends = 5.6($0.80) = $ 4.48 (million) EAT = $4.48/0.35 = $12.8 (million) EBIT = $12.8/(1 - 0.40) + $4.4 = $25.733 (million) PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Operating income 80. Metromat has the following equity accounts on its balance sheet: Common stock ($2 par, 2.4 million shares) Contributed capital in excess of par Retained earnings Total common stockholders' equity

$

4,800,000 33,600,000 134,400,000 $172,800,000

The current market price of Metromat's shares is $16. If the firm declares a 15% stock dividend and a $0.15 per share cash dividend, what will be the impact on contributed capital in excess of par? Assume a marginal tax rate of 40%. a. decreases $2.56 million b. increases $5.04 million c. increases $5.76 million d. does not change ANS: B Solution: Increase = 2.4(0.15)($14) = $5.040 million PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividend 81. Sadaplast has just declared a 25 percent stock dividend. The annual dividend, before the stock dividend was declared, was $1.00. Sadaplast intends to pay a dividend of $1.05 per share after the stock dividend is paid. What is the percentage increase in the cash dividend that will accompany the stock dividend? a. 6.25% b. 26.25% c. 31.25% d. 5.00% ANS: C Solution: Percentage increase = [1.25($1.05) - 1.0($1.00)]/1.0($1) = 0.3125 or 31.25% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividend 82. Urguhart has just declared a 4 for 3 stock split. If the pre-split price of common stock was $54 a share, what do you expect the post-split price will be? a. $72.00 b. $36.18 c. $42.23 d. $40.50

ANS: D Solution: Price = 3(54)/4 = $40.50 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Understand stocks and bonds TOP: Stock split

NAT: Analytic skills

83. Concin has the following equity accounts on its balance sheet: $

2,250,000 89,400,000 67,503,189 $159,153,189

Common stock ($0.25 par, 9 million shares) Contributed capital in excess of par Retain earnings

The current market price for a share of Concin's stock is $24.25. If the firm declares a 10% stock dividend and a $0.06 per share cash dividend, what will be the impact on Common stock on the above equity account? a. no change b. increase of $225,000 c. increase of $54,000 d. increase of $21,600,000 ANS: B Solution: Increase = 9,000,000(.10)(.25) = $225,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Stock dividend ESSAY 1. What is the signaling effect of dividend payments?

ANS: Changes in dividend payments represent a signal to investors concerning management’s assessment of the future earnings and cash flows of the company. Since management is an “insider” of the company, it is perceived that managers know more about the company than outside resources.

Dividend changes are thought to provide unambiguous signals about the company’s future prospects.

These signals may not be conveyed fully by any other method.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Dividend policies

2. What are the factors that determine the dividend policy of a firm?

ANS: 1. Legal constraints: Many states have laws that regulate the dividend payments that a firm chartered in that state can make.

2. Restrictive covenants: Lenders have payout restrictions placed on the borrowing firm with regard to dividends as an assurance that funds will be available to repay the loan.

3. Tax considerations: If a firm excessively retains too much of their earnings the IRS may impose penalties on the earnings of the firm.

4. Liquidity and cash flow considerations: Many firms find it difficult to pay dividends while maintaining an acceptable level of liquidity.

5. Access to capital markets and borrowing capacity: A firm may want to invest earnings in a more favorable investment rather than pay dividends. If liquidity is diminished, the firm may have difficulty borrowing funds.

6. Earnings stability: Companies want to have a consistent payout schedule for dividends even in times of financial stress. Firms with stable cash flows can be fairly confident about its future and frequently reflects this confidence in higher dividend payments.

7. Inflation: Replacement of used assets becomes more expensive in inflationary environments.

Inflation can force a firm retain more earnings as it attempts to maintain its working capital position.

8. Shareholder preferences: Companies in closely held companies may be better able to set dividends according to the preferences of the stockholders. In larger firms, it becomes impossible for a firm to cater to the desires of the stockholders regarding dividend payouts.

9. Protection against dilution: To prevent the issuance of new stock to raise capital, a firm may retain more earnings. This manner permits existing stockholders to retain their proportionate share of ownership in the company which could be diluted if new stock is issued.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Determinants of dividend policy

3. What is a DRIP and how does it work?

ANS: A DRIP is a dividend reinvestment plan. Under these plans, shareholders can have their dividends automatically reinvested in additional shares of the company’s common stock. There are two types of DRIPS. One type involves the purchase of existing stock and the other type involves the purchase of newly issued stock. The first type of plan is executed through a bank that, acting as a trustee, purchases the stock on the open market and then allocates it on a pro rata basis to the participating shareholders. In the second type of plan, the cash dividends of the participants are used to purchase, often at a small discount (up to 5%) from the market price, newly issued shares of stock.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Dividend reinvestment plans

4. What effect does a stock split have on outstanding shares of stock and what is its purpose?

ANS: A stock split has the effect of increasing the number of shares of stock outstanding and reducing the price of each outstanding share. From an accounting standpoint, stock splits are accomplished by reducing the par value of existing shares of stock and increasing the number of shares outstanding. Although stock splits have an impact similar to stock dividends, they normally are not considered an element of a firm’s dividend policy.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Stock dividends and stock splits

5. What are the procedures for repurchasing stock?

ANS: Firms carry out share repurchase programs in a number of ways.

1. A company may buy directly from its stockholders in a tender offer.

2. A company may purchase the stock in the open market.

3. A company may privately negotiate purchases from large holders.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Procedures for repurchasing stocks.

Chapter 16—WORKING CAPITAL POLICY AND SHORT-TERM FINANCING MULTIPLE CHOICE 1. The length of the operating cycle is equal to the length of the a. inventory conversion period b. receivables conversion period c. cash conversion period d. a plus b ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Operating cycle analysis

2. The length of the operating cycle for a firm is equal to the length of the a. payables deferral period b. cash conversion cycle c. receivables conversion period d. a plus b ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Operating cycle analysis

3. The ______ shows the time interval over which additional non-spontaneous sources of working capital financing must be obtained to carry out the firm's activities. a. inventory conversion period b. cash conversion cycle c. payables deferral period d. receivables conversion period ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Operating cycle analysis

4. Net working capital represents: a. the amount of current assets financed by noncurrent sources of funds. b. the difference between current assets and long-term liabilities c. the difference between current assets and fixed assets d. a and b ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Introduction

5. Which of the following accounts is (are) not part of a firm's working capital? a. plant and equipment b. marketable securities c. cash d. a and c ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Working capital policy

6. Which of the following factors does not directly affect the firm's level of investment in working capital? a. the firm's inventory and credit policies b. the age of the firm's plant and equipment c. the firm's sales level d. the length of the firm's operating cycle ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Working capital policy

7. Under a conservative approach to working capital management, a firm tends to hold a relatively ______ proportion of its total assets in the form of current assets. a. small b. constant c. stable d. large ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 8. The rate of return on fixed assets is normally assumed to be ______ the rate of return on current assets (especially cash and marketable securities). a. less than b. greater than c. equal to d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 9. All other things being equal, a policy of holding a relatively ______ proportion of the firm's total assets in the form of current assets will tend to result in a ______ expected profitability or rate of return on the total assets of the firm. a. large, higher b. small, higher c. constant, higher d. constant, lower ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 10. All other things being equal, a policy of holding a relatively ______ proportion of the firm's total assets in the form of current assets will tend to result in a ______ risk of the firm encountering financial difficulties. a. large, higher b. small, higher c. constant, higher d. constant, lower ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Importance of working capital

NAT: Reflective thinking

11. The relationship between the maturity of debt and its associated cost (interest rate) is referred to as the a. term structure of interest rates b. investment opportunity curve c. risk-return tradeoff function d. a and b ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of short-term versus long-term debt

NAT: Reflective thinking

12. Historically, the yield curve has generally been ______, which indicates that long-term interest rates usually have been ______ short-term interest rates. a. upward sloping, lower than b. downward sloping, higher than c. upward sloping, higher than d. level, about equal to ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of short-term versus long-term debt

NAT: Reflective thinking

13. Lenders normally feel that the relative risk associated with short-term debt is ______ the risk associated with long-term debt. a. lower than b. equal to c. higher than d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of debt TOP: Risk of long-term versus short-term debt

NAT: Reflective thinking

14. Borrowers (e.g., business firms) feel that there is more risk associated with short-term debt (as compared with long-term debt) because of the a. uncertainty arising from interest rate fluctuations b. risk of being unable to refund the debt c. relatively high cost of short-term debt d. a and b ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Risk of long-term versus short-term debt

NAT: Reflective thinking

15. All other things being equal, a policy of financing its assets with a relatively ______ proportion of short-term debt will tend to result in ______ expected after-tax earnings for the firm. a. large, lower b. constant, higher c. constant, lower d. large, higher ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans

16. All other things being equal, a policy of financing its assets with a relatively ______ proportion of short-term debt will tend to ______ the variability (or risk) of the after-tax earnings of the firm. a. large, decrease b. small, increase c. constant, lower d. large, increase ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 17. Which of the following working capital financing policies subjects the firm to the greatest risk? a. financing fluctuating current assets with long-term debt b. financing permanent current assets with long-term debt c. financing permanent current assets with short-term debt d. financing fluctuating current assets with short-term debt ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 18. With the matching approach to meeting the financing needs of the firm, fixed and permanent current assets are financed with a. long-term debt b. short-term debt c. equity funds d. a and c ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 19. When the level of working capital is increased, all of the following are expected to occur except a. expected profitability decreases b. expected profitability increases c. risk decreases d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 20. Which of the following factors affect the firm's level of investment in working capital? a. the length of the firm's operating cycle b. the firm's sales level c. the firm's inventory and credit policies d. all of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Levels of working capital investment

NAT: Reflective thinking

21. The relationship between the maturity of debt and its associated cost (interest rate) is referred to as a. term structure of interest rates b. risk-return tradeoff function

c. seniority structure of interest rates d. a and c ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of short-term and long-term debt

NAT: Reflective thinking

22. The optimal level of working capital investment is the level that is expected to a. maximize return on total assets b. maximize earnings per share c. maximize shareholder wealth d. minimize interest expenses ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Optimal proportions of short-term and long-term debt

NAT: Reflective thinking

23. The aggressive approach to the financing of a firm's current assets uses a ______ proportion of short-term debt and a ______ proportion of long-term debt. a. low, high b. relatively high, relatively low c. high interest, low interest d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 24. If a firm uses only short-term debt to finance the fluctuating level of current assets, the firm is said to be using the ______ approach to asset financing. a. aggressive b. moderate c. matching d. conservative ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 25. Basically the overall working capital policy decision involves a ______ of alternative policies. a. profit-risk tradeoff b. financial choice c. risk decision d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Overall working capital policy

NAT: Reflective thinking

26. The ______ is the optimal working capital investment and financing policy. a. aggressive policy b. moderate policy c. conservative policy d. none of the above ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital TOP: Overall working capital policy 27. The operating cycle begins with the ______ and ends with the ______. a. purchase of resources, selling of the product on credit b. payment for purchases, liquidation of receivables c. purchases of resources, receipt of cash d. payment for purchases, receipt of cash ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Operating cycle analysis

28. Net working capital is defined as: a. total current assets b. current assets minus current liabilities c. total assets minus total liabilities d. current assets plus current liabilities ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Working capital policy

29. The size and nature of a firm's investment in current assets is a function of a number of different factors including all of the following except a. how efficient the firm manages its fixed assets b. the length of the operating cycle c. the sales level d. credit policies ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Levels of working capital investment

NAT: Reflective thinking

30. The ______ assets are those that are affected by the seasonal or cyclical nature of company sales. a. current b. permanent current c. fluctuating current d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Profitability vs. risk tradeoff for alternative financing plans 31. Which of the following assets (if any) are not part of a firm's working capital investment? a. cash b. accounts receivable c. inventory d. none of the above ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Working capital policy

32. The firm's inventory conversion period (measured in days) is equal to its average inventory divided by its __________. a. cost of sales b. sales

c. cost of sales/365 d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating cycle analysis

33. A firm's cash conversion cycle is equal to its operating cycle minus its __________. a. inventory conversion period b. receivables conversion period c. payables deferral period d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating cycle analysis

34. The firm's receivables conversion period (measured in days) is equal to its accounts receivable divided by its __________ . a. annual credit sales/365 b. annual credit sales c. annual sales/365 d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating cycle analysis

35. The size of a firm's investment in current assets is a function of all of the following factors except a. sales level b. inventory policies c. credit policies d. stockholders equity ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Levels of working capital investment

NAT: Reflective thinking

36. A firm's net working capital position is a widely used measure of its _________. a. leverage b. profitability c. risk d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Importance of working capital

NAT: Reflective thinking

37. Many __________ contain provisions requiring firms to maintain a minimum net working capital provision. a. loan agreements with commercial banks b. bond indentures c. a and b d. none of the above ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Importance of working capital

NAT: Reflective thinking

38. A firm's operating cycle is equal to its __________. a. inventory conversion period plus receivables conversion period b. cash conversion cycle minus payables deferral period c. a and b d. none of the above ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating cycle analysis

39. An anticipated need for short-term borrowed funds is best shown in a. an operating budget b. a capital budget c. a production budget d. a cash budget ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash budgets

40. Computerized financial planning models may be classified as any of the following except: a. deterministic b. optimistic c. probabilistic d. none of the above ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Computerized financial forecasting and planning models

NAT: Reflective thinking

41. If a firm shows a profit on the quarterly income statement, then a. there will be no need for additional financing b. the firm may need additional financing c. the firm will increase its cash balance d. all the above may be correct ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Cash budgets

42. Renfro Industries balance sheet for December 31, 20x3 is as follows: Assets ($000) Cash Marketable Securities Accounts Receivable Inventories Plant & Equip.

Less: Deprec.

Net Plant & Equip.

Total Assets

$

8,000 4,000 60,000 100,000 220,000 64,000 156,000

$328,000

Liabilities and Equity ($000) $ 36,000 Accounts Payable 12,000 Notes Payable 32,000 Other Current Liabilities 80,000 Long-term debt 48,000 Preferred Stock 20,000 Common Stock 40,000 Paid-in Surplus 60,000 Retained Earnings $328,000 Total Claims

What is Renfro's net working capital at the end of 20x3? a. -$8 million b. $36 million c. $92 million d. $172 million

ANS: C Solution: Net W.C. = $8,000 + $4,000 + $60,000 + $100,000 - $36,000 - $12,000 - $32,000 = $92,000(000) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Net working capital calculation

NAT: Analytic skills

43. What is the inventory conversion period for O'Brian's if it has sales of $320,000, an average inventory of $5,333, and a cash conversion cycle of 20 days? Assume that the cost of sales is 55 percent of sales. a. 6 days b. 11 days c. 13.5 days d. 15 days ANS: C Solution: Inv. Conv. Pd. = $5,333/($176,000/365) = 11.06 or 11 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle analysis

44. What is the length of the cash conversion cycle for a firm with annual sales (all cash) of $280,000, an inventory conversion period of 35 days, and a payables deferral period of 25 days. a. 0 days b. 25 days c. 10 days d. none of the above ANS: C Solution: CCC = 35 - 25 = 10 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle analysis

45. Tefft Industries has an average inventory of $170,000, sells on terms of 2/10, net 30, and its cost of sales is $540,000. What is Tefft's inventory conversion period? a. 85 days b. 115 days c. 105 days d. cannot be determined from the data given ANS: B Solution: ICP = $170,000/($540,000/365) = 114.9 or 115 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle analysis

46. If Swatch's inventory conversion period is 45 days, its payables deferral period is 35 days, and its receivables conversion period is 50 days, then its cash conversion cycle must be ______ days. a. 60

b. 90 c. 30 d. cannot be determined from information given ANS: A Solution: CCC = 45 + 50 - 35 = 60 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle analysis

47. Runners Ink, Inc. had sales last year of $700,000 and 35 percent of its sales are for cash, with the remainder buying on terms of net 30 days. If the receivables conversion period is actually 38 days, what is Runners Ink's accounts receivable? a. $72,877 b. $25,507 c. $47,370 d. none of the above ANS: C Solution: AR = 38[($700,000)(0.65)]/365) = $47,370 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle analysis

48. Sherwood Packing had sales of $3.2 million and a gross profit margin of 35% last year. If Sherwood's inventory averaged $0.4 million last year, what was the length of the inventory conversion period? a. 130.4 days b. 70.2 days c. 195.5 days d. 45.6 days ANS: B Solution: Cost of sales = $3.2 (1 - 0.35) = $2.08 Inv. conv. pd. = $0.4/($2.08/365) = 70.19 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Inventory conversion period

49. Last year Bizmart had credit sales of $32 million and a net profit margin of 8%. If Bizmart had accounts receivable of $4.5 million, what was the length of the receivables conversion period? a. 51.3 days b. 56.3 days c. 54.9 days d. 47.2 days ANS: A Solution: Rec. conv. pd. = $4.5/($32/365) = 51.3 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Receivables conversion period

NAT: Analytic skills

50. Linear Technology had sales (all on credit) of $36 million and a gross profit margin of 30% last year.

If Linear Technology's inventory averaged $3.9 million, and its accounts receivable were $5.0 million, what was the length of its operating cycle? a. 90.2 days b. 128.9 days c. 111.9 days d. 107.2 days ANS: D Solution: Inv. conv. pd. = $3.9/($25.2/365) = 56.5 days Rec. conv. pd. = $5/($36/365) = 50.7 days Operating cycle = 56.5 + 50.7 = 107.2 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Operating cycle

51. Crystal Oil has $9 million in accounts payable, $1.8 in salaries and taxes payable, and $10.4 in other current liabilities. If Crystal Oil had a cost of sales of $54 million and selling, general, and administrative expense of $18 million, what is the length of its payables deferral period? a. 107.47 days b. 73.02 days c. 54.75 days d. 45.63 days ANS: C Solution: Pay. def. pd. = ($9 + $1.8)/[($54 + $18)/365] = 54.75 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Payables deferral period

52. Laserscope has an inventory conversion period of 45 days, a receivables conversion period of 42 days, and a payables deferral period of 51 days. What is the length of its cash conversion cycle? a. 54 days b. 36 days c. 48 days d. can determine with more information ANS: B Solution: Cash conv. cycle = 45 + 42 - 51 = 36 days PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Cash conversion cycle

53. Great Skot expects to have cash receipts in June of $532,160. Skot's cash disbursements in June are $581,720, including an interest payment on a bond issue of $32,000. If Skot wishes to maintain a cash balance of $40,000, how much will Skot have to borrow if it started the month with a cash balance of $52,000? a. Surplus of $2,440. Will not have to borrow b. Surplus of $34,440. Will not have to borrow c. $5,560 d. $37,560

ANS: D Solution: Cash balance = $52,000 + $532,160 -$581,720 = $2,440 Loan needed = $40,000 -$ 2,440 = $37,560 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Loan needs analysis - cash flows

NAT: Analytic skills

54. Gates Industries balance sheet and income statement for the year ending December 31, 1978 are as follows: Balance Sheet ($ million) Cash Accounts receivable Inventories* Fixed assets (net) Total assets

$10.0 15.0 12.0 30.0 $67.0

Accounts payable Salaries, benefits, & payroll taxes payable Long-term debt Stockholders' equity Total liab. & stock. equity

$15.0 3.0 15.0 34.0 $67.0

Income Statement ($ million) $125.0 75.0 30.0 13.0 $ 7.0

Net sales (all credit) Cost of sales Selling, general, & admin. expenses Other expenses Earnings after tax *Note: Average inventories also equal $12.0 (million).

Determine the length of the firm's cash conversion cycle. a. 102.2 days b. 29.2 days c. 39.6 days d. none of the above/cannot be computed ANS: C Solution: Inventory conversion period = $12.0/($75.0/365) = 58.4 days Receivables conversion period = $15.0/($125.0/365) = 43.8 days Operating cycle = 58.4 + 43.8 = 102.2 days Payables deferral period = ($15.0 + $3.0)/[($75.0 + $30.0)/365] = 62.6 days Cash conversion cycle = 102.2 - 62.6 = 39.6 days PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Cash conversion cycle

55. Barnes Company has highly seasonal sales and financing requirements. Barnes has made the following projections of its asset needs and net additions to retained earnings over the next year (in $ million).

Quarter

Fixed Assets

Current Assets

Net Additions to Retained Earnings

1 2 3 4

$60 $60 $65 $65

$30 $35 $40 $35

$1 $2 $4 $2

Net worth (equity) at the beginning of the year is $50 million. The company does not plan to sell any new equity during the coming year. Assume that Barnes follows a matching approach to finance its assets, i.e., long-term debt and equity are used to finance fixed and permanent current assets and short-term debt is used to finance fluctuating current assets. Determine the amount of long-term and short-term debt respectively outstanding at the end of the third quarter ($ million). a. $39; $2 b. $48; $0 c. $41; $7 d. none of the above/cannot be determined ANS: C Solution:

Qtr

F/A

C/A

T/A

Net Add to R/E

Total Equity

Total Debt

Ltd

Std

1 2 3 4

$60 60 65 65

$30 35 40 35

$ 90 95 105 100

$1 2 4 2

$51 53 57 59

$39 42 48 41

$39 41 41 41

$0 1 7 0

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Asset financing - matching approach

NAT: Analytic skills

56. Simmons Industries is considering two alternative working capital investment and financing policies.

Policy A requires the firm to keep its current assets at 60% of forecasted sales and to finance 75% of its debt requirements with long-term debt (and 25% with short-term debt). Policy B, on the other hand, requires the firm to keep current assets at 40% of forecasted sales and to finance 50% of its debt requirements with long-term debt (and 50% with short-term debt). Forecasted sales for next year are $20 million. Earnings before interest and taxes are projected to be 20% of sales. The firm's corporate income tax rate is 40%. Its fixed assets total $10 million. The firm desires to maintain its existing capital structure that consists of 50% debt (both long-term and short-term) and 50% equity. Interest rates on short- and long-term debt are 8% and 10% respectively.

Determine the expected rate of return on equity next year for Simmons Industries under each of the working capital policies. a. 26.9%, 30.4% b. 21%, 26.7% c. 8.1%, 9.1% d. 16.1%, 21.3% ANS: D Solution: ($ Million) Sales Current Assets Fixed Assets Total Assets Total Debt (0.50 x T/A)

Policy A 0.60 x 20.0 =

Policy B $20.0 12.0 10.0 22.0 11.0

0.40 x 20.0 =

$20.0 8.0 10.0 18.0 9.0

Short-term Debt 0.25 x 11.0 = Long-term Debt 0.75 x 11.0 = Equity (0.50 x T/A) Total Debt & Equity EBIT (0.20 x 20.0) Int. Exp. STD 2.75 x 0.08 = LTD 8.25 x 0.10 = Total Interest Earnings Bef. Taxes Income Taxes (0.40 x EBT) EAT Rate of Return on Equity $1.773/11.0 = 16.1%

2.75 8.25 11.0 22.0 4.0 0.22 0.825 1.045 2.955 1.182 1.773

0.50 x 9.0 = 0.50 x 9.0 =

4.5 4.5 9.0 18.0 4.0 0.36 0.45 0.81 3.19 1.276 1.914

4.5 x 0.08 = 4.5 x 0.10 =

$1.914/9.0 = 21.3%

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand risk and return TOP: Profitability vs. risk tradeoff for alternative financing plans 57. Laserscope Inc. is trying to determine the best combination of short-term and long-term debt to employ in financing its assets. Laserscope will have $16 million in current assets and $20 million in fixed assets next year and expects operating income (EBIT) to be $4.1 million. The company's tax rate is 40% and its debt ratio is 50%. The firm's debt will be financed by one of the following policies:

Financing policy Aggressive Conservative

Amount of Short-term debt $12 6

Interest rate LTD (%) STD(%) 11.0 10.3

7.5 7.0

What is the return on shareholder's equity under each policy? a. aggressive = 12.70% & conservative = 12.22% b. aggressive = 8.47% & conservative = 8.14% c. aggressive = 4.23% & conservative = 4.07% d. aggressive = 7.67% & conservative = 8.81% ANS: B Solution: Aggressive

Conservative

EBIT I EBT T EAT ROE

$4.100 1.560 2.540 1.016 1.524 8.47%

$4.100 1.656 2.444 0.978 1.466 8.14%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Working Capital financing policy

NAT: Analytic skills

58. Cisco Systems wishes to analyze the joint impact of its working capital investment and financing policies on shareholder return. The company has $24 million in fixed assets. Cisco wishes to maintain a debt ratio of 40%. The company's tax rate is also 40%. The following information was developed for the two policies under consideration (dollars in millions):

Investment in current assets

Aggressive

Conservative

$28

$34

Amount of short term debt EBIT Interest rate--LTD (%) Interest rate--STD(%)

$16 $5.4 12.0 7.5

$10 $5.8 11.0 7.0

For the aggressive approach, Cisco's ROE is ________ and for the conservative approach the ROE is _________. a. 4.18%, 3.77% b. 11.62%, 10.48% c. 6.97%, 6.29% d. none of the above are correct ANS: C Solution: Aggressive

Conservative

Total Debt EBIT I EBT T EAT ROE

$20.800 $ 5.400 1.776 3.624 1.450 $ 2.174 6.97%

$23.200 $ 5.800 2.152 3.648 1.460 $ 2.188 6.29%

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital TOP: Working capital investment and financing policy

NAT: Analytic skills

59. Cryo-vac expects sales to increase 20% next year from the current level of $5,000,000. The firm has current assets of $1,000,000 and fixed assets of $1,500,000. Cryo-vac has current liabilities of $750,000 of which $300,000 are in notes payable. What additional financing will Cryo-vac need to support the expected sales increase if its profit margin is 8% and the firm expects to pay out $200,000 in dividends? An increase in net fixed assets of $300,000 will be required. a. $130,000 b. $ 70,000 c. Surplus of $70,000 d. $270,000 ANS: A Solution: AFN = 300,000 + 1,000,000(.20) - 450,000(.2) - 6,000,000 (.08) + = $130,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

200,000

NAT: Analytic skills TOP: Additional funds needed

60. Commercial paper is: a. long-term with maturities greater than one year. b. short-term with maturities under six months. c. short-term with maturities that do not exceed nine months. d. long-term with maturities of greater than five years.

ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Commercial paper

61. When pledging accounts receivables, which of the following statements is/are correct?

I. Pledging requires permission of the SEC. II. In pledging accounts receivables, the firm loses title to the receivables and they are no longer listed on the balance sheet. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Pledging accounts receivable

62. Factoring accounts receivable is done: a. on a default basis b. on a consignment basis c. on an interest only basis d. on a non-recourse basis ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Factoring accounts receivable

NAT: Reflective thinking

63. When factoring accounts receivables, the factor is the: a. negotiated accounts receivable account. b. the percent deduction in payment to the firm. c. the financial institution that buys the accounts receivable. d. the method of determining how much money is lent to the firm.

ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand financial analysis and cash flows TOP: Factoring accounts receivable 64. In considering factoring accounts receivable, which of the following statements is/are correct?

I. Maturity factoring occurs when the firm receives payment at the normal collection or due date of the factored accounts.

II. Advance factoring occurs when the firm receives payment in prior to the normal collection or due date of the factored accounts. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Factoring accounts receivable ESSAY 1. What is financial forecasting?

ANS:

NAT: Reflective thinking

Financial forecasting allows a firm to estimate the amount of additional financing it will require in an upcoming period. The proportions of short-term and long-term debt that make up the additional financing requirements can be determined by analyzing the profitability -- risk trade-offs of alternative working capital investment and financing policies.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Introduction 2. Name some factors that affect the firm’s investment decision to invest in current assets.

ANS: The firm must consider: 1. the type of products manufactured.

2. the length of the operating cycle.

3. the sales level (higher sales require more investment in inventories and receivables).

4. inventory policies (amount of inventory required to meet higher than expected demand or unanticipated delays in obtaining new inventories).

5. credit policies 6. how efficiently the firm manages current assets.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Levels of working capital investment 3. Why is working capital so important to a firm’s continued profitability?

ANS: A firm must have working capital to operate and survive. It is used by firms to maintain liquidity (their ability to meet their cash obligations as they come due). Liquidity is necessary to maintain the firm’s credit rating, avoid the forced liquidation of assets and potential bankruptcy.

Working capital is also important as a measure of the firm’s risk. The firm’s working capital position affects its ability to obtain debt financing. Many loan agreements with banks and other lending institutions contain a provision requiring the firm to maintain a minimum net working capital position.

Many bond indentures contain these provisions as well.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Working capital policy 4. Explain trade credit.

ANS: Trade credit is an important source of short-term financing for business firms. Trade credit occurs when a firm is allowed to delay payment for merchandise received. Most trade credit is on an open account basis whereby a firm sends a purchase order to a supplier, receives the goods and then pays according to the terms on the invoice. Once established, trade credit is almost automatic. Open account trade credit appears on the balance sheet as accounts payable.

Promissory notes are sometimes used in place of open accounts. A promissory note is a formal obligation to repay the credit. The amount to be paid and the due date are specified on the note and is generally used when the creditworthiness of a firm is questioned. Promissory notes appear on the balance sheet as notes payable.

PTS: 1 NAT: Reflective thinking LOC: Knowledge of capital budgeting

5. What are accrued expenses and how are they handled as unsecured short-term credit?

ANS: Accrued expenses are: accrued wages, taxes and interest. These are expenses not yet paid by the firm but are owed. As such, they represent an interest-free source of financing.

Accrued wages represent the money owed to employees between paydays. Once the employees receive their paychecks, the accrued wages account goes to zero. Accrued taxes and interest would accumulate based on the frequency with which theses expenses must be paid. A firm can use accrued taxes between payment dates. A firm has no control over when these as.mounts are owed, so the amount of financing provided by these sources depends solely on the amounts of the payments themselves.

PTS: 1 NAT: Reflective thinking LOC: Knowledge of capital budgeting 6. Explain how a firm uses commercial paper as a short-term financing source and explain the disadvantage of using this form of financing.

ANS: Commercial paper is a short-term unsecured promissory note issued by major corporations. Only companies with good credit ratings are able to borrow funds through the sale of commercial paper. Purchasers of commercial paper include corporations with excess funds to invest, banks, insurance companies, pension funds, money market mutual funds and other types of financial institutions. Maturities on commercial paper range from several days to a maximum of nine months.

Commercial paper is attractive as a source of financing because interest rates tend to be below the prime lending rate.

The primary disadvantage of this type of financing is that it is not always a reliable source of funds. The commercial paper market is impersonal. It may be difficult to find investors willing to purchase new issues of commercial paper to replace maturing issues. Also, the amount of loanable funds available in the commercial paper market is limited to the amount of excess liquidity of the various purchasers of commercial paper. During tight money periods, enough funds may not be available.

Commercial paper is sold on a discount basis; the firm receives less than the face amount but the investor receives the full face amount at maturity. The annual financing cost of commercial paper depends on the maturity date of the issue and the prevailing short term rates. In addition to the interest costs, borrowers also must pay a placement fee to the commercial paper dealer for arranging the sale of the issue.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Commercial paper

Chapter 17—THE MANAGEMENT OF CASH AND MARKETABLE SECURITIES MULTIPLE CHOICE 1. Which of the following methods is (are) used to transfer surplus funds from local (collection) bank accounts to concentration (disbursement) bank accounts? a. wire transfers b. electronic depository transfer checks c. (mail) depository transfer checks d. all of these answers are correct ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections 2. ______ are processed through the Automated Clearing House (ACH) System. a. Drafts b. Wire transfers c. Check-like electronic images d. Floats ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Electronic funds transfer 3. ______ consists of short-term unsecured promissory notes issued by large, well-known corporations and finance companies. a. Negotiable certificates of deposit b. Commercial paper c. Repurchase agreements d. Bankers' acceptances ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Commercial paper 4. ______ are short-term debt instruments issued as part of a commercial transaction, with payment guaranteed by a commercial bank. a. Negotiable certificates of deposit b. Commercial paper c. Repurchase agreements d. Bankers' acceptances ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; knowledge of financial analysis and cash flows TOP: Bankers' acceptances 5. Which of the following statements concerning auction rate money market preferred stocks is (are) true? a. The price of the stock stays near par. b. Fifty percent of the dividends are exempt from corporate income taxes. c. The dividend yield on these securities is adjusted every 20 days through an auction process, where investors can exchange their stock for cash. d. The price of the stock stays well above par.

ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Auction rate preferred stocks 6. The primary reason(s) why firms hold liquid asset balances is (are): a. for transactions purposes b. for precautionary purposes c. to compensate its broker for various services rendered to the firm d. for transaction and precautionary purposes ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows

TOP: Liquid asset balance 7. The "shortage" costs associated with inadequate liquid asset balances include a. higher cash discounts b. possible financial insolvency c. lower interest expense d. possible financial insolvency and lower interest expense ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Optimal liquid asset balance 8. Liquid asset balances include all of the following except a. accounts receivable b. checking account balances c. marketable securities d. currency on hand ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Optimal liquid asset balance 9. The firm's optimal liquid asset balance occurs where the sum of the opportunity holding and ___________ costs is minimized. a. borrowing b. compensating balance c. shortage d. capital ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Optimal liquid asset balance 10. The difference between the firm's checking account balance shown on the books of the bank and the account balance shown on its own books is known as a. overdraft b. compensating balances c. surplus balances d. float ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Float 11. All of the following are methods used in expediting the collection of cash except a. wire transfers b. lockboxes c. drafts d. decentralized collection centers and concentration banks ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections 12. The costs of a lockbox collection system include

a. b. c. d.

foregone returns on the required compensating balances service fees charged by the bank increased bad-debt expenses foregone returns on the required compensating balances and service fees charged by the bank

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Lockboxes 13. The fastest method for moving funds between banks is a. special courier services b. wire transfers c. drafts d. float ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Wire transfers and depository transfer checks 14. Which of the following statements concerning "zero balance" systems is (are) correct? a. Zero balance systems help utilize disbursement float more effectively. b. Exactly enough funds are transferred into the zero balance accounts each day to cover the checks that have cleared. c. The function of the concentration account is to receive all deposits coming into the zero balance system. d. all of these answers are correct ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Scheduling and centralizing payments 15. Which of the following statements concerning drafts is (are) correct? a. Drafts require the firm to keep larger balances in its disbursement account. b. When a draft is transmitted to the firm's bank for collection, the bank must present the draft to the firm for acceptance before payment is made. c. Both a and b are correct. d. Neither a nor b is correct.

ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Drafts 16. The optimal amount of the firm's liquid asset balance to be invested in marketable securities is a function of a. the interest earned over the expected holding period b. the transaction cost involved in buying and selling the securities c. the spread between long-term and short-term interest rates d. the interest earned over the expected holding period and the transaction cost involved in buying and selling the securities ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial markets and interest rates TOP: Investing in marketable securities

17. Which of the following criteria is generally least important in selecting marketable securities for inclusion in the firm's portfolio? a. length of maturity b. yield c. marketability d. default risk ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Choosing marketable securities 18. Which of the following types of marketable securities is considered to have the lowest default risk? a. bankers' acceptances b. U.S. Treasury issues c. repurchase agreements d. commercial paper ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Types of marketable securities 19. Which of the following types of marketable securities normally has the lowest yields? a. Federal agency issues b. Treasury bills c. repurchase agreements d. commercial paper ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Types of marketable securities 20. Which of the following types of marketable securities is most suitable for a smaller firm with only a few thousand dollars to invest at any given time? a. money market mutual funds b. Treasury bills c. Federal agency issues d. commercial paper ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Types of marketable securities 21. Which of the following types of marketable securities has a relatively weak secondary market? a. Bankers' acceptances b. Federal agency issues c. negotiable certificates of deposit d. commercial paper ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Types of marketable securities 22. The primary reason(s) that firms do not hold long-term U.S. Treasury securities in their marketable securities portfolio is because a. the interest-rate risk associated with these securities is too high

b. the transactions costs associated with these securities is too high c. the default risk associated with these securities is too high d. these securities are not readily marketable ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Choosing marketable securities 23. All of the following would be viable securities to purchase with temporary excess cash except: a. a recently issued 30 year Baa corporate bond b. U.S. Treasury bill c. the commercial paper of General Motors Acceptance Corporation d. a repurchase agreement ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Choosing marketable securities 24. The "shortage" costs associated with inadequate liquid asset balances include all of the following except a. deterioration of the firm's credit rating b. foregone cash discounts c. lost sales d. possible financial insolvency ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Optimal liquid asset balance 25. All of the following are cash management strategies to expedite collections except a. a lockbox collection system b. wire transfers c. decentralized collection system d. the use of drafts instead of checks ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Expediting collections 26. The cash management function is concerned with determining a. the optimal size of a firm's liquid asset balance b. the appropriate types and amounts of short-term investments the firm should make c. the most efficient methods of controlling the collection and disbursement of cash d. all of these answers are correct.

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Introduction 27. In addition to providing their commercial customers with lines of credit and/or term loans, banks provide all of the following tangible services except a. handling of dividend payments b. registration and transfer of a firm's stock c. establishment of credit terms d. cash management

ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Knowledge of financial markets and interest rates TOP: Corporate-bank relations 28. The objective of cash collection and disbursement policies is to a. minimize storage costs b. speed up collections and slow down disbursements c. maximize the return on near cash equivalents d. avoid using float ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Controlling the collection and disbursement of cash 29. The primary components or sources of float include all the following except a. check clearing float b. collection float c. processing float d. mail float ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Float 30. In general the ______ the number of checks being handled and the ______ the dollar amount of each check, the greater the benefit of a lockbox arrangement is to a firm. a. smaller, greater b. greater, smaller c. greater, greater d. smaller, smaller ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Lockboxes 31. ______, which are similar to other checks except they are not payable on demand, are used primarily to provide for centralized control over payments authorized in field offices. a. Preauthorized checks b. Drafts c. Mail depository transfer checks d. Electronic depository transfer checks ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Drafts 32. All of the following are criteria that a firm should consider when deciding where to invest excess cash reserves among the different types of securities except a. rate of return b. maturity date c. issue date d. marketability ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial markets and interest rates

TOP: Choosing marketable securities 33. To minimize the cost associated with misdirected funds between subsidiaries, many multinational companies have instituted a process called ______. a. multinational cash consolidation b. multilateral netting c. unilateral netting d. cash restriction ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial markets and interest rates TOP: International issues: Cash management 34. The first step in efficient cash management is the development of a _____. a. liquid asset balance b. cash budget c. proforma cash flow statement d. compensating spreadsheet ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Cash flows and the cash budget

NAT: Reflective thinking

35. There is a(n) _____ relationship between a firm's liquid asset balance and "shortage" costs. a. direct b. no c. inverse d. very small ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Optimal liquid asset balance

36. A(n) _____ is an unsigned, nonnegotiable check drawn on the local collection bank and payable to the concentration bank. a. pre-authorized check b. bankers acceptance check c. special remittance d. mail depository transfer check ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Wire transfers and depository transfer checks

NAT: Reflective thinking

37. A _____ is a security issued by a commercial bank which entitles the holder to receive the amount deposited plus accrued interest on a specified date. a. negotiable certificate of deposit b. commercial paper c. banker's acceptance d. repurchase agreement ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial markets and interest rates TOP: Negotiable certificate of deposit

NAT: Reflective thinking

38. The Essex Company found that an average of 10 days elapses between when customer payments are received and the deposited funds clear the customer's bank and become usable by the firm. Essex's annual sales are $240 million. (Assume 365 days per year when converting from annual data to daily data or vice versa.) What is the increase in Essex's average cash balance assuming that it can reduce the time required to process customer payments by 3 days through more efficient payment processing methods? a. $666,667 b. $120,000,000 c. $1,972,603 d. $270,000 ANS: C Solution: Increase in cash balance = $240,000,000/365 x 3 = $1,972,603 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections 39. The Essex Company found that an average of 10 days elapses between when customer payments are received and the deposited funds clear the customer's bank and become usable by the firm. Essex's annual sales are $240 million (Assume 365 days per year when converting from annual data to daily data or vice versa.) Suppose that Essex is able to reduce the time required to process customer payments by 4 days through more efficient payment processing methods. Given that these additional funds can be used to reduce the firm's outstanding bank loans (10% interest rate), what is the annual pretax savings in interest expense? a. $263,014 b. $96,000,000 c. $66,667 d. $2,630,149 ANS: A Solution: Savings = [($240,000,000/365) x 4] x 0.10 = $263,014 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Expediting collections 40. Osborne Shipbuilding Company, located in Baton Rouge, receives large remittances from its customers in New York and California. If the firm deposits these checks in its local bank, two business days are required for the checks to clear and the funds to become usable by the firm. However, if Osborne sends an employee to New York or California and presents the check for payment at the bank upon which it is drawn, the funds are available immediately to the firm. The firm can earn 8% per annum on short-term investments and the cost of sending an employee to New York or California to present the check for payment is $500. What is the net benefit to the firm of employing this special handling technique for a $5 million check received on Tuesday (assume 365 days per year)? a. $2,192.00 b. $1,692.00 c. $2,000.00 d. $1,095.50 ANS: B Solution: Benefit = $5,000,000(2)(0.08/365) - $500 = $1,692

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Special check handling analysis 41. Zycad has sales of $110 million a year. If Zycad reduces their processing float by 3 days, what is the increase in the firm's average cash balance? Assume 365 days per year. a. $916,667 b. $904,110 c. $872,180 d. $30,137 ANS: B Solution: Increase in cash balance = $110,000,000/365 x 3 = $904,110 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Reduction of processing float 42. MLX has annual sales of $320 million per year and has calculated that the collection float is 12 days.

If MLX is currently paying 9.35 percent on its line of credit, what amount of interest expense could be saved if the collection float is reduced by 3 days? Assume 365 days per year. a. $249,333 b. $573,808 c. $299,200 d. $245,918 ANS: D Solution: Interest savings = $320,000,000/365 x 3 x 0.0935 = $245,918 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Reduction of collection float 43. Pronet has annual sales of $724 million from its 600 retail stores. Pronet can reduce its mail float by 2 days through the use of wire transfers. The annual cost of the wire transfers is expected to be $105,610. If Pronet's cost of short-term funds is 9.75 percent, should the change to wire transfers be made? Assume 365 days per year. a. No, loss of $247,340 b. Yes, savings of $281,185 c. Yes, savings of $474,582 d. No, loss of $105,610 ANS: B Solution: Interest savings = ($724,000,000/365)(2)(0.0975) - $105,610 = $281,185 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Wire transfers

44. Tocor is considering the implementation of a lockbox collection system for its mid-western and western sales regions. Sales in those two regions are 30 percent of Tocor's annual sales of $560 million. The lockbox system will cost $187,000 a year and reduce collection time by 3 days. If Tocor could invest any released funds at 10.85 percent, should it use the lockbox system? Assume 365 days per year. a. Yes, savings of $149,819 b. Yes, savings of $312,397 c. No, loss of $37,181 d. No, loss of $35,100 ANS: C Solution: Net benefits of lockbox = ($560,000,000/365)(0.3)(3)(0.1085) - $187,000 = -$37,181 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Lockbox 45. Average daily sales for Sierra are $140,000. The financial manager can reduce the float by 4 days using a lockbox system that will cost $33,000. If the opportunity cost of any funds released is 11 percent, what is the annual savings from this system? a. $28,600 b. $14,520 c. $61,600 d. $35,000 ANS: A Solution: Lockbox savings = $140,000(4)(0.11) - $33,000 = $28,600 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Lockbox 46. Lexicon has a daily average check collections of $180,000 and it takes the firm 5 days before it can completely process those checks. An automated lockbox system that costs $33,000 a year would reduce the processing time by 2 days. Should Lexicon invest in this system if the opportunity cost of short-term funds is 12.3 percent? a. Yes, savings of $44,280 b. Yes, savings of $33,420 c. Yes, savings of $11,280 d. No, loss of $10,860 ANS: C Solution: Lockbox savings = $180,000(2)(0.123) - $33,000 = $11,280 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Lockbox

47. Marcos Company annual sales are $730 million. Suppose Marcos is able to reduce the time required to process customer payments by 3 days through more efficient payment processing techniques. Given that any funds released by these methods can be invested elsewhere in the company to yield a 15% pretax rate of return, determine the annual increase in pretax returns. (Assume 365 days per year in all calculations.) a. $900,000 b. $300,000 c. $6,000,000 d. cannot be determined from the information provided ANS: A Solution: Annual pretax returns = [($730,000,000/365) x 3] x 0.15 = $900,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Returns from expediting collections 48. Jester, Inc. has annual sales of $434 million. An average of 12 days elapses between the time a customer mails its payment and the funds are available to Jester. What is the increase in the average cash balance if the use of a lock box system is believed to reduce the collection time by 4 days? a. $ 4.76 million b. $49.6 million c. $633,640 d. $ 9.5 million ANS: A Solution: Increase = ($434,000,000/365)(4) = $4.756 million PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Lock box 49. Galway's sales average $12 million per day. If Galway could reduce the time between customer's mailing date and when these payments are available to Galway by 3 days, what would be the resulting annual increase in earnings if the opportunity cost of funds in 9.25%? a. $1.11 million b. $98,630 c. $3.33 million d. $9,123 ANS: C Solution: Increase = $12(.0925)(3) = $3.33 million PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections

50. Fagins, a nationwide department store chain, currently processes all of its credit sales payments at its St. Louis headquarters. The firm is considering the establishment of a lockbox arrangement with a Los Angeles bank to process payments from its customers in 10 western states. With the lockbox system, average mailing time for customers from this region would be reduced from 3 days to 1.5 days. Check clearing time would also be reduced from 4 days to 2.5 days. Annual collections from the western region are $150 million. Establishment of this lockbox system would reduce the compensating balance requirement at the firm's St Louis bank by $600,000 and reduce annual payment processing costs at the St. Louis office by $30,000. Funds released by the lockbox arrangement can be invested elsewhere in the firm to earn 12 percent before taxes. The Los Angeles bank has agreed to process Fagins' customer payments for an annual fee of $100,000. What are the annual net pretax benefits to Fagins of establishing a lockbox system with the Los Angeles bank (assume 365 days per year)? a. $222,000 b. $130,000 c. $1,832,877 d. $149,945 ANS: D Solution: Reduction in collection time = (3 - 1.5) + (4 - 2.5) = 3 days Amount. of funds released = $150,000,000/365 x 3 + $600,000 = $1,832,877 Net benefits = $1,832,877(0.12) + $30,000 - $100,000 = $149,945 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Lockbox system analysis 51. Fagins, a nationwide department store chain, currently processes all of its credit sales payments at its St. Louis headquarters. The firm is considering the establishment of a lockbox arrangement with a Los Angeles bank to process payments from its customers in 10 western states. Average mailing time for customers from this region would be reduced from 3 days to 1.5 days. In addition, check processing and clearing time would be reduced from 4 days to 2.5 days. Annual collections from the western region are $150 million. Establishment of this lockbox system would reduce the compensating balance requirement at the firm's St. Louis bank by $600,000 and reduce annual payment processing costs at the St. Louis office by $30,000. Funds released by the lockbox arrangement can be invested elsewhere in the firm to earn 12 percent. The Los Angeles bank has agreed to process Fagins' customer payments "free of charge" provided that the firm maintains a minimum compensating balance of $1,500,000 in its account at the bank. What are the annual net benefits to Fagins of establishing a lockbox system with the Los Angeles bank (assume 365 days per year)? a. $630,000 b. $332,877 c. $ 69,945 d. $41,096 ANS: C Solution: Reduction in collection time = (3 - 1.5) + (4 - 2.5) = 3 days Amt. of funds released = $150,000,000/365 x 3 + $600,000 - $1,500,000 = $332,877 Net benefits = $332,877(0.12) + $30,000 = $69,945 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Lockbox system analysis

52. A Delaware bank has offered to set up a lock-box arrangement to process Union Oil Company of California's (UNOCAL) credit card payments from customers in 8 mid-Atlantic states for an annual fee of $150,000 plus $0.05 per payment. Total collections from this area are $547.5 million annually -consisting of an average of 10 payments per year from 1,100,000 credit card customers. Average mailing time for customers from this region would be reduced from 3.5 days currently to 2 days with the lock-box system. Check processing and clearing time also would be reduced from 5 days presently to 1.5 days with the lock-box arrangement. Establishment of the lock-box system would reduce annual payment processing costs at its Los Angeles headquarters by $250,000 and reduce the compensating balance at its Los Angeles bank by $500,000. The Delaware bank will not require UNOCAL to maintain a compensating balance if it establishes a lock-box system. Funds released by the lock-box arrangement can be invested elsewhere in the firm to earn 15% per annum pretax. Determine the net pretax benefits to UNOCAL of establishing the lock-box system with the Delaware bank. (Assume 365 days per year in the calculations.) a. $675,000 b. $750,000 c. $500,000 d. $450,000 ANS: B Solution: Reduction in collection time = (3.5 - 2) + (5 - 1.5) = 5.0 days Amount of funds released = ($547,500,000/365) x 5.0 + $500,000 = $8,000,000 Cost of lock-box system = 1,100,000 x 10 x ($0.05) + $150,000 - $250,000 = $450,000 Net pretax benefits = $8,000,000 x 0.15 - $450,000 = $750,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Lock-box analysis 53. Lone Star Technologies has annual sales of $336 million. Management has determined that an average of 8 days elapses between the time customers mail their payments and when the funds are available to the firm. The cost of reducing the float 3 days will be $60,000. Should Lone Star work to reduce the float if the increase in cash can be invested to earn 7.5% per annum? a. Yes--savings of $9,041 b. Yes--savings of $147,123 c. Yes--savings of $78,080 d. No--loss of $18,080 ANS: B Solution: Savings = ($336,000,000/365)(3)(0.075) - $60,000 = $147,123 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections analysis 54. Currently Nemonix is using a decentralized collection system whereby customers mail their checks to one of the firm's eight regional locations. Its annual sales are $95 million. Checks are deposited each business day in a local bank and the amount of the deposit is sent to the firm's concentration bank in Dallas. The average time between deposit in the local bank and the availability of those funds, in Dallas, to Nemonix is 6 days. Nemonix has determined that the use of wire transfers would reduce the float by four days, but the transfer will cost $7.50. If transfers will be made on the 250 days that banks are open each year, should Nemonix switch to the wire transfer system? Assume that Nemonix can earn 8% on the funds released through this more efficient transfer.

a. b. c. d.

Yes-savings of $106,600 Yes-savings of $61,388 Yes-savings of $68,288 No-loss of $6,671

ANS: C Solution: Earnings on released funds = 4($95,000,000/365)(0.08) = $83,288 Additional costs = $7.50 (8)(250) = $15,000 Net (pretax) benefits = $83,288 - $15,000 = $68,288 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Wire transfer analysis 55. Tritonic is considering switching from depository transfer checks to using wire transfers for sending funds from its local banks to its bank in Chicago. The cost of the wire transfer is $5.25 more than the cost of depository transfer checks. The change would reduce the total float by 3 days. Tritonic can earn 8.5% on the funds released through the more efficient transfer. If Tritonic has 30 local banks, what annual sales level would the firm require before the change to wire transfers would be profitable?

Assume there are 250 business days each year. a. $391,544,118 b. $ 56,360,294 c. $ 84,286,029 d. $ 1,149,750 ANS: B Solution: Costs = $5.25(30)(250) = $39,375 Sales level =

$39,375 (365) (0.085)(3)

= $56,360,294

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Wire transfer analysis 56. Slimware is considering establishing a zero-balance system for its payroll account. Currently, the firm pays its hourly employees every week on late Friday afternoon and puts a check for $750,000 in the bank to cover the payroll each Monday morning. Slimware has determined that the checks clear its bank as follows: Day Monday Tuesday Wednesday Thursday Friday

Percent clearing 26% 51% 14% 7% 2%

What is the annual pretax return to Slimware if the firm can earn 9% on any funds released from employing the zero-balance system? Assume the company has 52 weekly pay periods each year. a. $10,374 b. $199.72 c. $24,601

d. $17,488 ANS: A Solution: Mon. Tues.

Wed. Thur.

$750,000(0.74)(0.09/365) = $750,000(0.23)(0.09/365) = $750,000(0.09)(0.09/365) = $750,000(0.02)(0.09/365) = Total per pay period = Annual return = $199.72(52) =

$136.85 42.53 16.64 3.70 $199.72 $10,385

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Zero-balance system analysis 57. Amazon's CFO is considering the fees charged by two banks at trying to determine which is best for her firm. First American charges a flat $0.11 per payment and First Western requires a minimum compensating balance of $500,000 plus $0.05 per payment. If Amazon's cost of funds is 8.50%, and the expected number of payments per year is 900,000, which bank should be chosen? a. FW, savings = $54,000 b. FA, savings = $23,000 c. FW, savings = $11,500 d. FW, savings = $18,500 ANS: C Solution: FW = 500,000(.085) + 900,000(.05) = $87,500 FA = 900,000(.11) = $99,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Bank service fee analysis 58. Dupree Funds is considering the fees charges by two banks. First America charges a flat rate of $0.11 per payment and First Western requires a minimum compensating balance of $500,000, plus $0.05 per payment. What is the number of payments per year where the costs of the two banks will be equal?

Assume Dupree's costs of funds is 9%. a. 281,250 b. 750,000 c. 900,000 d. 409,091 ANS: B Solution: x(.11) = 500,000(.09) + x(.05) x = 750,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Bank service fee analysis 59. Cash management involves the determination of: a. the minimal size of a firm’s asset balance b. the maximum amount of dividends that should be paid c. the optimal size of a firm’s liquid asset balance

d. the range of long-term financial alternatives ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Introduction 60. Cash management involves the determination of: a. the best locations for lockboxes b. setting up decentralized collection centers c. both a and b d. neither a nor b ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections 61. Concentration banking involves: a. using decentralized collection centers b. having a large balance at a large commercial bank c. having multiple accounts with a brokerage firm d. utilizing an investment banker for when trying to market both stocks and bonds ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Decentralized collection centers and concentration banks 62. Firms that have large multi-million dollar remittances use: a. the Federal Reserve System b. couriers c. lockboxes d. wire transfers ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Special handling of large remittances 63. An ordinary check that does not require the signature of the person or firm on whose account it is being drawn is a: a. cashier’s check b. preauthorized check c. depository check d. float ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Checks 64. Drafts are: a. payable on demand b. legally paid on the third business day c. requires the firm to keep large balances in its disbursement accounts d. more expensive than checks ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Drafts

65. The “Check 21” act allows banks to: a. use substitute checks to reduce check clearing time. b. delay paying the check without proper identification. c. choose when checks are processed. d. fingerprint people who are cashing checks.

ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Check clearing for the 21st century act 66. All of the following portfolio criteria used in determining which securities to include in a portfolio are concerned with risk EXCEPT: a. rate of return b. default risk c. marketability d. maturity date ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return; Understand investments TOP: Choosing marketable securities

NAT: Reflective thinking

ESSAY 1. Explain how companies can slow disbursements in order to keep funds in the bank for longer periods of time.

ANS: Firms can: 1. Schedule and centralize payments: Firms should pay bills on time; there is no benefit to paying bills early unless there is a cash discount for early payment.

Centralizing payments from disbursement accounts helps minimize the amount of idle funds a firm must keep in local field offices and divisional bank accounts.

2. Drafts: By issuing drafts instead of checks, the bank must present the draft to the firm for acceptance before making payment. Checks are payable on demand.

3. Minimize check-clearing float: By making payments from a checking account located a long distance from the supplier, the firm increases the time required for the check to clear through the banking system.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Controlling the collection and disbursement of cash 2. Name the three primary components (or sources) of float: ANS: 1. Mail float is the delay between the time a payment is sent to the payee through the mail and the time that payment arrives at the payee’s office.

2. Processing float is the delay between receipt of payment from a payer and the deposit of that receipt in the payee’s account.

3. Check-clearing float is the delay between the time a check is deposited in the payee’s account and the time the funds are available to be spent.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Controlling the collection and disbursement of cash 3. When and why is it best to use lockboxes? Explain when should alternative methods be used.

ANS: Lockboxes are best used when the number of checks handled is small and the dollar amount of each check is large. Under these conditions, the bank’s workload is light and the associated service fees, compensating balance, or both, are small. When large numbers of checks with small dollar amounts are involved, a lockbox system may not be profitable. The opportunity costs on the required compensating balances, the service fees, or both, may exceed the earnings the firm realizes from having the funds available a few days earlier.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of the role of the finance function; Knowledge of financial analysis and cash flows TOP: Expediting collections; Lockboxes 4. Banks use depository transfer checks to move surplus funds from bank accounts to its concentration bank account or accounts. Explain how this is done.

ANS: There are two types of depository transfer checks. A mail depository transfer check is an unsigned, nonnegotiable check drawn on the local collection bank and payable to the concentration bank. As it deposits customer checks in the local bank each day, the collection center mails a depository transfer check to the concentration bank authorizing it to withdraw the deposited funds from the local bank. Upon receipt of the depository transfer check, the firm’s account at the concentration bank is credited for the designated amount. Depository transfer checks are processed through the usual check clearing process. Although the use of depository transfer checks does not eliminate mailing and check-clearing time, it does ensure the movement of funds from the local collection center banks to the concentration bank in a timely manner.

An electronic depository transfer check can also be used to move funds from a local bank to a concentration bank. The process of transmitting deposit information to a concentration bank is similar to that for mail DTCs except that the information is sent electronically through an automated clearinghouse, such as the automated clearinghouse system of the Federal Reserve or Clearing House Interbank payments System. These systems eliminate the mail float in moving funds from the local bank to the concentration bank. Funds transferred this way are available for use by the firm in one day or less.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Wire transfers and depository transfer checks

Chapter 18—MANAGEMENT OF ACCOUNTS RECEIVABLE AND INVENTORIES MULTIPLE CHOICE 1. The credit policy variables that a firm can use to exercise control over its level of receivables investment include

a. b. c. d.

credit standards credit terms collection effort credit standards, credit terms, and collection effort

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of the finance function; knowledge of financial analysis and cash flows TOP: Shareholder Wealth and optimal investments in accounts receivable 2. Possible sources of relevant information about a credit applicant include a. financial statements submitted by the applicant b. credit reporting organizations c. U.S. Department of Commerce d. the applicant’s financial statements and credit reporting agencies ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of the finance function; Knowledge of financial markets and interest rates TOP: Gathering information on the credit applicant 3. ________are useful in monitoring the status and composition of a firm's accounts receivable. a. Numerical credit scoring systems b. Aging of accounts schedules c. Seasonal datings d. Aging of accounts schedules and seasonal datings ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Monitoring accounts receivable 4. The _______ measures the promptness with which customers repay their credit obligations. a. bad-debt loss ratio b. average collection period c. credit term d. cash discount ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Credit standards 5. Which of the following is(are) not related to the extension of credit to customers? a. compensating balances b. cash discounts c. quantity discounts d. compensating balances and quantity discounts ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Shareholder wealth and optimal investments in accounts receivable 6. The average collection period measures the: a. number of days between when a typical credit sale is made and when the firm receives the payment b. number of days it takes a typical check to "clear" through the banking system c. number of days beyond the end of the credit period before a typical customer payment is received

d. number of days before a typical account becomes delinquent ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Credit standards 7. Relaxing (i.e., lowering) the firm's credit standards is likely to result in a. lower sales b. smaller bad-debt losses c. a shorter average collection period d. possible higher pre-tax profits ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Credit standards 8. Which of the following is not a cost related to the extension of credit to customers? a. bad-debt losses b. cash discounts c. quantity discounts d. collection costs ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Shareholder wealth and optimal investments in accounts receivable 9. The primary objective of offering a cash discount is to a. reduce the firm's level of receivables investment b. reduce the number of bad checks received from customers c. encourage customers to place their orders prior to the peak selling period d. avoid just-in-time orders ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Cash discounts 10. Lengthening the credit period is likely to result in all of the following except a. higher sales b. more cash sales c. larger investment in receivables d. longer average collection period ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms 11. The objective of offering seasonal datings to customers is to a. encourage customers to place their orders prior to the peak selling period b. speed up the collection of accounts receivable c. increase the firm's inventory storage costs d. reduce the number of bad checks received from customers ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Seasonal datings

12. For the firm with a seasonal sales pattern, offering seasonal datings to its customers is likely to result in a. increased sales b. higher inventory investment and warehousing costs c. lower receivables investment cost d. an offer of a cash discount ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Seasonal datings 13. The most widely known credit reporting organization is: a. Moody's b. Standard and Poor’s c. National Association of Credit Management d. Dun and Bradstreet ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Gathering information on the credit applicant 14. Capacity, which is one of the traditional "five Cs" of credit analysis, refers to a. the general economic climate and its effect on the applicant's ability to pay b. the willingness of the applicant to meet its financial obligations c. the financial strength of the applicant (i.e., net worth) d. the ability of an applicant to meet its financial obligations ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Analyzing credit-worthiness and making the credit decision 15. Character, which is one of the traditional "five Cs" of credit analysis, refers to a. the ability of the applicant to meet its financial obligations (i.e., liquidity and cash flow) b. the general economic climate and its effect on the applicant's ability to pay c. the financial strength of the applicant (i.e., net worth) d. the willingness of the applicant to meet it’s financial obligations ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Analyzing credit-worthiness and making the credit decision 16. Potential losses can occur in the credit evaluation process when a. credit is denied to a credit-worthy customer b. the credit decision is delayed too long c. credit is denied to a customer who is not credit worthy d. credit is denied to a credit-worthy customer and the credit decision is delayed too long ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Evaluating individual credit applicants 17. The effect of a change in a firm's credit terms from "net 30" to "2/10, net 30" on its customer's balance sheets is likely to be a. decreased accounts receivable b. increased accounts receivable

c. decreased accounts payable d. increased accounts payable ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Cash discounts 18. The effect of a change in a firm's credit terms from "net 30" to "2/10, net 30" on its own balance sheet is likely to be a. decreased accounts receivable b. increased accounts receivable c. decreased accounts payable d. increased accounts payable ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Cash discounts 19. The primary goal of accounts receivable management should be a. minimizing lost sales b. maximizing shareholder wealth c. increasing market share d. minimizing receivables investment ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Shareholder wealth and optimal investments in accounts receivable 20. Traditional discussion of guidelines for examining credit worthiness include "the five Cs of credit".

Each of the following is one of the "five Cs" except a. capacity b. cooperation c. character d. conditions ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Analyzing credit-worthiness and making the credit decision 21. All other things being equal, the application of a seasonal dating to the terms of credit offered by the firms below would be expected to generate additional sales for each firm except a. a Christmas novelty manufacturer b. an agricultural implements manufacturer c. a wholesale frozen food supplier d. a swimsuit manufacturer ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Seasonal datings 22. Increasing collection expenditures is likely to result in a. a shorter average collection period b. reduced bad-debt losses c. higher accounts receivable balances d. a shorter average collection period and reduced bad-debt losses

ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Collection effort 23. _______ are the criteria the firm uses to screen credit applicants in order to determine which of its customers should be offered credit and how much. a. Credit terms b. Credit standards c. Seasonal datings d. Credit extension policies ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit standards 24. All the following are assumptions of the basic EOQ model except: a. annual demand known with certainty b. ordering costs fluctuate c. demand is uniform throughout the year d. orders are filled instantaneously ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Basic EOQ model 25. The _____ is the inventory level at which an order should be placed for replenishment of an item. a. nonzero inventory level b. safety stock c. reorder point d. inventory quantity ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Nonzero lead time 26. The types of inventories that manufacturing firms generally hold include all the following except: a. raw materials b. working stock c. finished goods d. work-in-process ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Inventory management 27. In general, the _____ a firm's production cycle, the _____ its work-in-process inventory. a. longer, larger b. longer, smaller c. shorter, larger d. length of cycle is not related to amount of work-in-process ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Work-in-process inventories

28. When an order is placed for an item that is manufactured internally within a company, ordering costs consist primarily of _____. a. storage and handling costs b. deterioration costs c. production set-up costs d. carrying costs ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Ordering costs 29. All of the following are components of carrying costs except: a. insurance b. storage costs c. handling costs d. set-up costs ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Carrying costs 30. The cost of funds invested in inventories is measured by the _____. a. cost of insuring the inventory b. stockout costs c. required rate of return d. rate of interest on borrowed funds ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Carrying costs 31. To minimize the possibility of running out of inventory, most companies add a ____ to their inventory. a. safety stock b. lead time stock level c. few days d. replenishment factor ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Probabilistic inventory control models 32. Safety stock is needed to absorb a. changes in accounts receivables b. cyclical changes c. random fluctuations in sales d. annual model changes ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Probabilistic inventory control models 33. The reorder point is a. the lead time multiplied by the daily usage plus safety stock b. the EOQ plus safety stock c. the lead time multiplied by the annual usage

d. a product of daily usage and the lead time ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Nonzero lead time 34. Mace Auto Parts Company sells to retail auto supply stores on credit terms of "net 60". Annual credit sales are $300 million (spread evenly throughout the year) and its accounts average 28 days overdue.

The firm's variable cost ratio is 0.75 (i.e., variable costs are 75 percent of sales). When converting from annual to daily data or vice versa, assume there are 365 days per year. Determine Mace's average collection period. a. 88 days b. 44 days c. 74 days d. 60 days ANS: A Solution: Average collection period = 60 + 28 = 88 days PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Average collection period 35. Mace Auto Parts Company sells to retail auto supply stores on credit terms of "net 60". Annual credit sales are $300 million (spread evenly throughout the year) and its accounts average 28 days overdue.

The firm's variable cost ratio is 0.75 (i.e., variable costs are 75 percent of sales). When converting from annual to daily data or vice versa, assume there are 365 days per year. Determine Mace's average investment in receivables. a. $ 821,918 b. $ 3,409,091 c. $72,328,767 d. $ 82,192 ANS: C Solution: Average Investment in Receivables = $300,000,000 x 88 /365 = $72,328,767 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Receivables investment 36. Mace Auto Parts Company sells to retail auto supply stores on credit terms of "net 60". Annual credit sales are $300 million (spread evenly throughout the year) and its accounts average 28 days overdue.

The firm's variable cost ratio is 0.75 (i.e. variable costs are 75 percent of sales). When converting from annual to daily data or vice versa, assume there are 365 days per year. Suppose that Mace's sales are expected to increase by 20 percent next year and, through more effective collection methods, the firm is able to reduce its average collection period by 20 days. Determine the firm's average investment in receivables for next year under these conditions. a. $67,068,493 b. $56,666,667 c. $ 5,294,118 d. $ 98,630 ANS: A

Solution: Average investment in receivables = $360,000,000 /365 x 68 = $67,068,493 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Receivables investment 37. Warren Motor Company sells $30 million of its products to wholesalers on terms of "net 30."

Currently, the firm's average collection period is 48 days. In an effort to speed up the collection of receivables, Warren is considering offering a cash discount of 2 percent if customers pay their bills within 10 days. The firm expects 50 percent of it's customers to take the discount and it's average collection period to decline to 30 days. The firm's required pretax return (i.e. opportunity cost) on receivables investment is 16 percent. Determine the cost of the cash discounts to Warren. a. $300,000 b. $ 60,000 c. $ 40,000 d. $ 48,000 ANS: A Solution: Cost of cash discounts = $30,000,000 x 0.50 x 0.02 = $300,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Cost of cash discounts 38. Warren Motor Company sells $30 million of its products to wholesalers on terms of "net 30."

Currently, the firm's average collection period is 48 days. In an effort to speed up the collection of receivables, Warren is considering offering a cash discount of 2 percent if customers pay their bills within 10 days. The firm expects 50 percent of it's customers to take the discount and it's average collection period to decline to 30 days. The firm's required pretax return (i.e. opportunity cost) on receivables investment is 16 percent. Determine Warren's pretax earnings on the funds released from the reduction in receivables. (Assume a 365 day year) a. $1,479,452 b. $236,712 c. $266,667 d. $1,082,191 ANS: B Solution: Reduction in A/R = $30,000,000/365 x 48 - $30,000,000/365 x 30 = $1,479,452 Earnings on Released Funds = $1,479,452 x 0.16 = $236,712 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms analysis 39. Warren Motor Company sells $30 million of its products to wholesalers on terms of "net 30."

Currently, the firm's average collection period is 48 days. In an effort to speed up the collection of receivables, Warren is considering offering a cash discount of 2 percent if customers pay their bills within 10 days. The firm expects 50 percent of it's customers to take the discount and it's average collection period to decline to 30 days. The firm's required pretax return (i.e. opportunity cost) on receivables investment is 16 percent. Determine the net effect on Warren's pretax profits of offering a 2 percent cash discount.

a. b. c. d.

$ 300,000 $236,712 -$63,288 -$236,712

ANS: C Solution: Net Change in Pretax Profits = $236,712 - $300,000 = -$63,288 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms analysis 40. Bluegrass Distilleries, Inc. refuses to extend credit to any wholesale distributors who have a history of being delinquent in repaying credit extended to them. This policy results in lost sales of $10 million annually. Based on past experience with these types of customers, the firm estimates that the average collection period would be 90 days and that the bad-debt loss ratio would be 6 percent. The firm's variable cost ratio is 0.80, making its profit contribution ratio 0.20. Bluegrass Distilleries' required pretax return (i.e., opportunity cost) on receivables investments is 20 percent. When converting from annual to daily or vice versa, assume there are 365 days per year. If Bluegrass Distilleries extends credit to these (previously delinquent) customers, determine the increase in the investment in receivables. a. $27,397 b. $2,465,753 c. $111,111 d. $125,000 ANS: B Solution: Additional receivables investment = $10,000,000/365 x 90 = $2,465,753 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms 41. Whirlwind Company sells to retail appliance stores on credit terms of net 30. Annual credit sales are $182,500,000 spread evenly throughout the year and its accounts average 20 days overdue. The firm's variable cost ratio is 0.70. Determine Whirlwind's average investment in receivables. (Assume 365 days per year an all calculations.) a. $17,500,000 b. $25,000,000 c. $15,000,000 d. cannot be determined from the information provided ANS: B Solution: Average collection period = 30 + 20 = 50 days Average investment in receivables = ($182,500,000)/365) x 50 = $25,000,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Receivables investment calculation 42. If a lawn mower assembly plant orders 25,000 frames per year at a price of $27 each, what is the EOQ if the ordering cost per order is $35 and the annual inventory carrying cost is 12 percent?

a. b. c. d.

735 255 567 520

ANS: A Solution: Q = [(( 2)(35)(25,000))/(.12)(27)].5 = 734.9 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ model 43. What is the optimal length of one inventory cycle for a firm that has an economic order quantity of 750 units, average daily demand of 68 units, and a price of $30 per unit? a. 25 days b. 11 days c. 2.7 days d. 331 days ANS: B Solution: T = 750/68 = 11.03 or 11 days PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Inventory cycle 44. Tool Mart sells 1400 electronic water pumps every year. These pumps cost $54.30 each. If annual inventory carrying costs are 12% and the cost of placing an order is $90, what is the firm's EOQ? a. 139 b. 122 c. 197 d. 148 ANS: C Solution: Q = [(2)(90)(1400))/(54.30)(.12)].5 = 196.66 or 197 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ model 45. Tool Mart sells 1400 electronic water pumps every year. These pumps cost $54.30 each. If annual inventory carrying costs are 12% and the cost of placing an order is $90, what is the optimal ordering frequency? a. 37 days b. 32 days c. 40 days d. 51 days ANS: D Solution: T = 197/(1400/365) = 51.3 or 51 days

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ model 46. Tool Mart sells 1400 electronic water pumps every year. These pumps cost $54.30 each. If annual inventory carrying costs are 12% and the cost of placing an order is $90, what is the total annual inventory costs? a. $1,923 b. $1,281 c. $3,406 d. $3,762 ANS: B Solution: TC = (1400/197)90 + (197/2)(54.30)(.12) = $1,281 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ model 47. Haulsee Inc. builds 800,000 golf carts a year and purchases the electronic motors for these carts for $370 each. Ordering costs are $540 and Haulsee's inventory carrying costs average 14% of the inventory value. What is the EOQ for Haulsee? a. 4,084 b. 1,528 c. 2,890 d. 572 ANS: A Solution: Q = [(2)(540)(800,000))/(370)(.14)].5 = 4,084 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ model 48. Haulsee Inc. builds 800,000 golf carts a year and purchases the electronic motors for these carts for $370 each. Ordering costs are $540 and Haulsee's inventory carrying costs average 14% of the inventory value. What is the total inventory costs? a. $565,445 b. $224,331 c. $211,555 d. $21,155,120 ANS: C Solution: TC = 800,000(540) + 4084 (51.80) 4, 084 2 = $211,554 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Inventory costs

49. Haulsee Inc. builds 800,000 golf carts a year and purchases the electronic motors for these carts for $370 each. Ordering costs are $540 and Haulsee's inventory carrying costs average 14% of the inventory value. What is the optimal ordering frequency? a. 0.70 days b. 1.86 days c. 5.18 days d. 8.64 days ANS: B Solution: T = 365(4084) = 1.86 800,000 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Optimal ordering frequency 50. Technico manufactures about 800,000 solar calculators per year. The computer chip used in the calculator cost $4.80 each and the cost of placing an order is $65. If the carrying costs are 16%, what is the EOQ for the chips. a. 25,495 b. 3,162 c. 8, 229 d. 11,637 ANS: D Solution: Q = [((2)(65)(800,000))/.768].5 = 11,637 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: EOQ model 51. Willoughby Industries, Inc. is considering whether to discontinue offering credit to customers who are more than 10 days overdue on repaying the credit extended to them. Current annual credit sales are $10 million on credit terms of "net 30". Such a change in policy is expected to reduce sales by 10 percent, cut the firm's bad-debt losses from 5 to 3 percent, and reduce its average collection period from 72 days to 45 days. The firm's variable cost ratio is 0.70 (profit contribution ratio is 0.30) and its required pretax return (i.e. opportunity cost) on receivables investments is 25 percent. Determine the net effect of this credit tightening policy on the pretax profits of Willoughby. When converting from annual to daily data or vice versa, assume that there are 365 days per year. a. -$ 863,014 b. $145,753 c. -$ 70,000 d. $300,000 ANS: B Solution: Reduction in Profit Contribution = $1,000,000 x 0.30 = $300,000 Reduction in A/R = $10,000,000/365 x 72 - $9,000,000/365 x 45 = $863,014 Earnings on Released Funds = $863,014 x 0.25 = $215,753 Decrease in Bad-Debt Losses = $10,000,000 x 0.05 - $9,000,000 x 0.03 = $230,000 Net Change in Pretax Profits = $215,753 + $230,000 - $300,000 = $145,753 PTS: 1

OBJ: TYPE: C. Prob.

NAT: Analytic skills

LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit standards analysis 52. Bluegrass Distilleries, Inc. refuses to extend credit to any wholesale distributors who have a history of being delinquent in repaying credit extended to them. This policy results in lost sales of $10 million annually. Based on past experience with these types of customers, the firm estimates that the average collection period would be 90 days and that the bad-debt loss ratio would be 6 percent. The firm's variable cost ratio is 0.80, making its profit contribution ratio 0.20. Bluegrass Distilleries' required pretax return (i.e., opportunity cost) on receivables investments is 20 percent. When converting from annual to daily data or vice versa, assume there are 365 days per year. If Bluegrass extends full credit to these (previously delinquent) customers, determine the total increase in credit-related costs. a. $1,000,000 b. $1,093,151 c. $400,000 d. $600,000 ANS: B Solution: Cost of additional receivables investment = $10,000,000/365 x 90 x 0.20 = $493,151 Bad debt losses = 0.06 x $10,000,000 = $600,000 Total costs = $493,151 + $600,000 = $1,093,151 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms 53. Bluegrass Distilleries, Inc. refuses to extend credit to any wholesale distributors who have a history of being delinquent in repaying credit extended to them. This policy results in lost sales of $10 million annually. Based on past experience with these types of customers, the firm estimates that the average collection period would be 90 days and that the bad-debt loss ratio would be 6 percent. The firm's variable cost ratio is 0.80, making its profit contribution ratio 0.20. Bluegrass Distilleries' required pretax return (i.e., opportunity cost) on receivables investments is 20 percent. When converting from annual to daily data or vice versa, assume there are 365 days per year. Determine the net effect on Bluegrass Distilleries' pretax profits of extending credit to these (previously delinquent) customers a. $906,849 b. $2,000,000 c. $306,849 d. $$1,500,000 ANS: A Solution: Net Change in Pretax Profits = $10,000,000 x 0.20 - ($10,000,000/365 x 90 x 0.20) 0.06 x $10,000,000 = $906,849 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms

54. The United Shoe Company (USC) does not extend credit to any retail shoe store with a "Fair" or "Limited" Dun and Bradstreet credit rating. As a result of this policy the company loses $36,500,000 in sales each year. Based on prior experience with these types of customers, USC estimates that the average collection period would be 120 days and the bad-debt loss ratio would be 10%. The firm's variable cost ratio is 0.75. USC's required pretax return on receivables investments is 18%. Determine the net change in pretax profits of extending credit to these retail shoe stores. (Assume 365 days per year in any calculations.) a. $9,125,000 b. $3,315,000 c. -$1,095,000 d. $2,160,000 ANS: B Solution: Additional sales = $36,500,000 Marginal profitability of additional sales = 0.25 x $36,500,000 = $9,125,000 Additional investment in receivables = ($36,500,000/365) x 120 = $12,000,000 Cost of additional investment in receivables = $12,000,000 x 0.18 = $2,160,000 Additional bad-debt loss = 0.10 x $36,500,000 = $3,650,000 Net change in pretax profits = $9,125,000 - $2,160,000 - $3,650,000 = $3,315,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand the role of the finance function; Knowledge of financial analysis and cash flows TOP: Credit extension decision 55. Wallace Company sells $73 million of its products to retailers on credit terms of "net 30". Its average collection period is 55 days. To speed up the collection of receivables, the company is considering changing its credit terms to "2/10, net 30". The company expects 40% of its customers to take the cash discount and its average collection period to decline to 35 days. Wallace's required pretax rate of return on receivables investments is 15%. Determine the net effect on Wallace's pretax profits of the change in credit terms. (Assume 365 days per year in any calculations.) a. -$860,000 b. $600,000 c. $16,000 d. $584,000 ANS: C Solution: Decrease in average receivables balance = ($73,000,000/365) x 55 - ($73,000,000/365) x 35 = $4,000,000 Earnings on funds released by the decrease in receivables = $4,000,000 x 0.15 = $600,000 Cost of cash discount = $73,000,000 x 0.4 x 0.02 = $584,000 Net change in pretax profits = $600,000 - $584,000 = $16,000 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms 56. RCMP has annual credit sales of $37 million. The credit terms are "net 30" and the current average collection period is 45 days. RCMP is considering changing its terms to 1/10, net 30 in an effort to reduce the average collection period. RCMP believes that 35% of its customers will take the discount, reducing the average collection period to 33 days. Should RCMP offer the discount? Assume the firm's required rate of return on its receivables investment is 14%.

a. b. c. d.

No, pretax profits decrease $88,700 Yes, pretax profits increase $53,600 Yes, pretax profits increase $40,801 No, pretax profits decrease $40,801

ANS: C Solution: Reduction is rec. bal. = ($37,000,000/365)(45 - 33) = $1,216,438 Return on reduction = $1,216,438(0.14) = $170,301 Cost of discount = $37,000,000(0.35)(0.01) = $129,500 Net change = $170,301 - $129,500 = $40,801 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit terms 57. Covers, Inc. (CI) sells its stainless steel products on terms of "2/10, net 40". CI is considering granting credit to retailers with total assets as low as $500,000. Currently the lowest asset limit is $750,000. CI believes sales will increase $7 million from the new credit group but the average collection period for this new group will be 60 days versus the current average collection period of 35 days. If management estimates that 20% of the new customers will take the cash discount but 4% of the new business will be written off as a bad-debt loss, should CI lower its credit standards? Assume CI's variable cost ratio is 0.7 and its required pretax rate of return on receivables investment is 15%. a. Yes, pretax profits increase $1,619,397 b. Yes, pretax profits increase $1,703,397 c. Yes, pretax profits increase $1,755,178 d. No, Pretax profits will decrease ANS: A Solution: Profit on new sales = $7,000,000(1 - 0.7) = $2,100,000 Cost of new rec. = ($7,000,000/365)(60)(0.15) = $172,603 Cost new bad debt losses = $7,000,000(0.04) = $280,000 Additional cash discounts = 7,000,000(0.20)(0.02) = $28,000 Net change in pretax profit = $1,619,397 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Credit standards 58. Cycles de Oro produces 120,000 high-tek bikes a year and orders the brake assembly from IKON for $15.40 each. The order cost is $84 and Cycles estimates their inventory carrying costs are 15%. What is their total ordering cost per year? a. $7,968 b. $3,412 c. $4,118 d. $6,437 ANS: B Solution: Q = [((2)(84)(120,000))/2.31].5 = 2,954 Order costs = 120,000 (84) = $3,412 2,954 PTS: 1

OBJ: TYPE: C. Prob.

NAT: Analytic skills

LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: EOQ order costs 59. Accounts receivable consist of the credit of the business. It can take the form of which of the following?

I. Trade credit II. Consumer credit a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounts receivable management

NAT: Reflective thinking

60. When a company measures its marginal costs and marginal returns it is developing: a. target capital structure b. optimal credit extension policy c. required rate of return d. a financing decision ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Shareholder wealth and optimal investments in accounts receivable 61. The proportion of the total receivables volume a company never collects is the: a. bad-debt loss ratio b. mismanaged accounts payable c. uncollectable bills d. recorded debts ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand financial analysis and cash flows

NAT: Reflective thinking TOP: Credit standards

62. All of the following are possible solutions to a large bad-debt loss ratio EXCEPT: a. Loosening credit b. Offering cash discounts for prompt payment c. Seasonal datings d. Determine creditworthiness of customers ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand financial analysis and cash flows

NAT: Reflective thinking TOP: Credit standards

63. All of the following are reliable sources of the creditworthiness of a customer EXCEPT: a. Credit reporting organizations b. Company’s experience c. Banks d. General credit application ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Gathering information on the credit applicant

NAT: Reflective thinking

64. A numerical credit scoring system may rate all of the following EXCEPT:

a. b. c. d.

D & B credit rating location of the business financial characteristics of the applicant current ratio of the applicant

ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Analyzing credit worthiness and making the credit decision 65. _______________ serves as a buffer between the various phases in the procurement-production-sales cycle of a manufacturing firm. a. cash b. accounts receivable c. notes payable d. inventories ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Inventory management

ESSAY 1. How does an optimal credit extension policy impact a company’s accounts receivables?

ANS: An optimal credit extension policy requires the company to examine and measure the marginal costs and marginal benefits associated with alternative policies. A more liberal extension of credit to a company’s customers stimulates sales and leads to increased profits, assuming all other factors remain constant. There may also be increased investment in inventory. These profits are offset by credit-related marginal costs including opportunity costs of the funds needed to support the higher level of receivables and increased bad-debt expenses .

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Shareholder Wealth and optimal investments in accounts receivable 2. What information could be used to judge the credit worthiness of a customer?

ANS: Information is available from a variety of sources: 1. Financial statements submitted by the customer.

2. Credit reporting organizations 3. Banks 4. A company’s own past experience with the customer PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Gathering information on the credit applicant 3. What are the “five Cs of credit”and how are they used?

ANS: 1. Character 2. Capacity 3. Capital

4. Collateral 5. Conditions A credit manager must be able to sort through a great deal of information to determine the creditworthiness of the customer. He/she must be able to extract key elements and make a reliable overall assessment. The “five C’s of credit” facilitate credit decisions and serve as a framework for analysis.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows; Understand the role of the finance function TOP: Analyzing credit-worthiness and making the credit decision 4. In trying to collect on past-due accounts, the firm may use several methods. List them.

ANS: A firm may: 1. Send notices or letters informing the customer of the past-due status of the account and requesting payment.

2. Telephone or visit the customer in an effort to obtain payment.

3. Employ a collection agency.

4. Take legal action against the customer.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Collection effort 5. Describe how an aging of accounts is a useful monitoring technique for accounts receivable.

ANS: In an aging analysis, a company’s accounts are classified into different categories based on the number of days they are past due. These classifications show both the aggregate amount of receivables and the percentage of the total receivables outstanding in each category. Aging of accounts receivable provides more information than summary ratios, as in the average collection period. Comparing aging schedules at successive points in time can help the credit manager monitor any changes in the quality of the company’s accounts.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Monitoring accounts receivable

Chapter 19—LEASE AND INTERMEDIATE TERM FINANCING MULTIPLE CHOICE 1. In the net advantage to leasing calculation, all cash flows (except salvage value) are discounted at the firm's a. weighted (marginal) cost of capital b. cost of internal equity capital c. pretax marginal cost of borrowing d. after-tax marginal cost of borrowing ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows TOP: Lease-buy analysis: The lessee's perspective 2. In the net advantage to leasing calculation, after-tax salvage value is discounted at the firm's a. weighted (marginal) cost of capital b. cost if internal equity capital c. cost of external equity capital d. after-tax marginal cost of borrowing ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Lease-buy analysis: The lessee's perspective

NAT: Reflective thinking

3. In a lease arrangement, the owner of the property is called the a. lessee b. lessor c. equity trustee d. lender ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Introduction to leasing

4. All of the following are attributes of operating leases except a. lease period normally equals the economic life of the asset b. lease payments under the initial lease contract are insufficient to recover the full cost of the asset for the lessor c. cancelable d. maintenance and insurance normally are responsibility of lessor ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating leases

5. All of the following are true of financial leases except a. non-cancelable b. lessee is normally responsible for maintenance and insurance c. lease payments are normally sufficient to amortize the original cost of the asset d. all financial leases are also leveraged leases ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial or capital leases

6. A sale and leaseback agreement a. is usually an operating lease b. is rarely used in today's leasing agreements c. is a method of providing liquidity for the lessee d. frequently is used for machinery financing, but rarely used in real estate ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Financial or capital leases

7. A primary difference between leveraged leases and other financial leases is that a. leveraged leases must be capitalized and shown on the lessee's balance sheet b. the lessor in a leveraged lease is invariably the manufacturer of the leased asset c. leveraged leases involve the use of non-recourse debt d. unleveraged leases are usually tax motivated

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Leveraged leases

8. Which of the following leases is not likely to be viewed as a lease from the perspective of the Internal Revenue Service? a. a 20 year lease for an asset having an economic life estimated to be 40 years b. a lease offering a renewal option based on the asset's remaining value at the time of the renewal c. a lease providing for a purchase option at the end of the lease period for a nominal sum d. a leveraged lease in which the lessor contributes 40 percent equity ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Tax status of true leases

9. All of the following are advantages of leasing except a. generally lower cost than ownership b. leasing smoothes out expenses c. leasing may increase a firm's liquidity d. it provides 100% financing ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing

NAT: Reflective thinking

10. All of the following are disadvantages of leasing except a. difficulty in making property improvements b. financial leases are non-cancelable c. normally higher maintenance charges d. generally higher cost than ownership ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing

NAT: Reflective thinking

11. Lease-buy analysis assumes that the alternative to leasing as the source of financing is a. buying for cash b. borrowing to buy c. buying with all equity funds d. buying with before-tax dollars ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Lease-buy analysis: The lessee's perspective

NAT: Reflective thinking

12. The contract period of an operating lease tends to a. be somewhat less than the economic life of an asset b. be equal to the economic life of the asset c. be somewhat greater than the economic life of the asset d. recover the full cost of the asset ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Operating leases

13. Leasing offers a number of potential advantages. All of the following are advantages except a. flexibility

b. effective depreciation of land c. generally lower costs d. may be the only source of financing available to the marginally profitable firm ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing

NAT: Reflective thinking

14. The sale and leaseback is advantageous to the lessee because a. the lessee cannot continue using the asset b. the lessee receives cash from the sale of the asset c. the lessee receives title to property at the termination of the lease d. the lessee is never required to pay taxes and insurance ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Sale and leaseback

15. In a(n) ______, the lessor receives the entire accelerated depreciation tax shield while making a relatively small equity investment. a. operating lease b. capital lease c. leveraged lease d. term lease ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Leveraged leases

16. Disadvantages of leasing include all of the following except a. leasing usually decreases a firm's liquidity b. leasing is often more expensive than purchasing c. loss of the asset's salvage value d. lessee may have difficulty getting approval to make property improvements on leased real estate ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing: Disadvantages

NAT: Reflective thinking

17. Leasing accounts for more than __________ percent of all business investment in equipment. a. 10 b. 30 c. 50 d. 90 ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Introduction

18. Lessees with __________ are most likely to use leveraged leases for large transactions. a. low profit levels b. large amounts of tax exempt income c. low profits and high amounts of tax-exempt income d. outlays of less than $300,000 ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Leveraged leases

19. Normally, when a firm operates under the protection of a bankruptcy court, lease payments ________. a. may be suspended b. must continue to be paid by lessors c. must be paid to lessors if assets are secured d. may be suspended if they are "true" leases ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Ethical issue: Continental Airline's leases in bankruptcy

NAT: Reflective thinking

20. All of the following have been cited as advantages of leasing by small businesses except: a. less cash required up front b. fewer restrictive covenants from lessor than lenders c. lower effective interest costs relative to borrowing d. quicker approvals from lessors than from lenders ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Entrepreneurial finance issues

NAT: Reflective thinking

21. Contech (lessee) wishes to lease a printing press valued at $60,000 from Wrenn Capital (lessor) for a period of 4 years. Wrenn expects to depreciate the asset on a straight-line basis to a salvage value of $0. Actual salvage value is expected to be $8,000 at the end of 4 years. If Wrenn requires a 12 percent after-tax rate of return on the lease, what is the lessor's amount to be amortized? Assume Wrenn's marginal tax rate is 40%. a. $60,000 b. $38,725 c. $41,778 d. $36,690 ANS: B Solution: Initial outlay Less: PV of salvage value $8,000(0.636)(0.60) Less: PV of dep. tax shield 15,000(3.037)(0.40) Amount to be amortized PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

$60,000 -3,053 -18,222 $38,725

NAT: Analytic Skills TOP: Lease payment calculation

22. Contech (lessee) wishes to lease a printing press valued at $60,000 from Wrenn Capital (lessor) for a period of 4 years. Wrenn expects to depreciate the asset on a straight-line basis to a salvage value of $0. Actual salvage value is expected to be $8,000 at the end of 4 years. If Wrenn requires a 12 percent after-tax return on the lease, what is the lease payment that Wrenn will require from Contech? Assume a marginal tax rate of 40%. Under the terms of the lease, payments will be made at the beginning of each of the 4 years. a. $11,385 b. $28,463 c. $18,975 d. $21,252 ANS: C Solution: $38,725 = PMT (3.037)(1.12) PMT = 11,385

Lease payment = 11,385/(1 - 0.40) = $18,975 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

23. T. Goho (lessee) wishes to lease a $25,000 car for 5 years. First Union Bank (lessor) has agreed to finance this lease and estimated the car will have a salvage value of $10,000 at the end of the lease. If First Union expects to depreciate the car on a straight-line basis to a salvage value of $0, what monthly lease payments will T. Goho have to make, given that First Union requires a 12% annual rate of return (assume a monthly interest rate of 1%)? Assume a marginal tax rate of 40%, and payments at the beginning of each month. a. $528 b. $495 c. $317 d. $653 ANS: A Solution: Initial outlay Less: PV of salvage value $6,000(0.567) Less: PV of dep tax shield $5,000(0.40)(3.605) Amount to be amortized

$25,000 3,402 7,210 $14,388

PMT = $14,388/[44.955(1.01)] = $316.88 Payment = $316.88/(1 - 0.40) = $528.14 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

24. Ajax Capital has determined that the amount to be amortized on an extruder is $540,000. What annual lease payment must Ajax (lessor) require from the lessee if the required rate of return is 16%? Assume that the lease payments will be made at the beginning of each of the 7 years of the lease agreement and that the marginal tax rate is 40%. a. $288,140 b. $222,827 c. $115,256 d. $192,093 ANS: D Solution: PMT = $540,000/[4.039(1.16)] = $115,256 Lease payment = 115,256/(1 - 0.40) = $192,093 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

25. Ajax Capital has determined the amount to be amortized on an extruder is $540,000. If the required rate of return is 14%, what will be the total interest received over the life of the lease given that lease payments will be made at the beginning of each of the 7 years of the lease agreement? Assume a marginal tax rate of 40%. a. $233,269 b. $748,786 c. $811,080

d. $110,467 ANS: B Solution: PMT = $540,000/[4.288(1.14)] = $110,467 Lease payment = $110,467/(1 - 0.40) = $184,112 Total interest = $184,112(7) - 540,000 = $748,786 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

26. Leigh Fibers wishes to lease an automated knitting machine valued at $420,000 from Ogden Capital for a period of 10 years. Ogden expects to depreciate the asset on a straight-line basis to a salvage value of $0. Actual salvage value is also expected to be $0 at the end of the 10-year period. If Ogden requires a 15% after-tax rate of return on the lease, what is the lease payment required from Leigh Fiber? Assume that the lease payments will be made at the beginning of each year and that the marginal tax rate is 40%. a. $111,470 b. $145,395 c. $96,930 d. $58,158 ANS: C Solution: $420,000 - $42,000(0.40)(5.019) = $335,681 PMT = $335,681/[5.019(1.15)] = $58,158 Lease payment = $58,158/(1 - 0.40) = $96,930 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

27. Paragon Leasing has been approached by Mid-America Trucking Company (MATC) to provide lease financing for a fleet of new tractors. Each tractor will cost $140,000 and will be leased by MATC for 7 years with lease payments made at the beginning of each year. Paragon will depreciate the tractors on a straight-line basis to $0 but the actual market value at the end of 7 years is estimated to be $25,000.

What are the required annual beginning-of-year lease payments if Paragon desires to earn a 14% after-tax rate of return? Assume a marginal tax rate of 40%. a. $36,037 b. $33,991 c. $38,750 d. $20,395 ANS: B Solution: $140,000 - $20,000(0.40)(4.288) - $25,000(1 - 0.40)(0.400) = $99,696 PMT = 99,696/(4.288(1.14)) = $20,395 Lease payment = $20,395/(1 - 0.40) = $33,991 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

28. Sigma Tools will lease a computerized stamping machine from StarBanc. The machine costs $500,000 and will be depreciated on a straight-line basis to a zero book value over the next 5 years, which is also the term of the lease. The expected salvage value in 5 years is $25,000. StarBanc's marginal tax rate is 30 percent and it requires an after-tax rate of return of 12 percent on investments of this type. What annual, beginning of the year, pretax lease payment must StarBanc receive to earn the required 12 percent return? a. $135,133 b. $93,540 c. $94,593 d. $100,000 ANS: A Solution: Initial outlay Less: PV of after-tax salvage ($25,000 x 0.567 x 0.7) Less: PV of depreciation tax shield ($100,000 x 0.3 x 3.605) Amount to be amortized Lease payment required after-tax PMT = $381,927/(3.605 x 1.12) Lease payment required pretax = $94,593/0.7 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Determining the lease payment

$500,000 9,923 108,150 $381,927 $ 94,593 $135,133

NAT: Analytic skills

29. ANB Leasing is planning to lease an asset costing $210,000. The lease period will be 6 years. At the end of 6 years, the salvage value is estimated to be $30,000. The asset will be depreciated on a straight-line basis of $30,000 per year over the 6-year period. ANB's marginal income tax rate is 40 percent, but its average tax rate is only 31.5%. If ANB Leasing requires a 12 percent after-tax rate of return on the lease, determine the required annual beginning of the year lease payments. a. $45,609 b. $31,592 c. $52,653 d. $46,120 ANS: C Solution: Initial outlay Less: PV of salvage ($30,000 x 0.507) Less: PV of depreciation tax shield ($30,000 x 0.4 x 4.111) Amount to be amortized Lease payment required after-tax R = $145,458/(4.111 x 1.12) Lease payment required pretax = $31,592/0.6 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Determining the lease payment

$210,000 15,210 49,332 $145,458 $ 31,592 $ 52,653

NAT: Analytic skills

30. Unilog is considering leasing a computer from UniNet under a 6-year lease. The computer costs $200,000 and will be depreciated as a 5-year MACRS asset. The expected salvage value of the computer after 6 years is $20,000. UniNet's marginal tax rate is 35 percent and its average tax rate is 30%. UniNet requires a 13 percent after-tax rate of return on leases of this type. What annual, pretax, beginning-of-the-year lease payment must Unilog make to UniNet? (Problem requires MACRS depreciation tables.) a. $48,786 b. $31,711 c. $50,500 d. $16,848 ANS: A Solution: Initial outlay Less: PV of salvage ($20,000 x 0.65 x 0.480) Less: PV of depreciation tax shield $40,000 x 0.35 x 0.885 $64,000 x 0.35 x 0.783 $38,400 x 0.35 x 0.693 $23,040 x 0.35 x 0.613 $23,040 x 0.35 x 0.543 $11,520 x 0.35 x 0.480 Amount to be amortized Lease payment required after-tax PMT = $143,260/(3.998 x 1.13) Lease payment required pretax = $31,711/0.65 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Determining the lease payment

$200,000 6,240 12,390 17,539 9,314 4,943 4,379 1,935 $ 50,500 $143,260 $ 31,711 $ 48,786

NAT: Analytic skills

31. Lancit Media Productions wishes to lease a high speed printer that costs $400,000 for a period of 4 years. The leasing company, GKN Leasing, expects to depreciate the entire value of the printer on a straight-line basis over the 4 year period. Actual salvage value is expected to be $50,000. If GKN requires a 12% after-tax rate of return on the lease, what annual lease payments will GKN require?

Assume GKN's marginal tax rate is 35% and that all lease payments occur at the beginning of each year. a. $80,270 b. $123,493 c. $138,312 d. $ 36,172 ANS: B Solution: Initial outlay Less: PV of salvage $50,000(0.65)(0.636) Less: PV of tax shield: $100,000(0.35)(3.037)

PMT = $273,035/(3.037)(1.12) = $80,270 Required lease payment = $80,270/0.65 = $123,493

$400,000 20,670 106,295 $273,035

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Determining the lease payment

NAT: Analytic skills

32. Index Laboratories is considering leasing a thermoplastic molder. The lease would require 7 beginning of the year payments of $122,000 each. If Index capitalizes this lease for financial reporting purposes at a 12% rate, what asset amount will be reported initially on its balance sheet? a. $623,625 b. $969,046 c. $556,808 d. $854,000 ANS: A Solution: PVAN = $122,000(4.564)(1.12) = $623,625 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease accounting

33. Uminum, the world's largest producer of feldspar, is considering leasing a sifter that costs $450,000.

The 5 year lease requires 5 beginning of the year payments. The leasing company is depreciating the sifter on a straight-line basis of $90,000 per year to a salvage value of zero, but assumes the actual salvage value at the end of 5 years is expected to be $25,000. If the leasing company desires to earn an 11% after-tax rate of return of the lease, what annual lease payment will they require? Assume a marginal tax rate of 40%. a. $125,145 b. $75,087 c. $148,517 d. $122,736 ANS: A Solution: Initial outlay Less: PV of salvage: $25,000(0.6)(0.593) Less: PV tax shield: $90,000(0.4)(3.696)

$450,000 8,895 133,056 $308,049

PMT = $308,049/(3.696)(1.11) = $75,087 Required lease payment = $75,087/0.6 = $125,145 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

34. Medarex is considering the lease of an electronic welder costing $210,000 from Key Leasing. The period of the lease will be 6 years. The welder will be depreciated under MACRS rules for a 5-year class asset. Medarex's marginal tax rate is 40%. Annual beginning of the year lease payments will be $50,000. Estimated salvage value is zero. If Medarex's after tax cost of borrowing is 15%, compute the net advantage to leasing. (Problem requires MACRS tables.) a. $8,527 b. $-17,592 c. $-67,174 d. $21,427

ANS: D Solution: Asset cost = $210,000

Yr.

AT Lease PMT

0 1 2 3 4 5 6

$30,000 30,000 30,000 30,000 30,000 30,000 -

After tax lease payment = $30,000

Deprec. $42,000 67,200 40,320 24,192 24,192 12,096

Dep. Tax Shield

NAL Cash Flows

PVIF

PV

$ 16,800 26,880 16,128 9,677 9,677 4,838

$180,000 -46,800 -56,880 46,128 39,677 39,677 4,838

1.000 0.870 0.756 0.658 0.572 0.497 0.432

$180,000 -40,716 -43,001 -30,352 -22,695 -19,719 -2,090 $ 21,427

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Financial applications in spreadsheets

NAT: Analytic skills TOP: Net advantage to leasing

35. Daymark (lessee) wishes to lease a printing press valued at $60,000 from Wrenn Capital (lessor) for a period of 4 years. Wrenn expects to depreciate the press using 3-year MARCS depreciation rates.

Actual salvage value is expected to be $8,000 at the end of 4 years. If Wrenn requires a 12% after-tax rate of return on the lease, what is the lessor's amount to be amortized? Assume a marginal tax rate of 40%. a. $40,693 b. $38,725 c. $37,640 d. $35,613 ANS: C Solution: Initial outlay Less: PV of salvage $8,000(0.636)(0.60) Less: PV Dep Yr. 1 $19,998(0.893)(0.40) Yr. 2 $26,670(0.797)(0.40) Yr. 3 $8,886(0.712)(0.40) Yr. 4 $4,446(0.636)(0.40) Amount to be amortized PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial applications and spreadsheets

$60,000 3,053 7,143 8,502 2,531 1,131 $37,640

NAT: Analytic skills TOP: Amount to be amortized

36. Daymark (lessee) wishes to lease a printing press valued at $60,000 from Wrenn Capital (lessor) for a period of 4 years. Wrenn expects to depreciate the press using 3-year MARCS depreciation rates.

Actual salvage value is expected to be $8,000 at the end of 4 years. Under terms of the lease, payments will be made at the beginning of each of the 4 years. If Wrenn requires a 12% after-tax rate of return on the lease, what is the lease payment that Wrenn will require from Daymark? Assume a marginal tax rate of 40%. a. $11,066 b. $18,443 c. $20,656 d. $12,393 ANS: B Solution:

$37,640 = PMT(3.037)(1.12) PMT = $11,066 Lease payment = 11,066/(1 - .40) = $18,443 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lease payment calculation

37. Sandia, Inc. wants to acquire a $360,000 computer controlled printing press. If owned the press would be depreciated on a straight-line basis over 10 years to a book salvage value of $0. The actual cash salvage value is expected to be $25,000 at the end of 10 years. If purchased, Sandia will incur annual maintenance expenses of $3,000. These expenses would not be incurred if the press is leased. If the press is purchased, Sandia could borrow the needed funds at an annual pre-tax interest rate of 10%.

The lease rate would be $48,000 per year, payable at the beginning of each year. If Sandia has an after-tax cost of capital of 12% and a marginal tax rate of 40%, what is the net advantage to leasing? a. $60,713 b. $65,543 c. $57,173 d. $37,737 ANS: D Solution: NAL = $360,000 - 48,000(0.60) - (28,800 + 14,400 - 1,800)(PVIFA.06,9) - 25,000(.60)(PVIF.12,10) - (14,400 - 1,800)(PVIF.06,10) = 360,000 - 28,800 - 281,602 - 4,830 - 7,031 = $37,737 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Net advantage to leasing

38. Prime Care has approached the leasing department of First City Bank to arrange lease financing for a $1.2 million CAT scanner. The economic life of the scanner is estimated to be 10 years. The estimated salvage value at the end of 10 years is $0. First City plans to depreciate the scanner on a straight-line basis over 10 years. If First City charges a beginning of the year lease payment of $255,395, what after-tax rate of return will the bank earn on the lease? Assume a marginal tax rate of 40%. a. 4.7% b. 16.8% c. 13% d. 40% ANS: C Solution: Try 13% $1,200,000 - $120,000(0.40)(5.426) = $939,552 {$939,552/[(5.426)(1.13)]} /0.60 = $153,237/0.60 = $255,395 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Lessor returns

39. In a leveraged lease, how much of the asset’s full purchase price does the lessor supply? a. 0-10% b. 20-40% c. 50-70% d. 80-100% ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: Leveraged lease

40. In a direct lease, the user-lessee first determines all of the following EXCEPT: a. which manufacturer will supply the equipment b. what equipment will be leased c. the terms of the lease d. what price will be paid for the asset ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Financial or capital leases: Direct lease

NAT: Reflective thinking

41. In considering the advantages of leasing, which of the statements is/are correct? a. Leasing provides approximately 50% of the necessary financing. b. Leasing can decrease the firm’s liquidity. c. Both a and b are correct. d. Neither a nor b is correct.

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing: Advantages

NAT: Reflective thinking

ESSAY 1. What are the advantages of leasing?

ANS: 1. Leases offer flexible financing -- there are fewer restrictive covenants.

2. The firm can depreciate land when leasing real estate.

3. Leasing may require lower payments due to tax benefits for the lessor.

4. Leasing may be the only source of financing for some companies.

5. Leasing smoothes out expenses for the lessee.

6. Leasing does not require a down payment.

7. Leasing increases a firm’s liquidity especially when transacting a sale and leaseback.

8. Leasing offers flexibility in acquiring assets.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing 2. What is a term loan?

ANS: Term loans include any debt obligation having an initial maturity between 1 and 10 years. Term loans are usually amortized by a series of installments. The interest rate normally ranges between 0.25 and 2.5 percent above the prime rate. Many term loan agreements require that some specific asset be pledged as security. The borrowing firm may have to agree to affirmative, negative and restrictive covenants governing its actions during the loan period.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Term Loans 3. Explain a leveraged lease.

ANS: A leveraged lease is a three-sided agreement among the lessee, the lessor, and the lenders.

The lessee selects the leased asset, receives all the income generated from its use, and makes periodic lease agreements. The lessor acts either for itself or as a trustee for an individual or a group of individuals to provide the equity funds needed to purchase the asset. The lenders lend the funds needed to make up the asset’s full purchase price. Specifically, the lessor normally supplies 20% 40% of the purchase price, and the lenders provide the remaining 60% - 80%.

In a leveraged lease, the lender receives mortgage bonds secured by: a first lien on the asset, an assignment of the lease, an assignment of the lease rental payments, or occasionally, a direct guarantee from the lessee or third party.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Leveraged leases 4. What are the disadvantages of leasing?

ANS: The primary disadvantage is cost. Leasing is often a more expensive alternative. The actual cost difference between leasing and ownership depends on a number of factors and varies from case to case.

Another disadvantage is the loss of the asset’s salvage value. In real estate, the loss can be substantial. A lessee may also have difficulty getting approval to make property improvements on leased real estate. If the improvements alter the property substantially or reduced its potential range of uses, the lessor may be reluctant to permit them.

In addition,if a leased asset becomes obsolete or if the capital project financed by the lease becomes uneconomical, the lessee may not cancel the lease without paying a substantial penalty.

In bankruptcy, lease payments must be made, whereas interest and principal payments are suspended.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Advantages and disadvantages of leasing: Disadvantages

Chapter 20—FINANCING WITH DERIVATIVES MULTIPLE CHOICE 1. ________ are forms of options. a. Warrants b. Convertible securities c. Leases d. Warrants and convertible securities ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

2. A(n) __________ is a call option issued by a company on its securities, usually common stock. a. debenture b. warrant c. futures contract d. extendible note ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

3. A __________ is a fixed income security with a call option on common stock. a. convertible security b. warrant c. futures contract d. derivative security ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Convertible securities

4. Which of the following (if any) are factors affecting the value of a call option? a. time remaining until expiration date b. interest rates c. expected stock price volatility d. all of these factors affect the value of a call option ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Variables affecting call option valuation

5. The __________ is the price that the call option buyer pays the writer of the option if the buyer decides to exercise the option. a. option premium b. option discount c. conversion price d. exercise price ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Option valuation concepts

6. When a company issues convertible securities, its usual intention is: a. future issuance of common stock b. future reduction of outstanding common stock c. future issuance of non-convertible debt and preferred stock d. future issuance of preferred stock ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Convertible securities

7. A warrant has an exercise price of $15. The underlying common stock has a market price of $10. The formula value of a warrant would be a. $5 b. $0 c. -$5 d. cannot be determined from the information given ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of warrants

8. The conversion value (i.e., stock value) of a convertible bond is defined as the ________ times the _________. a. conversion ratio, conversion price b. conversion premium, exercise price c. conversion ratio, common stock market price d. conversion ratio, exercise price ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand derivative markets

TOP: Valuation of convertible securities

9. The difference between the market value of a convertible bond and the higher of its conversion or straight-bond value is the a. exercise premium b. investment premium c. conversion premium d. liquidation premium ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of convertible securities

10. The conversion premium of a convertible bond tends to be _________ when the conversion value is ______ the straight-bond value. a. smallest, nearly equal to b. largest, less than c. largest, greater than d. largest, nearly equal to ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of convertible securities

11. All other things being equal, the _____ the exercise price, given the stock price, the _________ is the call option value. a. higher, higher b. higher, lower c. lower, lower d. lower, higher ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Variables affecting call option valuation

12. The _______ the time remaining before an option expires, the _______ the option value. a. longer, lower b. shorter, higher c. longer, higher d. shorter, lower ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Variables affecting call option valuation

13. The _______ the expected stock price volatility, the _______ the value of the call option. a. greater, higher b. lower, higher c. greater, lower d. lower, lower ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Variables affecting call option valuation

14. The price at which convertible securities are exchangeable for common stock is the a. conversion value b. par value c. put price d. conversion price

ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of convertible securities

15. The conversion ratio of a convertible security may change when a. a cash dividend is paid b. there is a change in the market value of the security c. a stock dividend is paid d. there is a rights offering ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of convertible securities

16. All of the following are reasons why companies issue convertible securities except: a. cheaper total cost than nonconvertible securities b. lower interest payments than nonconvertible securities c. sell common stock at a price above current market price d. deferred issuance of common stock ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Managing long-term funding with convertibles

17. The market value of a convertible debt issue is usually above the a. conversion ratio b. conversion value c. straight-bond value d. higher of either the conversion value or the straight-bond value ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of convertible securities

18. Conversion of a convertible security may be forced by the issuing company by a. raising the interest rate b. calling the securities for redemption c. lowering the dividend on common stock d. none of these are methods of forcing conversion ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Converting convertible securities

19. As a financing device, warrants have been used in connection with a. bond swaps b. equity offerings c. debt restructurings and bond swaps d. bond swaps, equity offerings, and debt restructurings ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Warrants

NAT: Reflective thinking

20. Which of the following is not a common feature of financing with warrants? a. an exercise price that is below the market price of common stock at the time the warrant is issued b. typical life of a warrant is between 5 and 10 years c. warrant is usually detachable from a debenture or preferred stock d. if a warrant is issued as part of a “unit,”it is usually detachable from a debenture or preferred stock

ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of warrants

21. All of the following are reasons why firms issue warrants except: a. lowers agency costs b. increases leverage at time of issue c. permits a company to sell common stock at a price above the price prevailing at the time of warrant issue d. allows a firm to sell common stock in the future without incurring underwriting costs at the time of sale ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Reasons for issuing warrants

22. Prior to a warrant's expiration, its market price will be _______ the formula value a. equal to b. less than c. greater than d. negative as compared to ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of warrants

23. Craig Supermarkets, Inc. has convertible debentures ($1,000 par value) that are callable at 108 percent of par value. The conversion price of the debenture is $40 per share, and the Craig common stock currently is selling at $55 a share. The company a. could not get the convertible holders to convert if it called the debt b. has no intention of calling the convertibles c. could force conversion by calling the issue d. could realize a gain of $15 a share if it called the convertibles ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Converting convertible securities

24. A firm that issues warrants a. can expect to receive additional funds if the formula value of the warrant is zero at the expiration date b. has to pay the same per share dividend to the warrant holders as it pays to its stockholders c. cannot issue convertible securities while the warrants are outstanding d. can expect to receive additional funds if the formula value of the warrant is positive at the expiration date ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Warrants

NAT: Reflective thinking

25. Which of the following securities (if any) is not an example of an option? a. warrant b. convertible security c. right d. futures contract ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

26. A __________ is a fixed-income security issued by a company with a call option on its common stock.

a. b. c. d.

warrant convertible debenture lease extendible note

ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Options

NAT: Reflective thinking

27. A security whose payoffs (returns) depend on the value of another security is known as a(n) __________. a. interest rate swap b. master limited partnership c. contingent claim d. extendible note ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand derivative markets TOP: The relationship between the exercise price and the stock pr 28. __________ are examples of contingent claims. a. Convertible bonds and warrants b. Warrants and extendible notes c. Options and extendible notes d. Convertible bonds, options, and warrants ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand derivative markets TOP: The relationship between the exercise price and the stock pr 29. The preemptive right allows shareholders the a. opportunity to maintain their original ownership percentage b. right to purchase shares in the secondary markets c. right to vote for members of the board of directors d. all of these answers are correct ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Analysis of rights offerings

30. In general, the market price of a "right" is ______ than the theoretical value and this difference in values ______ as the right's expiration date approaches. a. less, decreases b. less, increases c. greater, decreases d. greater, increases ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of rights

31. A security that gives the holder the option to sell the note back to the issuer at par is known as a(n) _________. a. call option b. extendible note c. adjustable rate preferred stock d. warrant ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand derivative markets

TOP: Extendible notes

32. ________ earnings per share are calculated based on the assumption that all dilutive securities are converted into common shares. a. Primary b. Full primary c. Fully diluted d. First class ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Convertible securities and earnings dilution

33. If the exercise price of an M-tel warrant is $48 and the stock splits 2 for 1, what will be the post-split exercise price of the warrant? Assume the warrant was selling for $20 before the stock split. a. $24 b. $20 c. $10 d. $48 ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Features of warrants

34. The similarities between convertible securities and warrants include all of the following except: a. both tend to reduce agency costs b. the purpose of both is the deferred issuance of common stock c. both give the company full control over when the common stock is issued d. all of these answers are correct ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Comparison of convertible securities and warrants

35. A method that a multinational firm could use to hedge against transaction exposure when it is committed to a transaction denominated in a foreign currency is to _________. a. sell ECU dollar options b. purchase put options c. sell SDR adjustable options d. purchase foreign transaction options ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Int'l issues: Hedging foreign currency transaction...

36. Bonds may have a _____ which gives the holder of the bond the right to sell it back to the issuer under certain conditions. a. warrant b. put option c. rights offering d. call option ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

37. A type of financial derivative that would allow a firm to hedge against changes in interest rates over a 5-year period is a _____. a. interest rate futures contract b. commodity soup

c. interest rate swap d. interest rate put option ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Interest rate swap

38. The most basic type of interest rate swap is the: a. fixed for floating rate swap b. exchange-rated swap c. LIBOR for prime rate swap d. Interest rate rights offering ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Interest rate swap

39. The conversion price of CRX's convertible ($1000 par) subordinated debentures is $40 and the present market price of CRX common stock is $48. Determine the present conversion value of the convertible issue. a. $1,000 b. $1,200 c. $ 833 d. $1,680 ANS: B Solution: Conversion value = ($1,000/$40)($48) = $1,200 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Conversion value calculation 40. Rizzo Company has debentures ($1,000 par) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature in 12 years. In addition, the convertible debenture is callable at 110% of the par value. Straight debt of equivalent risk is yielding 12%. The company's common stock is selling at $22 per share. The company has a marginal tax rate of 40%. Determine the conversion value of the issue. a. $1,000 b. $ 880 c. $1,136 d. $1,120 ANS: B Solution: Conversion value = ($1,000/$25)($22) = $880 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Conversion value calculation 41. Rizzo Company has debentures ($1,000 par) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature in 12 years. In addition, the convertible debenture is callable at 110% of the par value. Straight debt of equivalent risk is yielding 12%. The company's common stock is selling at $22 per share. The company has a marginal tax rate of 40%. Determine the straight-bond value of the issue. a. $1,000 b. $ 496 c. $ 880

d. $ 753 ANS: D Solution: Straight-bond value = $80(6.194) + $1,000(0.257) = $753 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Straight bond value calculation 42. The Marsh Company, whose present balance sheet is summarized below, is considering the issuance of $50 million of 8% subordinated debentures that are convertible into common stock at a price of $20.

Balance Sheet (millions of dollars) Current Assets Fixed Assets, net Total

$150 $350 $500

Current Liabilities Long-term Debt Common Equity Total

$100 $150 $250 $500

Determine the amount of long-term debt (LTD) and common equity (CE) on the pro forma balance sheet, assuming conversion of the entire issue (Answers are in $ million). a. LTD $150, CE $250 b. LTD $150, CE $300 c. LTD $200, CE $300 d. LTD $200, CE $250 ANS: B Solution: No calculations needed PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Effect of conversion 43. People Southwest Airlines (PSW) has warrants outstanding that have an exercise price of $10. Each warrant entitles the holder to purchase one share of PSW common stock. Last week PSW common stock was selling for $12 per share and, at the same time, the warrants traded at $5 each. Determine the formula value of PSW warrants. a. $0 b. $2 c. $5 d. $11 ANS: B Solution: Formula Value = ($12 - $10)(1) = $2 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 44. PSW has warrants outstanding that have an exercise price of $10. Each warrant entitles the holder to purchase one share of PSW common stock. Last week PSW common stock was selling for $12 per share and, at the same time, the warrants traded at $5 each. Determine the warrant's premium over the formula value. a. $0

b. $2 c. $3 d. $5 ANS: C Solution: Premium = $5 - $2 = $3 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 45. The capital structure of Springmaid Company is as follows: Long-term debt Common stock, $1 par Contributed capital in excess of par Retained earnings Total

$

400 million 50 million 250 million 600 million $1,300 million

The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine the common stock at par account balance after exercise of the warrants. a. $50 million b. $54 million c. $56 million d. $35 million ANS: B Solution: New shares = ($100,000,000/$1,000)(40)(1) = 4,000,000 shares at warrant Common stock account = $50 million + 4 million shares ($1/ share) = $54

exercise million.

PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Effect of warrant exercise on capital accounts 46. The capital structure of Springmaid Company is as follows: Long-term debt Common stock, $1 par Contributed capital in excess of par Retained earnings Total

$

400 million 50 million 250 million 600 million $1,300 million

The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine the contributed capital in excess of par account balance after exercise of the warrants. a. $250 million b. $330 million c. $254 million d. $326 million

ANS: D Solution: Account balance = $250 million + ($19 x 4 million) = $326 million PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Effect of warrant exercise on capital accounts 47. The capital structure of Springmaid Company is as follows: Long-term debt Common stock, $1 par Contributed capital in excess of par Retained earnings Total

$

400 million 50 million 250 million 600 million $1,300 million

The company has decided to raise additional capital by selling $100 million of 8% debentures with warrants attached. Each $1000 debenture will have 40 warrants attached, and each warrant will entitle the holder to purchase one share of common stock at $20. Assume that no other changes in the capital structure occur between now and the time the warrants are exercised. Determine how much total capital the company will raise as a result of the issuance of debentures with warrants attached (after exercise of the warrants). a. $100 million b. $ 80 million c. $180 million d. $20 million ANS: C Solution: Total capital raised = $100 million + $20 x 4 million shares = $180 million PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Effect of warrant exercise on capital accounts 48. Sharp Innovations has warrants outstanding and each entitles the holder to purchase 1 share of common stock at an exercise price of $14 a share. If the current market price of the warrant is $9 and the common stock price is $22, what is the premium over the formula value for the warrants? a. $1 b. $5 c. $8 d. $2 ANS: A Solution: Formula Value = ($22 - $14)(1) = $8 Premium = $9 - $8 = $1 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 49. Graybar recently sold a convertible bond with a $1,000 par value for a flotation cost of 2 percent (each bond produced $980 for the firm). What is the conversion price if the conversion ratio is 22? a. $44.55 b. $45.45 c. $50.00

d. $4.45 ANS: B Solution: Conversion Price = $1,000/22 = $45.45 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Conversion price calculation 50. To raise capital funds, Twixt, Inc. issued $2 million worth of debentures with warrants attached. The warrants had an exercise price of $15 and each warrant entitled the holder to two shares of common stock. If the current market price per share of Twixt is $20, what is the formula value of a Twixt warrant? a. $10 b. $ 5 c. $20 d. $ 0 ANS: A Solution: Formula Value = ($20 - $15)(2) = $10 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 51. JDH, Inc. presently has warrants outstanding that expire 5 years from today. Each warrant entitles the holder to purchase 2 shares of the company's common stock at an exercise price of $30 a share. The warrants currently are trading at $4 each, and the JDH common stock currently is trading at $28 a share. Calculate the warrants' formula value. a. -$4.00 b. -$2.00 c. $0.00 d. $2.00 ANS: C Solution: Formula value = Max{$0; ($28 - $30)(2)} = $0 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Formula value of a warrant 52. The Bates Company has debentures ($1,000 par value) outstanding that are convertible into the company's common stock at a price of $50. The convertibles have a coupon interest rate of 9% and mature 20 years from today. Straight debt of equivalent risk is yielding 12% today. The company's common stock today is selling at $60 a share. Calculate the conversion value of the issue. a. $1,000 b. $1,200 c. $ 800 d. $300 ANS: B Solution: Conversion value = ($1,000 / $50)($60) = $1,200 PTS: 1

OBJ: TYPE: E. Prob.

NAT: Analytic skills

LOC: Understand derivative markets

TOP: Convertible security

53. Mills Trucking, Inc. has debentures ($1,000 par value) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature 20 years from today. Straight debt of equivalent risk is yielding 10% today. The company's common stock today is selling at $23 a share. Calculate the straight-bond value of the issue. a. about $830 b. about $1,000 c. about $950 d. about $1,500 ANS: A Solution: Straight-bond value = $80(PVIFA0.10,20) + $1000(PVIF0.10,20) = $80(8.514) + $1000(0.149) = $830 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Convertible security 54. The Ogden Company has warrants outstanding that entitle the holder to purchase 4 shares of the company's common stock at an exercise price of $20 per share. The market price of the warrants is $30 and the common stock price is $25. Determine the premium over the formula value that the warrants are selling for. a. $20 b. $25 c. $10 d. $30 ANS: D Solution: Formula value = max {0; (common stock price - exercise price) x number of shares obtainable with each warrant} = max {0; ($25 - $20) (4)} = $20 Premium = $30 - $20 = $10 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 55. The Coatesville Company has decided to sell additional common stock through a rights offering. The company has 12 million shares outstanding and plans to sell an additional 1.5 million shares through a rights offering. Each shareholder will receive one right for each share currently held, and thus each right will entitle shareholders to purchase 0.125 shares. The Coatesville common stock is currently selling at $50 per share, and the subscription price of the rights will be $45 per share. Determine the theoretical value of the right for the rights on case. a. $0.556 b. $0.455 c. $0.50 d. $0.625 ANS: A Solution: R = ($50 - $45)/(8+1) = $0.556 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Rights valuation

56. The Coatesville Company has decided to sell additional common stock through a rights offering. The company has 12 million shares outstanding and plans to sell an additional 1.5 million shares through a rights offering. Each shareholder will receive one right for each share currently held, and thus each right will entitle shareholders to purchase 0.125 shares. The Coatesville common stock is currently selling at $50 per share, and the subscription price of the rights will be $45 per share. Determine the theoretical value of the rights for the ex rights case. a. $0.455 b. $0.50 c. $0.625 d. $0.556 ANS: D Solution: R = ($49.444 - $45)/8 = $0.556 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Rights valuation 57. What is the value of a CKS Food's option prior to expiration if the exercise price is $20 and the current stock price is $20? a. greater than $0 b. $0 c. less than $0 d. can not be valued ANS: A Solution: Value greater than stock price - exercise price or greater than $0 since $20 - 20 = 0 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Option valuation 58. A Sorsi bond has a par value of $1,000 but is currently selling for $920. If the bond has a conversion ratio of 23 what is the conversion price? Current stock price is $30. a. $40.00 b. $43.48 c. $33.33 d. $30.67 ANS: B Solution: CP = $1,000/23 = 43.478 or $43.48 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Convertible security 59. Lear Holdings plans to sell 60,000 units, each unit consisting of a $1,000 debenture and 15, 7-year warrants. Each warrant allows the holder to purchase one common-share at $30. If the stock price goes to $38 and all warrants were exercised, what is the total capital raised by Lear? a. $94.2 million b. $90.6 million c. $87 million d. $77 million

ANS: C Solution: Capital = 60,000(1,000) + 60,000(15)(30) = $87,000,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Understand derivative markets TOP: Warrants

NAT: Analytic skills

60. Jackson Electronics (40% marginal tax rate) is considering issuing convertible debentures. Its investment banker tentatively has agreed to issue a 9.0 percent, 20-year convertible debenture ($1000 par value). The conversion price will be $50 a share. Jackson's financial managers only want to issue the convertible if its after-tax component cost of capital is less than or equal to 8.0 percent. Otherwise, they plan to issue non-convertible debt. Jackson's current common stock price is $43 a share. The company expects to call the convertible issue 5 years from now when the common stock price is expected to be $60 a share. Under the conditions given in this problem, what is the minimum price per debenture that Jackson can receive and keep the after-tax cost of capital for the debentures at 8.0%? a. about $1,033 b. about $ 946 c. about $ 897 d. $1200 ANS: A Solution: Issue price =

=

[$90(1 - 0.4)] / (1.08)t + $1,200 / (1.08)5

= $54(3.993) + $1,200(0.681) = $1,032.82 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Convertible cost of capital 61. A debenture of the Allegro Company (par value $1,000) is convertible into the company's common stock at a price of $50 per share. The convertible bond has a coupon interest rate of 7% and matures in 10 years. Straight debt of equivalent risk and maturity is yielding 8%. The company's common stock is currently selling for $60 per share. Determine the conversion value and straight-bond value of Allegro Company's convertible bonds. a. $1,200; $1,000 b. $1,000; $933 c. $1,200; $933 d. $1,000; $1,000 ANS: C Solution: Conversion value = (conversion ratio) (stock price) = ($1,000/$50) ($60) = $1200 Straight-bond value = $70 (PVIFA0.08,10) + $1,000 (PVIF0.08,10) = $70 (6.710) + $1000 (0.463) = $933 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Conversion value and bond value

62. Mercury Inc. issued bonds with warrants attached that had an exercise price of $22. Each warrant allows the holder to purchase two shares. Since the issuance, the stock split 2 for 1, the current stock price is $24 and the warrant price is $30. How much is the warrant selling above its formula value? a. 84.6% b. 130.8% c. 15.4% d. 269% ANS: C Solution: Formula value = (24-11)2 = $26 Increase = (30 - 26)/26 = .1538 or 15.4% PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand derivative markets TOP: Warrant valuation 63. Which of the following is/are a feature of convertible securities?

I. Conversion price II. Conversion stock a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Understand derivative markets TOP: Convertible securities: Features of convertible securities

NAT: Reflective thinking

64. Firms issue warrants for which of the following reasons?

I. Allows the company to sell stock at a price above what other company stock is selling for.

II. Allows the company to choose which investors are allowed to buy the company’s stock. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Reasons for issuing warrants

65. In comparing warrants and rights, they: a. are similar in that the company can discriminate as to who buys new company stock. b. are similar in that they allow the purchase of existing stock only c. are different in that both allow the firm to receive additional funds at the time they are exercised. d. are different in that rights allow the holder of the right to vote in corporate elections based on the number of shares the right can purchase.

ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Comparison of convertible securities and warrants

66. The value of the right can be calculated under one of the following circumstances. a. using the Gordon model b. trading ex-rights c. market order d. based on a margin account

ANS: C PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Valuation of rights

67. An option has a ______________ claim. a. fixed b. contingent c. subordinated claim d. superior claim ANS: B PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Summary: Options

68. The conversion ratio of a convertible security is: a. the number of shares that can be obtained b. the value of the shares obtained c. the price at which the security is exchangeable d. the loss in the security’s value once it is exchanged.

ANS: A PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Summary: Convertible securities

69. Conversion of a convertible security can occur in two ways. Which of the following is/are correct?

I. It can be a voluntary conversion at specific times prior to the expiration date.

II. It can be a forced conversion at any time prior to the expiration date. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 LOC: Understand derivative markets

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Converting convertible securities

ESSAY 1. What is an interest rate swap? Describe how they are used.

ANS: A swap is a type of financial derivative that is used to protect financial institutions and businesses against interest rate fluctuations. It is a contractual agreement between two parties (financial institutions or businesses) to make periodic payments to each other. One party borrows at fixed interest rates and lends money at floating rates. The other party has a variable rate debt and fixed rate loans. To protect against detrimental changes in interest rates they agree to a swap contract. The fixed rate debtor is protecting itself from declining interest rates. Should rates fall, this company would normally receive declining payments from its lenders. With a swap, the interest payments would continue at a fixed rate. The floating rate used in computing the payments between the parties to the swap is tied to the London Interbank Offer Rate (LIBOR). At the same time, the floating rate debtor agrees to pay the interest costs in excess of a specified rate for a given period of time. Should interest rates increase in the future, it will receive increased payments from the other swap party to cover its losses.

PTS: 1 OBJ: TYPE: Fact LOC: Understand derivative markets

NAT: Reflective thinking TOP: Interest rate swap

2. Why would a company issue convertible securities instead of straight bonds?

ANS: Convertibles are generally offered by relatively small, risky companies. These companies need funds to finance growth, but investors are reluctant to lend money to risky companies without promises of high interest payments and assurances from the company to properly manage the debt. Some reasons to issue convertible bonds are: 1. To avoid restrictive covenants associated with creditors, it is usually easier and cheaper to offer bondholders an equity stake in the company by offering convertible bonds.

2. Convertibles can offer lower interest payments or dividends because investors are willing to accept the conversion privilege as part of their overall return.

3. Firms that issue convertibles can sell their common stock at a higher price than the prevailing market price at the time of the issue.

4. Earnings from projects may not begin until some time after financing occurs. At the beginning of a project the company may prefer debt or preferred stock financing. After start-up the company may prefer common stock financing. Convertibles resolve this problem by allowing the deferred issue of common stock, which minimizes the dilution in earnings per share resulting from the immediate issuance of common stock.

PTS: 1 OBJ: TYPE: Fact LOC: Understand derivative markets

NAT: Reflective thinking TOP: Managing long-term funding with convertibles

3. List some securities that have option features.

ANS: There are many securities that contain option features: 1. Common stock - they have short-term options. They may also contain a rights offering which occurs when common stockholders are given an option to purchase additional shares of the company’s common stock in proportion to the fraction they currently own.

2. 30-Year Treasury Bonds 3. Stock market indexes 4. Foreign currency options 5. Convertible fixed income securities - such as debentures and preferred stock which may be exchanged for the company’s common stock at the holder’s discretion.

6. Warrants - these are issued by the company and allow the holder to purchase shares of the company’s common stock at a specific price during a specific time period.

PTS: 1 OBJ: TEXT: Fact LOC: Understand derivative markets

NAT: Reflective thinking TOP: Introduction

4. What variables affect the call option valuation?

ANS: Items like the option’s exercise price, the price of the underlying stock and the length of time before the option’s expiration date affect the option’s value. In addition, the level of interest rates and the expected volatility of the underlying stock’s price also play a factor.

PTS: 1 OBJ: TEXT: Fact LOC: Understand derivative markets

NAT: Reflective thinking TOP: Variables affecting call option valuation

5. Explain how conversion of a convertible affects earnings and how does a firm handle this on its financial statements?

ANS: If a convertible security is ultimately exchanged for common stock, the number of shares will increase and the earnings per share will decrease. Companies are required to disclose this potential dilution by reporting both primary and fully diluted earnings per share. Primary earnings per share are calculated based on the number of common shares outstanding plus common stock equivalents. A common stock equivalent must meet certain tests, but it basically includes any convertible security that derives its value primarily from the common stock into which it can be converted. Fully diluted earnings per share are calculated based on the assumption that all dilutive securities are converted into common shares. In calculating primary or fully diluted earnings per share, earnings must be adjusted for the interest or preferred dividends saved as the result of conversion.

PTS: 1 OBJ: TYPE: Fact LOC: Understand derivative markets

NAT: Reflective thinking TOP: Convertible securities and earnings dilution

Chapter 21—RISK MANAGEMENT MULTIPLE CHOICE 1. Which of the following statements about risk is/are correct?

I. Risk is the possibility that the actual cash flows will be different that the expected cash flows.

II. Risk management is utilized by companies in order to provide a chance to make a quick profit. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Introduction

NAT: Reflective thinking

2. Currency and commodity price volatility is a component of which of the following types of risk? a. Systematic risk b. Unsystematic risk c. Operational risk d. Non-diversifiable risk ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

3. The most important reason to hedge business risk is to: a. reduce the chance of a business takeover. b. reduce employee theft. c. reduce management inaccuracies. d. reduce the chance of financial distress ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

4. All of the following are reasons to reduce financial distress EXCEPT: a. enhanced debt capacity. b. reduced WACC.

c. better currency exchange ratio. d. ensure adequate cash flows.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

5. Which of the following is/are a company’s largest risk?

I. exchange rate risk II. future raw material price risk a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

6. Which of the following is a related benefit of hedging external risks for a company? a. Management can determine international markets for their product. b. Management can forecast political events that may impact their sales. c. Management can focus on performance and compensation factors that are under their control. d. Management can determine the economic forces that will impact their earnings.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

7. Which of the following statements about hedging of business risks by investors is/are correct?

I. Operational information about companies is widely available and investors find it relatively simple to hedge business risk.

II. Investors have the necessary capital required to implement hedging strategies and do so consistently. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

8. All of the following are non-hedging strategies that can be used to manage business risk EXCEPT: a. acquisition of additional information b. forward contracts c. diversification d. insurance ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

9. To offset the lack of marketing information which could result in corporate risk, a firm can do which of the following? a. Manufacture the product overseas. b. Develop more raw material suppliers. c. Test-market a product. d. Change advertising.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Acquisition of additional information

10. When a lack of information can result in business risk, management can do all of the following to acquire additional information EXCEPT: a. Refer to the annual reports of competitors for needed information. b. Purchase information from those that possess the knowledge needed. c. Form a panel to evaluate the product d. Test market a product ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Acquisition of additional information

11. Firms work to diversify. All of the following are diversification methods that firms use EXCEPT: a. Firms seek to expand the customer base. b. Firms seek to obtain raw materials from a number of suppliers. c. Firms seek to isolate their product by selling to a single niche market. d. Firms seek to produce more than one product.

ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Diversification

12. Which of the following statements about diversification is/are correct?

I. Diversification may be able to reduce the risk of a portfolio to less than the weighted average risk of the assets.

II.Diversification is always prudent and should be expanded to include new, unrelated products whenever possible. a. I only b. II only c. Both I and II d. Neither I nor II ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Diversification

13. Which of the following is a motive for using insurance to manage risk? a. Premiums, no matter how high, are consistent and easy to budget. b. The firm intends to make money from the insurance company if a specified loss happens. c. The firm does not want to be concerned with small, inconsequential losses and chooses to have the insurance company handle them. d. Insurance can provide protection against events that can cause financial distress.

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Insurance

NAT: Reflective thinking

14. All of the following are losses generally insured by corporations EXCEPT: a. Death of key employees b. Executive bonuses c. Fraud d. Product liability ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Insurance

NAT: Reflective thinking

15. Which of the following is a loss that companies would self-insure?

a. b. c. d.

Product breakage Fraud Unexpected business interruptions Officer liability

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact TOP: Insurance

NAT: Reflective thinking

16. A firm can reduce risk by gaining control over the operating environment. Which of the following is an example? a. Using general purpose assets. b. Hedging through a futures contract. c. Increasing the customer base. d. Using patents and copyrights.

ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Gaining control over the operating environment

17. Which of the following is generally used to enforce rights under patents and copyrights? a. Legal action b. Takeover threats c. Diversification d. Retained earnings ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Gaining control over the operating environment

18. Which of the following is a firm-specific asset? a. Sewing machines designed for the manufacture of summer and winter clothes. b. Fire-retardant paint in lime green. c. Auto plant that can produce six styles of vehicles. d. A manufacturing plant that makes spiral staircases, wood railings and stairway carpeting.

ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Limited use of firm-specific assets

19. All of the following are methods whereby a hedge is accomplished EXCEPT: a. Using derivative securities b. Owning several shares of a company’s stock c. Buying or selling a forward contract d. Using an option in the cash market ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Hedging strategies for risk management

20. Which of the following statements is/are correct about a forward contract?

I. Forward contracts require a good faith deposit before an agreement can be reached.

II. Forward contracts are considered extremely risky since the price for the asset is determined when the contract matures. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Forward contracts

21. Forward contracts are most common in ______________ markets. a. stock b. agricultural c. currency d. bond ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Forward contracts

22. Which of the following is the current price in a futures contract? a. volatile price b. spot price c. short price d. long price ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

23. In the futures market, losers must pay winners each day. This is called: a. paying up b. selling short c. taking a long position d. marking to market ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

24. Which of the following is a facilitator in all futures trades since all contracts are purchased from or sold by this entity? a. The futures clearinghouse b. The futures trading floor c. The futures broker d. The futures exchange ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

25. Which of the following statements is/are true about futures contracts?

I. The buyer of the contract must take delivery of the underlying commodity.

II. To reverse a position, the buyer of a contract must sell an identical contract which is recognized as offsetting the other one. a. I only b. II only c. Both I and II d. Neither I nor II ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

26. Which of the following statements is/are correct about the reasons why hedging is difficult to do perfectly?

I. Available futures contract sizes may not match the hedging needs of the firm.

II. There may be a change in the relationship between the futures price and the local spot price. a. I only

b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

27. Which of the following describes basis risk? a. a natural disaster that affects the underlying commodity b. the risk that the commodity is not marketable c. the variance in the price of the commodity and the value of the American dollar d. a change in the relationship between the futures price and the local spot price ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Futures contracts

28. Which of the following is the most important reason for firms to use risk management techniques? a. To make supernormal profits b. To reduce the chance of catastrophic financial distress c. To reduce management’s liability d. To control inventory losses ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

29. Financial derivatives can be used to manage all of the following risks EXCEPT: a. earnings risks b. currency risks c. pricing risks d. interest rate risks ANS: A PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

30. Which of the following statements about risk management strategies is/are correct?

I. It reduces the variability of a firm’s expected cash flows.

II. It reduces the chance of catastrophic financial distress. a. I only b. II only c. Both I and II d. Neither I nor II ANS: C PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

31. Forward contracts are said to posses _______________ risk. a. business risk b. financial risk c. performance risk d. spot risk ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Hedging strategies for risk management: Forward contracts 32. A long hedge requires ______________________ a futures contract

a. b. c. d.

the creation of the selling of the buying of margining

ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Hedging strategies for risk management: A long hedge

NAT: Reflective thinking

33. A short hedge requires the ________________ a futures contract. a. margining b. creating c. buying of d. selling of ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return TOP: Hedging strategies for risk management: A short hedge

NAT: Reflective thinking

34. A risk that shareholder wealth-maximizing managers should seek to offset in the firm that they are managing is: a. dividend payout risk b. exchange rate risk c. research and development risk d. leasing risk ANS: B PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Why manage risk

35. Acquisition of additional information can be accomplished by all of the following EXCEPT: a. Employing individuals or firms with the needed expertise b. Test-marketing c. Paying to have new issues of bonds “rated” d. Changing the location of the distributorship ANS: D PTS: 1 LOC: Understand risk and return

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Acquisition of additional information

ESSAY 1. List several reasons why a firm may choose to employ risk management techniques.

ANS: 1. Reduce the chance for financial distress.

2. Assure that the firm will have adequate cash flows to make investments in times of financial difficulty.

3. Help management to focus on issues that are key to the performance of the firm that are under management’s control..

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return 2. What is a hedge?

NAT: Reflective thinking TOP: Managing risk

ANS: A hedge is a transaction that limits the risk associated with fluctuations in the price of a commodity, currency, or financial instrument. A hedge is accomplished by taking offsetting positions in the ownership of an asset or security through the use of derivative securities.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Hedging strategies for risk management

3. How does hedging reduce or eliminate business risks?

ANS: When a company hedges a transaction, it assumes offsetting risks that neutralize the original risk. The primary purpose of hedging is to reduce the chance of financial distress. Because financial distress is costly and may ultimately lead to forced liquidation, it is desirable to reduce the risk of financial distress. If a transaction is large enough - for example raw materials - there are potential, but unanticipated, price swings that could lead to financial distress and/or bankruptcy of the firm. It is portably worthwhile for the firm to seek to hedge against this risk. A collateral benefit of reducing the probability of financial distress through hedging is the fact that firms engaging in effective risk management strategies will normally have an enhanced debt capacity in their capital structure, resulting in a reduced weighted cost of capital.

Hedging also helps a firm manage their risk in order to assure that they will have adequate cash flows to make needed investments. If a firm needs capital, external capital suppliers may be reluctant to provide funds for intangible asset investments such as R&D or marketing activities at a time when the firm is having difficulty generating operating cash flows.

It also may be advantageous for a firm to hedge some of its largest risks so that the focus of management’s attention is properly placed on issues under management’s control.

PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Why manage risk

4. List some nonhedging risk management strategies.

ANS: Nonhedging strategies are: 1. Acquisition of additional information through “test-marketing” or by employing consultants with the needed expertise.

2. Diversification 3. Insurance 4. Control over the operating environment by establishing distributorships, using patents and copyrights and enforcing rights under patents and copyrights through legal action.

5. Limited use of firm-specific assets PTS: 1 OBJ: TYPE: Fact LOC: Understand risk and return

NAT: Reflective thinking TOP: Nonhedging risk management strategies

5. List five hedging strategies for risk management ANS: 1. Forward contracts

2. Futures contracts 3. Long hedges 4. Short hedges 5. Options hedging strategy PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Understand risk and return TOP: Hedging strategies for risk management

Chapter 22—INTERNATIONAL FINANCIAL MANAGEMENT MULTIPLE CHOICE 1. Which of the following actions would not tend to increase the value of a country's currency? a. relatively low interest rates b. government trade policies that limit imports c. relatively low rate of inflation d. restrictions on foreign exchange transactions ANS: A PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

2. When interest rate parity exists, the forward rate will differ from the spot rate by just enough to __________. a. offset the difference in the real rate of return b. permit the buyer of a covered option to make a profit c. offset the interest rate differential between the two currencies d. result in a perfect interest rate arbitrage ANS: C

PTS: 1

OBJ: TYPE: Fact

TOP: Interest rate parity

3. The __________ states that the differences in interest rates between two countries should be offset by equal, but opposite, changes in the future spot exchange rate. a. expectations theory b. interest rate parity c. purchasing power parity d. international Fisher effect ANS: D PTS: 1 TOP: The International Fisher effect

OBJ: TYPE: Fact

4. Which of the following is not a primary category of foreign exchange risk that multinational firms must consider? a. economic exposure b. operating exposure c. translation exposure d. transaction exposure ANS: B

PTS: 1

OBJ: TYPE: Fact

TOP: Foreign exchange risk

5. Motorola has a contract to deliver cellular telephones in Japan in 6 months from now and the payment for these telephones will be in Japanese yen. What type of foreign exchange risk does Motorola face? a. economic exposure

b. operating exposure c. transaction exposure d. translation exposure ANS: C

PTS: 1

OBJ: TYPE: Fact

TOP: Transaction exposure

6. When a multinational firm has one or more foreign subsidiaries with assets and liabilities denominated in a foreign currency, it faces __________ exposure. a. economic b. operating c. translation d. transaction ANS: C

PTS: 1

OBJ: TYPE: Fact

TOP: Translation exposure

7. Under current accounting procedures, all of the following balance sheet items are translated into dollars at the rate of exchange prevailing on the date of the balance sheet except: a. stockholder's equity b. fixed assets c. current liabilities payable in a foreign currency d. long-term liabilities payable in a foreign currency ANS: A

PTS: 1

OBJ: TYPE: Fact

TOP: Translation exposure

8. An increase in the value of a foreign currency relative to the U.S. dollar __________ the conversion value of the foreign subsidiary's liabilities. a. decreases b. increases c. has no effect on d. is an average of ANS: B

PTS: 1

OBJ: TYPE: Fact

TOP: Translation exposure

9. To protect itself against transaction exchange rate risk, a U.S. company that purchases automobiles from a Japanese manufacturer may use all of the following techniques except: a. borrow U.S. funds and invest them in interest-bearing Japanese securities b. execute a contract in the forward exchange market c. sell yen in the spot market at the time of each transaction d. execute a contract in the foreign exchange futures market ANS: C PTS: 1 TOP: Managing transaction exposure

OBJ: TYPE: Fact

10. Firms engaged in international transactions incur __________ because of fluctuations in the exchange rates among currencies. a. credit risk b. political risk c. market risk d. exchange rate risk ANS: D

PTS: 1

OBJ: TYPE: Fact

TOP: Foreign exchange risk

11. The theory of interest rate parity states that the annual percentage differential in the forward market for a currency quoted in terms of another currency is equal to the approximate difference in __________ prevailing in the two countries. a. inflation rates

b. interest rates c. trade deficit rates d. GNP growth rates ANS: B

PTS: 1

OBJ: TYPE: Fact

TOP: Interest rate parity

12. A euro is a a. monetary unit used in transactions between European central banks b. monetary unit used in providing capital to the World Bank c. monetary unit used in transactions between Common Market countries d. composite currency whose value is based on the weighted value of several European currencies ANS: D PTS: 1 TOP: Managing translation exposure

OBJ: TYPE: Fact

13. A parent company's foreign investment risk exposure depends on the foreign subsidiary's net _____ position. a. cash b. equity c. present value d. working capital ANS: B

PTS: 1

OBJ: TYPE: Fact

TOP: Translation exposure

14. A U.S. company that purchases goods on credit from a German supplier can protect itself against transaction exchange risk by a. executing a contract in the forward exchange market b. borrowing U.S. funds and investing in interest-bearing German securities c. borrowing German funds and investing in interest-bearing U.S. securities d. executing a contract in the forward exchange market, and by borrowing U.S. funds and investing in interest-bearing German securities ANS: D PTS: 1 TOP: Managing transaction exposure

OBJ: TYPE: Fact

15. Primary sources of demand for British pounds in the foreign exchange market include a. foreign buyers of British exports who must pay for their purchases in pounds b. foreign investors who desire to make investments in physical or financial assets in Great Britain c. speculators who expect British pounds to increase in value relative to other currencies d. all of these answers are correct ANS: D PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

16. Primary sources of supply of British pounds in the foreign exchange market include: a. British importers who need to convert their pounds into foreign currency to pay for purchases b. foreign investors who desire to make investments in physical or financial assets in Great Britain c. speculators who expect British pounds to increase in value relative to other currencies d. U.S. importers who need to convert dollars to pounds to pay for purchases ANS: A PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

17. Government trade policies that restrict imports into a country tend to _____ the supply of the country's currency in the foreign exchange market and tend to _____ the value of the country's currency with respect to other currencies. a. increase, decrease b. increase, increase c. decrease, decrease d. decrease, increase ANS: D PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

18. Which of the following trade policies will tend to decrease the supply of the country's currency in the foreign exchange market? a. imposition of tariffs b. imposition of export quotas c. financing exports with low interest loans d. imposition of tariffs and export quotas ANS: A PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

19. When the Federal Reserve (acting through member commercial banks) sells U.S. dollars in the foreign exchange market, it _____ the supply of U.S. dollars and hence tends to _____ the value of the U.S. dollar relative to other currencies. a. increases, raise b. decreases, lower c. increases, lower d. decreases, raise ANS: C PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

20. A high rate of inflation within a country will tend to _____ the value of its currency with respect to the currencies of other countries that are experiencing lower rates of inflation. a. increase b. decrease c. have no effect on d. cannot be determined because of insufficient information ANS: B PTS: 1 TOP: Factors that affect exchange rates

OBJ: TYPE: Fact

21. The theory that the annual percentage differential in the forward market for a currency quoted in terms of another currency is equal to the approximate difference in interest rates in the two countries is known as a. covered interest arbitrage b. inflation c. hedging d. interest rate parity ANS: D

PTS: 1

OBJ: TYPE: Fact

TOP: Interest rate parity

22. Firms transacting business with foreign companies can lower exchange rate risk exposure by a. limiting transaction exposure

b. hedging c. purchasing LIBORs d. using the PPP to make exchange rate forecasts ANS: B

PTS: 1

OBJ: TYPE: Fact

TOP: Transaction exposure

23. Basic hedging techniques include all of the following except a. money market hedge b. forward market hedge c. primary market hedge d. none, because all are basic hedging techniques ANS: C PTS: 1 TOP: Managing transaction exposure

OBJ: TYPE: Fact

24. In general, when a foreign subsidiary's assets are _____ than its liabilities, ______ will occur when the exchange rate on the currency of the country in which the foreign subsidiary operates loses value. a. greater, currency exchange gains b. greater, currency exchange losses c. less, nothing d. greater, nothing ANS: B PTS: 1 TOP: Managing translation exposure

OBJ: TYPE: Fact

25. What is the nominal interest rate in Canada if the real rate of return is 2.5% and the expected inflation rate was 4.5% a. 7.00% b. 6.89% c. 7.11% d. 7.07% ANS: C Solution: i = .025 + .045 + (.025)(.045) = .0711 or 7.11% PTS: 1

OBJ: TYPE: E. Prob.

TOP: International Fisher effect

26. If U.S. prices are expected to rise by 3 percent over the coming year and prices in Switzerland are expected to rise by 7 percent during the same time, what is the expected spot rate in one year of the Swiss franc given that the current spot exchange rate is $0.168 a. $0.1612 b. $0.1613 c. $0.1617 d. $0.1745 ANS: C Solution: S1/$0.168 = 1.03/1.07 S1=$0.1617 PTS: 1

OBJ: TYPE: E. Prob.

TOP: Purchasing power parity

27. If one year U.S. nominal interest rates are 4 percent, one year Canadian nominal interest rates are 7.5 percent, and the current spot exchange rate, S0, is $0.587, then the expected spot rate in one year will be: a. $0.568 b. $0.607 c. $0.564 d. $0.573 ANS: A Solution: S1/$0.587=1.04/1.075 S1=$0.568 PTS: 1

OBJ: TYPE: E. Prob.

TOP: Interest rate parity

28. If the annual nominal interest rate on 5-year U.S. Government Treasury bonds is 7 percent and the annual nominal interest rate on 5-year Canadian bonds is 7.75%, what is the expected future spot rate in 5 years given that the current spot exchange rate between U.S. dollars and Canadian dollars is $0.739? a. $0.734 b. $0.714 c. $0.765 d. $0.733 ANS: B Solution: S5/$0.739 = (1.07)5/(1.0775)5 = 1.4026/1.4524 S5 = $0.714 PTS: 1

OBJ: TYPE: E. Prob.

TOP: Interest rate parity

29. If the annual nominal interest rate on 5-year U.S. Government Treasury bonds is 7 percent, and the annual nominal interest rate on 5-year Canadian bonds is 5.5 percent, what is the expected future spot rate in 5 years given that the current spot exchange rate between U.S. dollars and Canadian dollars is $0.587? a. $0.595 b. $0.547 c. $0.578 d. $0.630 ANS: D Solution: S5/$0.587 = (1.07)5)/(1.055)5 = 1.4026/1.307 S5 = $0.6299 PTS: 1

OBJ: TYPE: E. Prob.

TOP: Interest rate parity

30. Crown Honda purchased one of its most popular models for 965,600 yen. The exchange rate for the yen was 142 yen per U.S. dollar at the time of purchase but then rose to 171.8 yen by the time payment was made. What was the dealer's gain or loss on the change in rates? a. gain of $1,180 b. loss of $1,427 c. loss of $1,180 d. gain of $1,427

ANS: A Solution: Old cost = 965,600/142 = $6,800 New cost = 965,600/171.8 = $5,620 Gain = $6,800 - $5,620 = $1,180 PTS: 1 OBJ: TYPE: E. Prob.

TOP: Effect of changing exchange rates 31. HBA Limited purchased several Mercedes Benz automobiles from its West German broker. The contract was for 10,000,000 euros, due in 180 days. The present exchange rate is $0.51 per euro and the 180 day forward rate is $0.514. If the rate actually goes to $0.50 in 180 days, what is the dollar gain or loss incurred if no hedge is taken relative to a hedged position? a. $392,157 gain b. $ 40,000 loss c. $100,000 gain d. $140,000 gain ANS: D Solution: Current hedged value Value in 180 days Gain

= 10,000,000($0.514) = 10,000,000($0.50)

= $5,140,000 = 5,000,000 = $ 140,000

PTS: 1 OBJ: TYPE: E. Prob.

TOP: Gain on exposed foreign exchange position 32. If the annual nominal interest rate on 10-year U.S. Government Treasury bonds is 7.35 percent and the annual nominal interest rate on 10-year Japanese bonds is 5.75 percent, what is the expected future spot rate in 10 years given that the current spot exchange rate between U.S dollars and Japanese yen is $0.00959? a. $0.00834 b. $0.01114 c. $0.00973 d. $0.00946 ANS: B Solution: S10/$0.00959 = (1.0735)10 / (1.0575)10 S10 = $0.01114 PTS: 1

OBJ: TYPE: C. Prob.

TOP: Interest rate parity

33. If the 182-day interest rate is 1.75 percent in the U.S. and 2.625 percent in Germany, and the current spot exchange rate between dollars and euros is $0.583, what will the 180-day forward rate be if IRP holds? a. $0.578 b. $0.588 c. $0.573 d. $0.581 ANS: A Solution: F/$0.583 = 1.0175/1.02625

F = $0.578 PTS: 1

OBJ: TYPE: C. Prob.

TOP: Interest rate parity

34. If U.S. prices are expected to rise by 3.5 percent over the coming year and prices in Great Britain are expected to rise by 5.25 percent during the same time, what is the expected spot rate in one year given that the current spot exchange rate is $1.497? a. $1.522 b. $1.470 c. $1.472 d. $1.499 ANS: C Solution: S1/$1.497 = 1.035/1.0525 S1 = $1.472 PTS: 1

OBJ: TYPE: C. Prob.

TOP: Purchasing power parity

35. What is the real rate of return if the risk-free rate is 3.25 percent and the expected rate of inflation is 2.75 percent? a. 0.50% b. 0.51% c. 0.487% d. 1.49% ANS: C Solution: iR = .0325 -.0275-iR(.0275) iR = .00487 or 0.487% PTS: 1

OBJ: TYPE: C. Prob.

TOP: International Fisher effect

36. What is the real rate of return if the risk-free rate is 4 percent and the expected rate of inflation is 2.5 percent? a. 0.43% b. 1.50% c. 6.35% d. 1.46% ANS: D Solution: iR = 0.04 - 0.025 - 0.025iR iR = 0.0146 or 1.46% PTS: 1

OBJ: TYPE: C. Prob.

TOP: International Fisher effect

37. The (6 month) interest rate on 180 day U.S. Treasury bills is 7.64%. In the foreign exchange markets, the spot rate between U.S. dollars and British pounds is 1 pound = $1.5525. The 180-day (6 month) forward rate is 1 pound = $1.5188. Determine the expected rate of interest on 6 month British government debt securities, assuming interest rate parity between the dollar and pound exists. a. 13.52% b. 5.47% c. 7.31% d. 10.03%

ANS: D Solution: ($1.5188) / ($1.5525) = (1.0764)/1 + iUK iUK = 10.03% PTS: 1

OBJ: TYPE: C. Prob.

TOP: Interest rate parity

38. The 6 month interest rate on 180 day U.S. Treasury Bills is 7.5 percent. In the foreign exchange markets, the spot rate between U.S. dollars and Australian dollars is 1 Australian dollar = $0.452 and the 180 day (6 month) forward rate is 1 mark = $0.46. Determine the expected rate of interest on 6 month Australian government debt securities, assuming that the interest rate parity between the U.S. dollar and Australian dollar exists. a. 7.35% b. 1.77% c. 5.63% d. 3.82% ANS: D Solution: $0.46 / $0.452 = 1.075 /1 + iWG iWG = 5.63% PTS: 1

OBJ: TYPE: C. Prob.

TOP: Interest rate parity

39. If the spot rate (in U.S. dollars) for the Australian dollar is $0.559 and the 180 day forward rate is trading at a premium of 2.86%, then the 180 day forward rate is: a. $0.551 b. $0.567 c. $0.575 d. $0.583 ANS: B Solution: 2.86 = (x - $0.559) (12/6)(100%) $0.559 x = $0.567 PTS: 1

OBJ: TYPE: C. Prob.

TOP: Exchange rate

40. Today, short-term interest rates in Australia are 8.50% and the corresponding U.S. rate is 6.0%. The current discount on forward Australian dollars is 2.0%. Can a U.S. trader use covered interest arbitrage to take advantage of this situation? If so what is the net effect? a. No. Lose 1/2% b. No. Lose 2 1/2% c. Yes. Gain 1/2% d. Yes. Gain 2 1/2% ANS: C Solution: Sell dollars, buy Australian dollars and invest in Australian securities at 8.5%. Sell Australian dollars forward at 2% discount. Trader earns 8.5% - 2% = 6.5% compared to 6% U.S. rate.

PTS: 1

OBJ: TYPE: C. Prob.

TOP: Covered interest arbitrage

ESSAY 1. Name the factors that affect exchange rates.

ANS: Exchange rates vary based on: 1. The supply and demand for each currency, and 2. The political and economic conditions that influence the supply of, or demand for, a country’s currency. These may include: a. inflation b. interest rates among countries c. a government’s trade policies d. a government’s political stability e. a country’s trade policies: tariffs, import quotas, and foreign exchange restrictions. f. government political stability which may involve risk of expropriation of investments or restrictions on the amount of funds that may be taken out of a country.

PTS: 1

OBJ: TYPE: Fact

TOP: Factors that affect exchange rates

2. How does a firm manage economic exposure due to changes in exchange rates?

ANS: To manage economic exposure, a firm may use any or all of the following strategies: 1. Shift production from high-cost plants to lower-cost plants (such as moving production plants from the U.S. to Mexico).

2. Increase productivity (such as adopt labor-saving techniques or reduce product cycles).

3. Raw material and supply outsourcing to lower-cost locations.

4. Increase product differentiation to reduce the price sensitivity in the market.

5. Enter markets with strong currencies and reduce involvement in competitive markets with weak currencies.

PTS: 1

OBJ: TYPE: Fact

TOP: Managing Economic Exposure

3. What are two hedging techniques that a U.S. company might use to protect itself against foreign exchange risk with regard to transaction exposure?

ANS: 1. Execute a contract in the forward exchange market or in the foreign exchange futures market.

2. Execute a money market hedge.

PTS: 1

OBJ: TYPE: Fact

TOP: Transaction exposure

Chapter 23—CORPORATE RESTRUCTURING MULTIPLE CHOICE 1. Forms of business combinations include: a. mergers b. consolidations c. holding companies and consolidations d. mergers, consolidations, and holding companies

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Summary

2. Which of the following terms are not associated with mergers and acquisitions? a. white knight b. tender offers c. greenmail d. declaration of bankruptcy ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Anti-takeover measures

3. When the net income of the combined companies after merger exceeds the sum of the net incomes prior to the merger, ______ is said to exist. a. goodwill b. synergy c. leverage d. greenmail ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reasons for mergers

4. The reasons why a company may choose external growth by merger over internal growth include a. economies of scale b. more rapid growth c. tax considerations and rapid growth d. economies of scale, tax considerations, and more rapid growth ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reasons for mergers

5. When the market value of a company's common stock is below the replacement value of the firm's net assets, this company is frequently referred to as a possible ______. a. white knight b. leveraged buyout c. takeover candidate d. conglomerate ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reasons for mergers

6. The acquisition of a company in which the buyer borrows a large amount of the purchase price, using the purchased assets as collateral for a large portion of the borrowings, is known as a ______. a. pooling of interests b. leveraged buyout c. conglomerate merger d. tender offer ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Leveraged buyouts

7. In general, the greatest economies of scale are possible with ______ mergers. a. conglomerate b. vertical c. horizontal

d. integrated ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reasons for mergers

8. A combination of two or more companies in which neither competes directly with the other and no buyer-seller relationship exists is known as a a. conglomerate merger b. vertical merger c. horizontal merger d. takeover ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Types of mergers

9. A combination of two or more companies that have a buyer-seller relationship with each other is known as a a. conglomerate merger b. vertical merger c. horizontal merger d. takeover ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Types of mergers

10. What is a form of business combination in which a company purchases all or a controlling block of another company’s common shares and the two companies become affiliated? a. horizontal merger b. vertical merger c. conglomerate d. holding company ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Understand financial analysis and cash flows

NAT: Reflective thinking TOP: Holding companies

11. A combination of two or more companies that compete directly with each other is known as a a. conglomerate merger b. vertical merger c. horizontal merger d. takeover ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Types of mergers

12. The major methods typically used to value merger candidates include all the following except a. comparative price-earnings ratio method b. adjusted book value method c. discounted cash flow method d. bottom line comparison method ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Valuation techniques

13. The basic methods used in combining financial accounts in a merger include all of the following except the a. goodwill consolidation method

b. purchase method c. pooling of interests method d. book value method ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounting aspects of mergers

NAT: Reflective thinking

14. In the ______ method of combining financial accounts in a merger, the acquired company's assets are recorded on the acquiring company's books at their cost (net of depreciation) when originally acquired. a. goodwill consolidation b. purchase c. pooling of interests d. EVA ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounting aspects of mergers

NAT: Reflective thinking

15. In the ______ method for combining financial accounts in a merger, the total value paid or exchanged for the acquired company's assets is recorded on the acquiring company's books. a. pooling of interests b. goodwill consolidation c. purchase d. book value ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounting aspects of mergers

NAT: Reflective thinking

16. In a ______ form of business combination, a parent-subsidiary relationship exists between the acquiring and acquired companies. a. leveraged buyout b. holding company c. consolidation d. leveraged buyout or consolidation ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Holding companies

17. A form of business combination in which two (unaffiliated) companies contribute financial and/or physical assets, as well as personnel, to a new company to engage in some economic activity is known as a _____. a. joint venture b. conglomerate merger c. merger d. consolidation ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Joint ventures

18. Employee Stock Ownership Plans (ESOPs) are useful instruments for financing leveraged buyouts because in an ESOP transaction a. employees have a greater voice in the final decision b. lenders can offer below market interest rates

c. ESOPs can be used only when employees take over management functions d. ESOPs attract greater external equity investments ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Leveraged buyouts

19. In a(n) ______ common stock in a division or subsidiary is distributed to shareholders of the parent company on a pro rata basis. a. spin-off b. reverse LBO c. equity carve-out d. tender offer ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Divestitures and restructuring

NAT: Reflective thinking

20. In the ______________ method of accounting for mergers, the total value paid or exchanged for the acquired firm’s assets is recorded on the acquiring company’s books. a. purchase b. goodwill c. pooling of interests d. stockholder’s equity ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounting aspects of mergers

NAT: Reflective thinking

21. One anti-takeover measure is the ______, where the target company makes a takeover bid for the stock of the bidder. a. poison put b. black knight defense c. Pacman defense d. shark repellent ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Anti-takeover measures

22. The accounting method used in most mergers is the _____ method. a. pooling of interests b. purchase c. consolidation d. merger ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Accounting aspects of mergers

NAT: Reflective thinking

23. A reorganization plan is reviewed by the ______ for fairness and feasibility. a. bankruptcy court b. Securities and Exchange Commission c. Federal Trade Commission d. bankruptcy court and the SEC ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reorganization

24. Legal bankruptcy proceedings focus on the decision of whether or not the firm's value as a going concern is greater than its a. liquidation value b. market value c. equity value d. historical value ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Formal alternatives for failing businesses under the...

NAT: Reflective thinking

25. Under Chapter(s) ______ of the bankruptcy laws, a company's assets are sold off and the proceeds are distributed to the creditors. a. 11 b. 7 c. 4 d. 7 and 11 ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Liquidation

26. Under Chapter(s) ______ of the bankruptcy laws, a company continues to operate while it attempts to work out a reorganization plan. a. 11 b. 7 c. 4 d. 4 and 11 ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reorganization

27. A(n) ______ is a situation in which a failing business is permitted to discharge its debt obligations by paying less than the full amounts owed to creditors. a. assignment b. composition c. extension d. insolvency ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Informal alternatives for failing businesses

NAT: Reflective thinking

28. A(n) ______ is a situation in which a failing business is permitted to lengthen the amount of time it has to meet its obligations with creditors. a. assignment b. composition c. extension d. insolvency ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Informal alternatives for failing businesses 29. Technical insolvency occurs when

NAT: Reflective thinking

a. the firm is unable to meet its current obligations as they come due, even though the value of its assets exceeds its liabilities b. the recorded value of the firm's assets is less than the recorded value of its liabilities c. the firm files a bankruptcy petition in accordance with the Federal bankruptcy laws d. the owners of the businesses lack experience ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Definitions of business failure

NAT: Reflective thinking

30. Legal insolvency occurs when a. the firm is unable to meet its current obligations as they come due, even though the value of its assets exceeds its liabilities b. the recorded value of the firm's assets is less than the recorded value of its liabilities c. the firm files a bankruptcy petition in accordance with the Federal bankruptcy laws d. the owners of the businesses lack experience ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Definitions of business failure

NAT: Reflective thinking

31. Bankruptcy occurs when the firm a. is unable to pay its debts b. files a bankruptcy petition in accordance with the Federal bankruptcy laws c. is more than 6 months overdue to its creditors d. is unable to pay its debts and files a bankruptcy petition in accordance with the Federal bankruptcy laws ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Definitions of business failure

NAT: Reflective thinking

32. ______ equals the proceeds that would be received from the sale of the firm's assets minus its liabilities. a. Market value b. Equity value c. Going-concern value d. Liquidation value ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Alternatives for failing businesses

NAT: Reflective thinking

33. ______ equals the capitalized value of the company's operating earnings minus its liabilities. a. Market value b. Equity value c. Going-concern value d. Liquidation value ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Alternatives for failing businesses

NAT: Reflective thinking

34. The process of liquidating a business outside of the jurisdiction of the bankruptcy courts is called a(n) a. assignment

b. composition c. extension d. voluntary insolvency ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Informal alternatives for failing businesses

NAT: Reflective thinking

35. Chapter 11 bankruptcy proceedings may be initiated by ______ or more of its unsecured creditors who have aggregate claims of at least ______. a. 2, $1,000 b. 2, $5,000 c. 3, $ 500 d. 3, $5,000 ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Formal alternatives for failing businesses under the bankruptcy laws 36. A combination in which all of the combining companies are dissolved and a new firm is formed is known as a ____. a. holding company b. leveraged buyout c. consolidation d. composition ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Types of mergers

37. In a ____, the acquiring company effectively announces that it will pay a certain price above the current existing price for a merger candidate's shares. a. leveraged buyout b. tender offer c. equity carve-out d. divestiture ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Tender offer

38. All of the following are anti-takeover measures except: a. black knight b. staggered board c. super major voting rules d. golden parachute ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Anti-takeover measures

39. In analyzing a merger the ____ is the number of the acquiring company shares received per share of acquired company stock owned. a. assignment b. composition c. price-purchase ratio d. exchange ratio ANS: D

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of financial analysis and cash flows

TOP: Analysis of a merger

40. A bond that contains a put option that can be exercised only if an unfriendly takeover occurs, is an example of a ____ . a. Pacman defense b. liability restructuring c. poison pill d. standstill option ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Anti-takeover measures

41. Essex Industries is considering the acquisition of the Twinsburg Company in a stock-for-stock exchange. The following financial data are available on both companies. (Assume no synergy is expected with this merger.) Calculate answers to nearest 0.001.

Sales Net income Common shares outstanding Earnings per share Dividends per share Common stock market price Price/earnings ratio

Essex $500 million $40 million 5 million $8.00 $3.00 $64 8

Twinsburg $50 million $3.74 million 1 million $3.74 $1.00 $24 6.42

Calculate the exchange ratio if Essex offers the Twinsburg stockholders a 20% premium over Twinsburg's current market price. a. 0.375 b. 2.22 c. 0.45 d. 0.288 ANS: C Solution: Effective price of Twinsburg = $24(1.2) = $28.80 Exchange ratio = $28.80/$64 = 0.45 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Exchange ratio calculation

42. Essex Industries is considering the acquisition of the Twinsburg Company in a stock-for-stock exchange. The following financial data are available on both companies. (Assume no synergy is expected with this merger.) Calculate answers to nearest 0.001.

Sales Net income Common shares outstanding Earnings per share Dividends per share Common stock market price Price/earnings ratio

Essex $500 million $40 million 5 million $8.00 $3.00 $64 8

Twinsburg $50 million $3.74 million 1 million $3.74 $1.00 $24 6.42

Calculate the post-merger earnings per share if the exchange ratio is 0.4 shares of Essex for each share of Twinsburg. (Assume total post-merger earnings are $43,740,000). a. $8.10 b. $7.33 c. $7.29 d. $7.42 ANS: A Solution: Number of new shares = 1,000,000 x 0.4 = 400,000 EPS = $43,740,000/5,400,000 = $8.10 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: EPS after a merger

43. Essex Industries is considering the acquisition of the Twinsburg Company in a stock-for-stock exchange. The following financial data are available on both companies. (Assume no synergy is expected with this merger.) Calculate answers to nearest 0.001.)

Sales Net income Common shares outstanding Earnings per share Dividends per share Common stock market price Price/earnings ratio

Essex $500 million $40 million 5 million $8.00 $3.00 $64 8

Twinsburg $50 million $3.74 million 1 million $3.74 $1.00 $24 6.42

What is Essex's post-merger share price if the post-merger price/earnings ratio is 7.5, and the exchange ratio is 0.4. Assume total post-merger earnings are $43,740,000. a. $60.75 b. $54.98 c. $64.80 d. $30.42 ANS: A Solution: Price = $8.10 x 7.5 = $60.75 (see problem #40 for EPS calculation) PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Market value after a merger

44. Millicom is acquiring Vikonic's outstanding common stock for $15 million. Financial information (in $ millions) on these two firms prior to the acquisition is as follows:

Total assets, book value Liabilities, book value Stockholders' equity, book value

Millicom

Vikonic

$90 40 50

$40 27 13

What are the total assets and stockholders' equity (in $ millions) if the purchase method is used as the accounting method for this merger? a. $130, $63 b. $130, $67

c. $132, $65 d. $132, $67 ANS: C Solution: Stockholders equity = $50 + $15 = $65 Liabilities = $40 + $27 = $67 Total assets = $90 + $42 = $132 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Accounting treatment of purchase

NAT: Analytic skills

45. Millicom is acquiring Vikonic's outstanding common stock for $15 million. Financial information (in $ millions) on these two firms prior to the acquisition is as follows:

Total assets, book value Liabilities, book value Stockholders' equity, book value

Millicom

Vikonic

$90 40 50

$40 27 13

What are the total assets and stockholders' equity (in $ millions) if the pooling of interests method had been used as the accounting method for this merger? a. $130, $63 b. $130, $67 c. $132, $65 d. $132, $67 ANS: A Solution: Stockholders' equity = $50 + $13 = $63 Liabilities = $40 + $27 = $67 Total assets = $90 + $40 = $130 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Accounting treatment of pooling of interests

NAT: Analytic skills

46. Osicom Tech is acquiring Rexon's outstanding common stock for $32 million. Before acquisition financial information on these two firms is given as follows (in $ millions):

Total assets Liabilities Stockholders' equity

Osicom Tech

Rexon

$120 60 60

$50 25 25

What are the total assets and stockholders' equity (in $ millions) if the purchase method is used as the accounting method for this merger? a. $170, $85 b. $177, $92 c. $170, $92 d. $85, $92 ANS: B Solution:

Stockholders' equity Liabilities Total assets

= $60 + $32 = $92 = $60 + $25 = $85 = $120 + $57 = $177

PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Accounting treatment of purchase

NAT: Analytic skills

47. The annual after-tax free cash flow from the acquisition by Pacific Care of Universal Health is projected to be $12 million. These flows are expected to continue for 20 years. No value is placed on cash flows beyond 20 years. If the appropriate risk-adjusted discount rate for the merged firm is 15 percent, what is the maximum amount Pacific Care should pay to acquire Universal Health? a. $79,476,000 b. $70,164,000 c. $75,108,000 d. can not be determined from the information provided ANS: C Solution: PV = $12 million(6.259) = $75.108 million PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Merger valuation

48. After a merger with Velo Blind, Sunlite's earnings per share are $1.50. If Sunlite had a P/E ratio of 14 times before the merger and a price of $28 a share after the merger, what is Sunlite's post-merger P/E? a. 16.8 b. 14.3 c. 20.2 d. 18.7 ANS: D Solution: P/E = $28/$1.50 = 18.7 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: P/E ratio calculation

49. Whipple Industries is considering the acquisition of the Blanchard Company in a stock-for stock exchange. Selected financial data for the two companies is shown below. No synergy is expected in this merger.

Sales (millions) Net income (millions) Common shares outstanding (millions) Earnings per share Dividends per share Common stock price per share

Whipple

Blanchard

$150 25 8 $3.125 $1.50 $40

$30 3.5 2 $1.75 $0.75 $19.50

Determine the post-merger earnings per share if the Blanchard company shareholders accept an offer of $22 per share in a stock-for-stock exchange. a. $2.85

b. $3.175 c. $3.13 d. $1.75 ANS: C Solution: Number of new shares = 2 million ($22/$40) = 1.1 million EPS post-merger = ($25 + $3.5)/(8 + 1.1) = $3.13 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Earnings per share in a merger

NAT: Analytic skills

50. Sunlite is considering a merger with Velo Blind by offering the equivalent of $21 a share in a stock-for-stock transaction. Sunlite's current common stock price is $30 a share and Velo's is $17.

Other financial data on the two firms is as follows:

Sales (millions) Net income (millions) No. shares outstanding (millions) Earnings per share

Sunlite

Velo Blind

$100 10 8 $1.25

$20 3 1.2 $2.50

Assuming no economies of scale or synergistic benefits, what will be the post-merger earnings per share? a. $1.47 b. $1.41 c. $1.50 d. $1.25 ANS: A Solution: Exchange ratio = $21/$30 = 0.70 Post-merger shares outstanding = 8 + 1.2(.7) = 8.84 million EPS = $13 million/8.84 million = $1.47 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Exchange ratio calculation

51. Quarter Staff is being liquidated under Chapter 7 of the bankruptcy code. When it filed for bankruptcy, its balance sheet (in millions) was as follows: Assets Current assets Land & buildings Equipment Total assets

$14.9 10 6 $30.9

Liabilities & Capital Accounts payable Accrued wages Accrued taxes Notes payable Mortgage bonds Stockholders' equity Total liabilities & equity

$ 4.6 0.1 0.4 5.0 5.2 15.6 $30.9

The notes payable are an unsecured bank loan and the mortgage bond is secured by the land and building. The proceeds from the liquidation of the company's assets are as follows:

$ 7.2 4.5 2.1 $13.8

Current assets Land & building Equipment Total

If the bankruptcy administration charges were $500,000, what dollar amount will the trade creditors (accounts payable) receive and the liquidation? a. $1.65 million b. $3.71 million c. $4.60 million d. $2.55 million ANS: B Solution: Total liquidation proceeds

$13,800,000

Payments: Bankruptcy administration charges Accrued wages Accrued taxes Total priority claims Payment to mortgage bondholders Funds available for claims of general creditors

$

500,000 100,000 400,000 $1,000,000 $ 4,500,000 $ 8,300,000

General Creditors: Accounts payable Notes payable Mortgage bond Total

$ 4,600,000 5,000,000 700,000 $10,300,000

Settlement percentage = $8.3/$10.3 = 0.8058 Available to accounts payable = $4,600,000(.8058) = $3,706,680

PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Distribution of liquidation proceeds

NAT: Analytic skills

52. Buggy Whip Industries is being liquidated under Chapter 7 of the bankruptcy code. When it filed for bankruptcy, its balance sheet was a follows: Assets Current assets Fixed assets Land and buildings Equipment Total assets

$22,000,000 9,000,000 11,500,000 $42,500,000

*Bank loan is unsecured **Mortgage bonds are secured by land and buildings

Liabilities and Equity Accounts payable Accrued taxes Notes payable (bank)* Total current liabilities Mortgage bonds** Debentures Stockholders' equity Total liabilities and equity

$18,000,000 3,000,000 3,000,000 $24,000,000 8,000,000 4,000,000 6,500,000 $42,500,000

Assume that the liquidation is a voluntary petition, that no unpaid contributions to employee benefit plans exist, and that no customer layaway deposits are involved. The proceeds from the liquidation of the company's assets are as follows: $12,000,000 5,000,000 7,500,000 $24,500,000

Current assets Land and buildings Equipment Total

Bankruptcy administration charges are $2,500,000. Determine the amount that the mortgage bondholders will receive in this liquidation. a. $5,000,000 b. $6,500,000 c. $8,000,000 d. $10,500,000 ANS: B Solution: Total liquidation proceeds Payments: Bankruptcy administration charges Accrued taxes Total priority claims Payment to mortgage bondholders Funds available for claims of general creditors General Creditors Claims: Accounts payable Notes payable Mortgage bond ($8 million - $5 million) Debentures Total

$24,500,000 $ 2,500,000 3,000,000 $ 5,500,000 $ 5,000,000 $14,000,000 $18,000,000 3,000,000 3,000,000 4,000,000 $28,000,000

Settlement percentage to general creditors = $14,000,000/$28,000,000 = 0.5 Payment to mortgage bondholders = $5,000,000 + 0.5($3,000,000) = $6,500,000 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Distribution of liquidation proceeds

NAT: Analytic skills

53. Endevco is considering the acquisition of Geothermal Resources in a stock-for-stock exchange.

Assume no immediate synergistic benefits are expected. Selected financial data on the two companies are shown below:

Sales (millions) Net income (millions) Common shares outstanding (millions) Earnings per share Common stock (price per share)

Endevco

Geothermal

$720 $ 58 10 $5.80 $70.00

$140 $ 16 3 $5.33 $48

If Endevco is not willing to incur an initial dilution in its EPS, and if Endevco also feels that it will have to offer Geothermal shareholders a minimum of 20% over Geothermal's current market price, what is the maximum price per share that Endevco will have to pay for Geothermal's stock? a. $57.60

b. $64.33 c. $52.23 d. $60.00 ANS: B Solution: Pmax = (70/5.80)(5.33) = $64.33 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Merger analysis

54. Linpro Industries is considering the acquisition of Odetics, Inc. in a stock-for-stock exchange. Assume no immediate synergistic benefits are expected. Selected financial data on the two companies are shown below:

Sales (millions) Net income (millions) Common shares outstanding (millions) Earnings per share Common stock (price per share)

Linpro

Odetics

$480 $ 38 10 $ 3.80 $ 45.60

$90 $10.4 2.1 $ 4.95 $74.25

Calculate Linpro's postmerger EPS if the Odetics shareholders accept an offer of $90 a share in a stock-for-stock exchange. a. $4.38 b. $4.29 c. $3.42 d. $3.81 ANS: C Solution: ER = $90/$45.60 = 1.97 EPS = (38 + 10.4)/[10 + 2.1(1.97)] = $3.42 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Merger analysis

55. Morgan Foods is considering the acquisition of Old Spaghetti Warehouse Inc. in a stock-for-stock exchange. Selected financial data for the two companies is shown below. An immediate synergistic earnings benefit of $1.5 million is expected in this merger, due to cost savings.

Sales (millions) Net income (millions) Common stock outstanding (millions) Earnings per share Common stock (price per share)

Morgan

Old Spaghetti

$360 $ 30 10 $ 3.00 $ 36.00

$80 $ 8 2 $ 4.00 $44.00

Calculate the postmerger EPS if the Old Spaghetti shareholders accept an offer of $54 per share in a stock-for-stock exchange. a. $3.04 b. $2.92 c. $3.29 d. $3.17

ANS: A Solution: ER = $54/$36 = 1.5 EPS = ($30 + $8 + $1.5)/[10 + 2(1.5)] = $3.04 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Merger analysis

56. Koala Technologies is considering the acquisition of Laser Industries in a stock-for-stock exchange.

Selected financial data for the two companies is shown below. An immediate synergistic earnings benefit of $2.5 million is expected in this merger.

Sales (millions) Net income (millions) Common shares outstanding (millions) Earnings per share Common stock (price per share)

Koala

Laser

$90 $ 9.4 4.0 $ 2.35 $35.00

$10 $ 1.2 0.8 $ 1.50 $27.00

Calculate the postmerger EPS if the Laser shareholders accept an offer of $33.25 a share in a stock-for-stock exchange. a. $2.21 b. $2.25 c. $2.75 d. $2.23 ANS: C Solution: ER = $33.25/$35 = 0.95 EPS = ($9.4 + $1.2 + $2.5) / [4 + 0.8(0.95)] = $2.75 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Merger analysis

57. The most correct method of valuing a merger candidate is: a. adjusted book value method b. discounted cash flow method c. pooling of interests method d. comparative price-earnings ratio method ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Valuation techniques

58. The ________________ is the number of acquiring company shares received per share of acquiring company stock owned. a. stock equity ratio b. exchange ratio c. dividend exchange ratio d. interest parity ratio ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Analysis of a merger

59. A firm is technically insolvent when: it is unable to meet it current obligations and: a. the value of its assets exceeds the value of its liabilities.

b. the value of its assets is less than the value of its liabilities. c. it files a bankruptcy petition. d. it merges with another firm.

ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Definitions of business failure

NAT: Reflective thinking

60. A plan of reorganization must be all of the following EXCEPT: a. feasible b. fair c. a plan that allows the firm a chance to reestablish successful business operations d. a plan whereby the creditors due the most money are paid first.

ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Reorganization

ESSAY 1. Explain the motivation for a company to divest through a spin-off or equity carve-out.

ANS: Spinoffs or equity carve-outs may be motivated by a need for cash. The subsidiary or division becomes a separate company and stock in the separate company is distributed to shareholders of the parent company. Owners of the parent company who receive common stock can then keep the stock or sell them to other investors.

Spinoffs and equity carve-outs can be used to remove an underperforming unit that is hurting the overall firm.

Spinoffs and equity carve-outs can be used to develop or promote a company that is healthy but is buried among the underperforming units.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Divestitures and restructuring 2. What are some informal alternatives for salvaging a failing business?

ANS: 1. The company can stretch its payables.

2. The company can go to its bankers and request additional working capital loans.

3. Bankers may do some debt restructuring either through an extension (lengthening the time it has to meet its obligations) or composition (creditors agree to receive only a percentage of the total amount due) 4. Large companies can sell off real estate and/or various operating divisions.

5. The failing company can do a sale and leaseback of its land and buildings.

6. The failing company may form a “creditor’s committee” whereby the company agrees to cut various expenditures and the creditors agree to accept deferred payments.

7. The company can liquidate through the process of “assignment”.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Alternatives for failing businesses

3. Explain the difference between a stock purchase and an asset purchase in a merger transaction.

Which is preferred and why?

ANS: In a stock purchase the acquiring company buys the stock of the to-be-acquired company and assumes its liabilities. In an asset purchase the acquiring company busy only the assets (some or all) of the to-be-acquired company and does not assume any of its liabilities. Most buyers of a business prefer an asset purchase because unknown liabilities are not incurred. An asset purchase frequently allows the acquiring company to depreciate its new assets from a higher basis than is possible in a stock purchase. As a result, many companies will only acquire small companies only on the asset purchase basis.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Forms of merger transactions 4. A new takeover defense is boardmail. How does it work?

ANS: Some institutional investors have developed an anti-takeover measure called boardmail to fight poison pills and staggered elections of board members. Boardmail consists of requiring the board of directors to adopt weaker anti-takeover measures in exchange for voting support from the institutional owners. In some cases, institutions have been successful in placing sympathetic members on boards of companies in which the institution has a significant ownership interest.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Anti-takeover measures 5. There are three methods for valuing merger candidates. Briefly explain each of them.

ANS: The methods for valuing merger candidates are: 1. The comparative price-earnings ratio method examines the recent prices and P/E ratios paid for other merger candidates that are comparable to the company being valued. This method focuses on the current income statement and may not be useful if the P/E ratios of recent, similar mergers vary widely.

2. The adjusted book value method involves determining the market value of the company’s underlying assets. However, it may be difficult to accurately determine the market value of the merger candidate’s assets.

3. The discounted cash flow method calculates the present value of the company’s expected future free cash flows and compares this figure to the proposed purchase price to determine the proposed acquisition’s net present value.

The discounted cash flow method is the most correct of the three methods because this method compares the present value of the cash flow benefits from the merger with the present value of the merger costs.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Valuation techniques

Appendix 2A—TAXES MULTIPLE CHOICE 1. Intercompany dividends, or dividends paid by one corporation to another, are normally entitled to a ____ percent exclusion from Federal income taxes. a. 15 b. 30 c. 50 d. 70 ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Dividend income

2. A corporation's net operating loss may be carried _____ years and _____ years to offset taxable income in those years. a. back 20, forward 2 b. back 3, forward 5 c. back 5, forward 15 d. back 2, forward 20 ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows TOP: Loss carrybacks and carryforwards

NAT: Reflective thinking

3. For most large U.S. corporations, the maximum capital gain tax rate is a. 14% b. 35% c. 50% d. 28% ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capital gains income

4. The marginal tax rate for a firm with taxable income of $105,000 is a. 30% b. 39% c. 15% d. 34% ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Corporate income taxes

5. Capital losses are a. taxed at the same marginal rate as ordinary income b. taxed at the 20% rate c. deductible only against capital gains d. used to reduce interest payments ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capital gains income

6. From a tax standpoint, the advantage of an S corporation is that a. it avoids the double taxation of dividends b. additional depreciation is allowed c. it reduces dividend income d. interest income is not taxed ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: S corporations

7. __________ received by corporations are normally entitled to a 70 percent exclusion from federal income taxes. a. Capital gains income b. Dividend income c. Loss carrybacks and carryforwards d. none of the above ANS: B

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Understand stocks and bonds

TOP: Dividend income

8. Corporate capital gains income is currently taxed at __________ ordinary income. a. 80 percent of the marginal tax rate on b. the same marginal rate as c. 50 percent of the marginal tax rate on d. none of the above ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Capital gains income

9. Under the MACRS system of depreciation, a. there are five classes of assets b. real estate has a separate class using 150 percent declining balance c. a half-year convention normally is followed for equipment d. all of the above are correct ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of financial analysis and cash flows

NAT: Reflective thinking TOP: Depreciation rate

10. AMX corporation had operating income of $420,000 in 2001; received $12,000 in interest income; paid $22,000 in interest; received $20,000 in dividends; and paid $50,000 in dividends. What is the tax liability for AMX? a. $141,440 b. $146,200 c. $148,920 d. none of the above ANS: A Solution: Operating income Interest income Interest expense Taxable dividends Taxable income

$420,000 12,000 -22,000 6,000 $416,000

Tax = $113,900 + .34($416,000 - $335,000) = $141,440 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Corporate income tax

11. BET had a taxable income of $135,000 in 2001. What is its tax liability? a. $22,500 b. $52,650 c. $35,900 d. $15,900 ANS: C Solution: $22,250 + 0.39($135,000 - $100,000) = $35,900 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Corporate income taxes

12. What is the tax liability in 2001 for a corporation with taxable income of $425,000?

a. b. c. d.

$144,500 $132,750 $150,250 $122,700

ANS: A Solution: $113,900 + 0.34($425,000 - $335,000) = $144,500 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Corporate income taxes

13. For a corporation with ordinary taxable income of $425,000, what is the additional tax liability if $30,000 in dividends is received from shares it holds in another corporation? a. $7,140 b. $10,200 c. $11,700 d. $3,060 ANS: D Solution: $30,000(0.3)(0.34) = $3,060 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Tax on intercorporate dividends 14. Using the rates in Appendix 2A, determine the tax liability of Coastal Inc. in 2001 if the firm had the following stream of taxable income:

a. b. c. d.

Year

Taxable Income

1997 1998 1999 2000 2001

($450,000) (80,000) 60,000 145,000 360,000

$83,450 $ 5,250 $95,200 none of the above

ANS: B Solution: $35,000(0.15) = $5,250 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of financial analysis and cash flows TOP: Loss carrybacks and carryforwards

NAT: Analytic skills

15. Keegan Company had operating income of $740,000 in 2001, received $120,000 in preferred stock dividends, $20,000 in interest income and paid $15,000 in interest expenses. What is the tax liability for Keegan? a. $265,540 b. $294,100 c. $299,200

d. $270,640 ANS: A Solution: $740,000 36,000 5,000 $781,000

EBIT = Taxable Prfd. Stock dividend Net interest Taxable income Tax = $781,000(0.34) = $265,540 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of financial analysis and cash flows

NAT: Analytic skills TOP: Corporate income tax

16. Last year Cell 2 had a net operating loss of $120,000 and a capital loss of $80,000. This year (2001) the firm has an operating income of $230,000 and a capital gain of $40,000. What is Cell 2's tax liability this year? Assume there are no other tax loss carry backs or carry forwards. a. $4,500 b. $72,950 c. $26,150 d. $12,500 ANS: C Solution: Tax = 22,250 + 10,000(.39) = $26,150 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Loss carrybacks and carryforwards TOP: Corporate income tax ESSAY 1. How does a tax loss affect a corporation as it applies to past and future income?

ANS: Corporations that have net operating losses during a particular year are permitted by the tax laws to apply the losses against any taxable income in other years and thus lower their tax liability. A tax loss may be carried back 2 years against past income or carried forward 20 years to offset future income.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of financial analysis and cash flows TOP: Loss carrybacks and carryforwards 2. How are dividends received by a corporation treated for tax purposes?

ANS: Corporations that receive dividends are entitled to a 70% exclusion from federal income taxes. In other words, only 30% of the dividend received is includable as income. This reduces the tax liability for the recipient corporation. However, dividends paid by a firm are not considered a tax-deductible expense.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Dividend income

Appendix 5A—CONTINUOUS COMPOUNDING AND DISCOUNTING MULTIPLE CHOICE 1. With continuous compounding a. the effective rate is higher than the nominal rate b. the effective rate is higher than the logarithmic rate c. the base "e" is the effective rate d. all the above are correct ANS: A PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Effective rate calculations

2. In the continuous compounding equation, "e" is the a. natural log to the base 10. b. base number in natural logarithms c. natural log to the base 1. d. none of the above are correct ANS: B PTS: 1 LOC: Understand time value of money

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Continuous compounding

3. Determine the value of $10,000 at the end of 3 years invested at 8 percent assuming continuous compounding. a. $12,712 b. $12,400 c. $32,460 d. $12,600 ANS: A Solution: FV3 = 10,000(e)0.08(3) = $12,712 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 4. Determine the present value of $5,000 to be received 4 years from now at the continuously discounted rate of 8 percent. a. $6,886 b. $3,631 c. $4,616 d. None of the above ANS: B Solution: PV0 = $5,000(e)-0.08(4) = $3,631 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous discounting 5. First Texas National Bank is offering a one-year CD with a nominal rate of 9.5 percent. If compounding occurs continuously, what is the effective annual rate? a. 9.97% b. 16.76%

c. 9.66% d. 22.06% ANS: A Solution: Effective rate = 2.71828(0.095) -1 = 0.0997 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 6. What is the future value of $20,000 invested for 20 years at a nominal interest rate of 9 percent compounded continuously? a. $112,088 b. $120,993 c. $108,894 d. $147,781 ANS: B Solution: FV = 20,000(e)0.09(20) = $120.992.95 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Future value continuous compounding 7. Calculate the effective annual rate if the nominal annual rate is 9 percent compounded continuously. a. 9.74% b. 9.29% c. 9.42% d. 9.54% ANS: C Solution: Effective rate = e0.09 - 1.0 = 0.09417 or 9.42% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 8. What is the present value of $100,000 that will be received 20 years from now if the nominal discount rate is 11 percent, discounted continuously? a. $21,240 b. $11,080 c. $16,421 d. none of the above ANS: B Solution: PV = $100,000/e0.11(20) = $11,080.32 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous discounting 9. You have just won a lottery that promises to pay you $1,000,000 in 5 years. What is the present value of this lottery win at the continuously discounted rate of 10%? a. $621,000 b. $606,531

c. $648,720 d. $904,837 ANS: B Solution: PV = $1,000,000e-0.10(5) = $1,000,000/1.64872 = $606,531 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous discounting 10. Fred deposited $5,000 in an account that promised a nominal interest rate of 8% compounded continuously for his daughter who will be going to college in 18 years. How much will she have in the account in 18 years? a. $19,980 b. $20,054 c. $21,103 d. $21,694 ANS: C Solution: FV = $5,000 e0.08(18) = $21,103.48 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 11. Vida has just won a jackpot that will pay her $10,000 now, $10,000 in one year, and $10,000 in 2 years. What is the present value of this jackpot at the continuously discounted rate of 9%? a. $27,515 b. $28,345 c. $24,516 d. $27,492 ANS: D Solution: PV = $10,000 + $10,000/1.09417 + $10,000/1.19722 = $27,492 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous discounting 12. City Bank offers a 7 year CD with a nominal rate of interest of 7.0%. If compounding occurs continuously, what is the effective annual rate? a. 7.25% b. 6.77% c. 7.32% d. 7.00% ANS: A Solution: Effective rate = e.07 - 1 = 0.0725 or 7.25% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 13. What continuously compounded effective rate of interest will yield the same present value of a future cash flow as an annual rate of interest of 8.25%?

a. b. c. d.

8.60% 7.93% 8.25% 7.70%

ANS: B Solution: Continuous effective rate = ln(1 + 0.0825) = 0.07927 or 7.93% PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations 14. What is the value of $10,000 invested for 1 year at 8% compounded continuously? a. $10,800 b. $10,833 c. $10,824 d. $11,268 ANS: B Solution: FV = 1,000 (e).08 = $10,832.87 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 15. What is the value of $10,000 invested for 5 years at 8% compounded continuously? a. $14,693 b. $14,928 c. $14,918 d. $13,064 ANS: C Solution: FV = 10,000 (e).08(5) = $14,918.25 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 16. Friendly Bank offers you a loan at an annual interest rate of 10% compounded monthly. What is the effective rate the bank is charging you? a. 12.68% b. 10.00% c. 10.47% d. 10.83% ANS: C Solution: ieff = (1 + .10)12 -1 = .1047 12 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate: 17. Jane deposited $1000 into a saving account paying 12% interest compounded continuously. After 45 years, how much money did she have in the account?

a. b. c. d.

$25, 759.09 $157,896.32 $221,406.42 $257,895.78

ANS: C 1000e^(.12x45) = $221,406.42 PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 18. Paula invested $25 into a savings account when she was 6 years old. She is now 35. Her money grew at 2% compounded continuously. How much money does she have? a. $106.58 b. $85.19 c. $270.82 d. $94.16 ANS: A Solution on calculator: 25e^(.02x29) = $106.58 PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 19. Jack invested $25,000 into an account paying 6% compounded continuously. In five years how much money will he have? a. $92,190.45 b. $215,905.42 c. $65,871.15 d. $132,729.57 ANS: D Solution on calculator: 25,000e^(.06x5) = $132,729.57 PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand time value of money TOP: Continuous compounding 20. If interest is at 8% and it is compounded continuously, what is the effective interest rate? a. 7.25% b. 5.14% c. 8.33% d. 9.76% ANS: C PTS: 1 NAT: Analytic skills TOP: Effective rate calculations

OBJ: TYPE: E. Prob LOC: Understand time value of money

21. What is the effective interest rate on 12% if interest is compounded continuously? a. 15.11% b. 16.25% c. 14.11% d. 12.75%

ANS: D PTS: 1 NAT: Analytic skills TOP: Effective rate calculations

OBJ: TYPE: E. Prob LOC: Understand time value of money

22. What is the effective interest rate if 10% is compounded continuously? a. 10.52% b. 10.97% c. 11.06% d. 10.11% ANS: A PTS: 1 NAT: Analytic skills TOP: Effective rate calculations

OBJ: TYPE: E. Prob LOC: Understand time value of money

23. Brad deposited $5,250 into an account that earns 7% interest compounded continuously. How much money will he have in 15 years? a. $15,002.67 b. $12,175.90 c. $13,957.14 d. $14,964.25 ANS: A PTS: 1 NAT: Analytic skills TOP: Continuous compounding

OBJ: TYPE: E. Prob LOC: Understand time value of money

24. Moneybag Bank & Trust is offering loans at 5% compounded continuously. Before you decide to borrow using that interest rate, what payment would be required on a $200,000 loan for a 30 year loan? a. $1,089.59 b. $1,578.34 c. $1,183.92 d. $1,226.90 ANS: A Solution: Effective interest is 5.14% Solution using a calculator: N = 30 X 12 I = 5.14  12 PV = -200000 Solve for pmt.

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand time value of money TOP: Effective rate calculations ESSAY 1. With continuous compounding, why is the effective rate higher than the nominal rate?

ANS: The effective rate is higher than the nominal rate because, with continuous compounding, the money is working harder; that is, interest is being accumulated more frequently and this accumulated interest is available to earn its own interest on an on-going basis.

PTS: 1 OBJ: TYPE: Fact LOC: Understand time value of money

NAT: Reflective thinking TOP: Effective rate calculation

Appendix 10A—MUTUALLY EXCLUSIVE INVESTMENTS HAVING UNEQUAL LIVES MULTIPLE CHOICE 1. ____________ is (are) used when evaluating mutually exclusive investments having unequal lives. a. Equivalent annual annuities b. Replacement chains c. Linear programming d. a and b only ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Equivalent annual annuities

2. The advantage(s) of the equivalent annual annuity method over the replacement chain technique in evaluating mutually exclusive investments having unequal lives include a. the equivalent annual annuity method is often computationally simpler b. the equivalent annual annuity method simplifies the handling of the time discrepancies that frequently arise in the replacement chain method c. the equivalent annual annuity method is theoretically superior d. a and b only ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Equivalent annual annuities

3. When two or more mutually exclusive alternative investments have __________ , neither the net present value nor the internal rate of return method yields reliable accept-reject information unless the projects are evaluated for an equal period of time. a. unequal lives b. unequal net cash flows c. unequal net investments d. a and b ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Replacement chains

4. Creative Furniture is considering two mutually exclusive projects that would automate part of their production facilities. Project A costs $120,000 and would produce net cash flows of $37,000 annually for 5 years. Project B also costs $120,000 and will produce annual net cash flows of $25,000 for 10 years. Creative's cost of capital is 11 percent. Using a replacement chain, which project should be chosen? Assume that in 5 years, Project A will still cost $120,000 and produce 5 more years of $37,000 annual net cash flows. a. Project B. NPV of A is negative b. Project A. NPV of B is negative c. Project B. NPV is $492 higher d. Project A. NPV is $6,468 higher ANS: C Solution: NPVB = -$120,000 + $25,000(5.889) = $27,225 NPVA = -$120,000 - $120,000(.593) + $37,000(5.889) = $26,733

NPVB - NPVA = $492 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Replacement chains

5. Creative Furniture is considering two mutually exclusive projects that would automate part of their production facilities. Project A costs $120,000 and would produce net cash flows of $37,000 annually for 5 years. Project B also costs $120,000 and will produce annual net cash flows of $25,000 for 10 years. Creative's cost of capital is 11 percent. Using the equivalent annual annuity method, which project should be chosen? a. Project B, NPV is approximately $823 higher b. Project A, NPVB is negative c. Project B, NPV is $10,473 approximately higher d. Project B, NPV is $90.56 approximately higher ANS: A Solution: NPVA = -$120,000 + $37,000(3.696) = $16,752 NPVB = -$120,000+ $25,000(5.889) = $27,225 EAA(A) = $16,752/3.696 = $4,532.47 EAA(B) = $27,225/5.889 = $4,623.03 NPVA = $4,532.47/0.11 = $41,204.27 NPVB = $4,623.03/0.11 = $42,027.55 NPVB - NPVA = $823 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuity

6. Dorati Inc. is considering two mutually exclusive projects. Dorati used a 15% required rate of return to evaluate capital expenditure projects. If the two projects have the costs and cash flows shown below, using a replacement chain determine the NPV for each.

Year

Project S

Project T

0 1 2 3 4

-$70,000 $50,000 $60,000

-$100,000 $ 60,000 $ 70,000 $ 80,000 $ 90,000

Assume in two years Project S will still cost $70,000 and produce the same two years of cash flows. a. NPVs = $8,860: NPVT = $109,240 b. NPVs = $14,690: NPVT = $109,240 c. NPVs = $40,020: NPVT = $109,240 d. None of the above ANS: C Solution: NPVT = -100,000 + 60,000(.870) + 70,000(.756) + 80,000(.658) + 90,000(.572) = $109,240 NPVs = -70,000 - 70,000(.658) + 50,000(.870) + 60,000(.756) + 50,000(.658) + 60,000(.572) = 40,000 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Replacement chain

7. Lakeland Ramblers is considering two mutually exclusive projects to boost their tourist revenue.

Project A costs $60,000 and would produce net cash flows of $25,000 for 5 years. Project B cost $100,000 and will produce annual net cash flows of $25,000 for 10 years. If Lakeland's cost of capital is 12%, which project should be chosen using the equivalent annual annuity method? a. Project A, NPV is $17,941 higher b. Project B, NPV is $11,125 higher c. Project A, NPV is $28,383 higher d. Project B, NPV is $21,567 higher ANS: A Solution: NPVA = -60,000 + 25,000(3.605) = $30,125 NPVB = -100,000+25,000(5.650) = $41,250 EAA(A) = 30,125/3.605 = $8,356.45 EAA(B) = 41,250/5.65 = $6,203 NPVA = 8356/.12 = $69,633 NPVB = 6203/.12 =$51,692 NPVA - NPVB = 69,633 - 51,692 = $17,941 PTS: 1 OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuity

8. Casa Chica is considering replacing a piece of equipment. Alternative A costs $80,000, has an eight year life and would produce net cash flows of $18,000 in each of the eight years. Alternative B costs $65,000, has a six year life and would produce net cash flows of $18,000 in each of the six years. If Chica's cost of capital is 13 percent, which alternative should be chosen using the equivalent annual annuity method? a. Project A b. Project B c. Indifferent between the two projects d. Neither, because both projects have a negative NPV ANS: B Solution: NPVA = $-80,000 + $18,000(4.799) = $6,382 NPVB = $-65,000 + $18,000(3.998) = $6,964 EAA(A) =$6,382/4.799 = $1,330 EAA(B) = $6,964/3.998 = $1,742 NPVA = $1,330/0.13 = $10,231 NPVB = $1,742/0.13 = $13,400 NPVB - NPVA = $3,169 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuity

9. Toy Manufacturers (TM) is considering two mutually exclusive machines to use in its manufacturing process. The net cash flows for each are given below: Year

Axa

Beta

0 1 2 3 4 5

-$90,000 45,000 45,000 45,000

-$105,000 35,000 35,000 35,000 35,000 35,000

If the cost of capital for TM is 13%, which machine should they purchase? a. Beta: has the highest total net cash flows b. Beta: it has the highest NPV c. Axa: it has the highest NPV using infinite replacement d. Beta: it has the highest NPV using infinite replacement ANS: C Solution: NPVA = $-90,000 + $45,000(2.361) = $16,245 NPVB = $-105,000 + $35,000(3.517) = $18,095 EAAA = $16,245/2.361 = $6,881 EAAB = $18,095/3.517 = $5,145 NPVA = $6,881/0.13 = $52,931 NPVB = $5,145/0.13 = $39,577 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuities

10. Quorex is evaluating two mutually exclusive projects. Project A has a net investment of $48,000 and net cash flows over a six year period of $12,500 per year. Project B also has a net investment of $48,000 but its net cash flows of $8,640 per year will occur over a 12 year period. If Quorex has a cost of capital of 14% for these projects, which project , if either, should be chosen and what is its NPV? a. A, $862 b. A, $1,800 c. B, $2,475 d. B, $902 ANS: D Solution: NPVA = $-48,000 - $48,000(0.456) + $12,500(5.660) = $862 NPVB = $-48,000 + $8,640(5.660) = $902 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Replacement chains

11. Marvec needs to replace an extruder and two replacements look good. Extruder A costs $102,000 and has a 10 year life. Extruder B costs only $56,000 but its expected life is 6 years. Extruder A will generate net cash flows of $17,600 per year for 10 years and B will generate net cash flows of $13,800 per year for 6 years. If Marvec's cost of capital is 11%, which extruder should be chosen and what is its NPV? Use equivalent annual annuities. a. B, $564 b. B, $2,388 c. A, $1,646 d. A, $280 ANS: B Solution: NPVA = $-102,000 + $17,600(5.889) = $1,646 NPVB = $-56,000 + $13,800(4.231) = $2,388 EAAA = $1,646/5.889 = $279.50 EAAB = $2,388/4.231 = $564.41 NPVA = $279.50/0.11 = $2,541 NPVB = $564.41/0.11 = $5,131 PTS: 1

OBJ: TYPE: C. Prob.

NAT: Analytic skills

LOC: Knowledge of capital budgeting and cost of capital

TOP: Equivalent annual annuities

12. Kaneb is evaluating two alternative pipeline welders. Welder A costs $310,000, has a 7 year life, and is expected to generate net cash inflows of $78,000 in each of the 7 years. Welder B costs $320,000, has a 5 year life, and is expected to generate annual net cash inflows of $68,900 in each of the 5 years.

Kaneb's cost of capital is 16%. Using the equivalent annual annuity method, which alternative should be chosen and what is its NPV? a. B, $4,920 b. A, $7,111 c. B, $10,650 d. A, $7,800 ANS: C Solution: NPVA = $-310,000 + $78,000(4.039) = $5,042 NPVB = $-220,000 + $68,900(3.274) = $5,579 EAAA = $5,042/4.039 = $1,248 EAAB = $5,579/3.274 = $1,704 NPVA = $1,248/.16 = $7,800 NPVB = $1,704/.16 = $10,650 PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuities

13. Rollerblade, a maker of skating gear, is evaluating two alternative presses. Press A costs $88,000, has a 4 year life, and is expected to generate annual cash inflows of $30,100 in each of the 4 years. Press B costs $122,000, has an 8 year life, and is expected to generate annual cash inflows of $24,600 in each of 8 years. The cost of replacement for A is $96,000 and the replacement press will generate cash inflows of $30,100 for another 4 years. Rollerblade uses a 12% cost of capital. Which press should be chosen? a. A b. B c. Both A and B d. neither A or B ANS: A Solution: NPVA= -$88,000 - $96,000(0.636) + $30,100(4.968) = $480.80 NPVB= -$122,000 + $24,600(4.968) = $212.80 Choose A PTS: 1 OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Replacement chains

14. Boomerang Bungee Corp. is considering the following project. Determine the equal annual annuity for the project if the cost of capital is 14%.

Initial Investment: $75,000 Year Cash Inflows 1 $30,000 2 $35,000 3 $40,000 Year a. $5,527.89 b. $4,355.25

c. $7,768.67 d. $2,259.62 ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Equivalent annual annuities

15. What would be the equal annual annuity for Wallflowers Florist, Inc. if the cost of capital is 10% and the initial investment is $50,000 (rounded)?

Year Cash Inflows 1 $25,000 2 $30,000 3 $10,000 a. b. c. d.

$2,024 $5,033 $1,257 $8,358

ANS: A PTS: 1 NAT: Analytic skills TOP: Equivalent annual annuities

OBJ: TYPE: C. Prob.

LOC: Knowledge of capital budgeting and cost of capital

16. What is the equal annual annuity for Scorch & Burn Fire Extinguishers if their cost of capital is 8% and the initial investment is $75,000 (rounded)?

Year Cash Inflows 1 $25,000 2 $25,000 3 $45,000 a. b. c. d.

$5,304 $6,271 $2,058 $4,157

ANS: C PTS: 1 NAT: Analytic skills TOP: Equivalent annual annuities

OBJ: TYPE: E. Prob.

LOC: Knowledge of capital budgeting and cost of capital

17. The best way to measure projects with unequal lives is: a. the Gordon Model b. the payback period c. the net present value method d. equivalent annual annuity approach ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Mutually exclusive investments having unequal lives

NAT: Reflective thinking

18. Under most conditions the equivalent annual annuity method will give the same decision as: a. the net present value method b. linear programming c. the replacement chain method d. the internal rate of return ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital TOP: Mutually exclusive investments having unequal lives ESSAY 1. The importance of time discrepancies depends on several items when making capital budgeting decisions. State those items: ANS: 1. The number of years in the discrepancy. The fewer the years of the discrepancy, the less important it is.

2. The number of years into the future where the discrepancy occurs. The further into the future, the less important the discrepancy is.

3. The relationship between the rate of return on future investments and the cost of capital. When the NPV=0, the discrepancy can be ignored.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Replacement chain

Appendix 14A: BREAKEVEN ANALYSIS MULTIPLE CHOICE 1. The breakeven point occurs where total revenues intersects with: a. market returns b. the risk-free rate c. total costs d. total interest and taxes ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Breakeven analysis

2. Breakeven analysis is normally performed for a planning period of: a. five years b. one year or less c. ten years d. one month ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Some limitations of breakeven analysis

NAT: Reflective thinking

3. An example of a noncash outlay is: a. property b. marketing costs c. advertising d. depreciation ANS: D PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital 4. Breakeven analysis can be used to assess ______________ risk.

NAT: Reflective thinking TOP: Cash breakeven point

a. b. c. d.

financial operating sales volume

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis and risk assessment

NAT: Reflective thinking

5. Breakeven analysis can be used: a. when planning renovations b. when planning expansions c. when planning financial resources d. when planning new product development ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis: Introduction

NAT: Reflective thinking

6. The uses of breakeven analysis are all of the following EXCEPT: a. forecasting the profitability of the firm b. forecasting the impact of certain economic conditions on the firm’s profitability c. analyzing the impact of substituting fixed costs for variable costs in production d. analyzing the profit impact of a firm’s restructuring efforts.

ANS: B PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis: Introduction

NAT: Reflective thinking

7. The difference between the selling price per unit and the variable cost per unit is the: a. contribution to the bottom line b. contribution to revenue c. contribution margin d. contribution to EBIT ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Algebraic breakeven analysis

NAT: Reflective thinking

8. Another name for breakeven analysis is: a. cost-volume-profit analysis b. graphic analysis c. EBIT-EPS analysis d. degree of operating leverage ANS: A PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital

NAT: Reflective thinking TOP: Breakeven analysis

9. In a graphic breakeven analysis, the point where total revenue is less than total cost indicates that the firm has: a. net operating capital b. cash flow from investing c. a negative EBIT d. a positive return on capital ANS: C

PTS: 1

OBJ: TYPE: Fact

NAT: Reflective thinking

LOC: Knowledge of capital budgeting and cost of capital

TOP: Graphic breakeven analysis

10. The contribution margin per unit is the difference between: a. the selling price per unit and fixed costs b. the fixed costs and the variable costs c. the variable cost per unit and the selling price per unit d. the variable costs and the number of units sold ANS: C PTS: 1 OBJ: TYPE: Fact LOC: Knowledge of capital budgeting and cost of capital TOP: Algebraic breakeven analysis

NAT: Reflective thinking

11. The Foggy Futures Weather Network offers an annual almanac for sale each year with information about predicted weather patterns, severe storm safety tips and a tracking chart. The finished product sells for $35 with a variable cost per unit of $21. The company has operating costs of $1,050,000.

What is the firm’s breakeven point in units? a. 75,000 b. 50,000 c. 80,000 d. 65,000 ANS: A Solution: 1,050,000 / (35 - 21) = 75,000 PTS: 1 OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Algebraic breakeven analysis

NAT: Analytic skills

12. The Foggy Futures Weather Network offers an annual almanac for sale each year with information about predicted weather patterns, severe storm safety tips and a tracking chart. The finished product sells for $35 with a variable cost per unit of $21. The company has operating costs of $1,050,000.

What is the firm’s breakeven point in dollars? a. $1,750,000 b. $4,670,000 c. $2,625,000 d. $3,875,566 ANS: C Solution: 1,050,000 / (31-21) = 75,000 units 75,000 X 35 = $2,625,000 PTS: 1 OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital

NAT: Analytic skills TOP: Cash breakeven point

13. The Foggy Futures Weather Network offers an annual almanac for sale each year with information about predicted weather patterns, severe storm safety tips and a tracking chart. The finished product sells for $35 with a variable cost per unit of $21. The company has operating costs of $1,050,000.

Using 100,000 units as a base, what is the degree of operating leverage? a. 6.2 b. 5.7 c. 7.9 d. 4.0

ANS: D PTS: 1 NAT: Analytic skills TOP: DOL and breakeven analysis

OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital

14. The Foggy Futures Weather Network offers an annual almanac for sale each year with information about predicted weather patterns, severe storm safety tips and a tracking chart. The finished product sells for $35 with a variable cost per unit of $21. The company has operating costs of $1,050,000.

What is the probability of the firm having operating losses if the firm has a standard deviation of 4,000 units and the firm expects to sell 80,000 almanacs? (A normal distribution table - Table V - must accompany this problem) a. 10.56% b. 11.12% c. 14.92% d. 13.57% ANS: A 1,050,000/ (35-21) = 75,000 units 75,000 - 80,000 4,000

= -1.25

Using Table V the probability is 10.56% PTS: 1 OBJ: TYPE: Fact NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis and risk assessment 15. Bouncy Bungee Rubber Band Company is trying to determine its probability of incurring a loss. Its fixed costs are $2,760,000 per year, it sells its rubber bands for $3.75 per pack and the variable cost of these packs is $.75. They estimate they will sell 1,000,000 packs this year and they have a standard deviation of 40,000 units. (A normal distribution table - Table V - must accompany this problem). a. 3.22% b. 6.71% c. 5.48% d. 2.87% ANS: C Solution: 2,760,000 / (3.75 - .75) = 920,000 920,000 - 1,000,000 40,000

= 1.6

Using Table V the probability is 5.48% PTS: 1 OBJ: TYPE: Fact NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis and risk assessment 16. Kettle of Fish Hatcheries provides a stocked pond for fishing enthusiasts. They have fixed costs of $525,000, they charge $50 per person for pond access and the variable costs of stocking the pond average about $15 per person. How many people need to fish the pond annually to break even? a. 45,000 b. 15,000

c. 32,000 d. 10,000 ANS: B PTS: 1 NAT: Analytic skills TOP: Algebraic breakeven analysis

OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital

17. What is the breakeven point for Rough and Tough Clothiers, makers of heavy duty dungarees? They have the following costs: raw materials: $15 per pair labor costs : $ 8 per pair commissions: $ 2 per pair utilities: $50,000 rent: $96,000 taxes: $30,000 salaries: $150,000 The price of the dungarees is $55 per pair.

a. b. c. d.

13,040 32,600 25,000 17,650

ANS: B Solution: Fixed costs = $50,000 + $96,000 + $30,000 + $150,000 = $326,000 Variable costs = $15 + $8 + $2 = $25 326,000 55 - 25

=

PTS: 1 OBJ: TYPE: E Prob LOC: Knowledge of capital budgeting and cost of capital TOP: Algebraic breakeven analysis

NAT: Analytic skills

ESSAY 1. What are the possible uses for breakeven analysis?

ANS: Breakeven analysis can be used for: 1. forecasting the profitability for a firm, division, or product line, given a cost structure and expected sales level.

2. analyzing the impact of changes in fixed costs, variable costs and selling price on operating profits.

3. analyzing the impact of substituting fixed costs for variable costs in a production process.

4. analyzing the profit impact of a firm’s restructuring efforts designed to cut fixed costs.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Breakeven analysis 2. List the limitations of breakeven analysis:

ANS: Breakeven analysis makes certain assumptions: 1. that the selling price and variable costs stay constant 2. that all costs are classified as either fixed or variable.

3. that the firm is producing and selling a single product or a constant mix of different products.

4. that all costs - fixed costs, variable costs and selling price - are know at each level of output.

5. that the analysis is done for a time frame of one year or less.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking LOC: Knowledge of capital budgeting and cost of capital TOP: Some limitations of breakeven analysis

Appendix 20B—BOND REFUNDING ANALYSIS MULTIPLE CHOICE 1. In a bond refunding analysis, the principal benefit, or cash inflow, is the present value of the a. pretax interest savings over the life of the issue b. aftertax flotation cost savings c. aftertax interest savings over the life of the issue d. aftertax call premium ANS: C PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding analysis

2. In a bond refunding analysis, the net investment calculation includes a. aftertax call premium b. flotation cost of new debt c. overlapping interest d. all of the above ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding analysis

3. Bond refunding occurs when a company redeems a callable issue and a. sells an equity issue, thereby reducing outstanding debt b. sells a new issue with a lower coupon rate c. sells a preferred issue with a low dividend rate d. none of the above is correct ANS: B PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding analysis

4. In bond refunding analysis the _____ is believed to be the most appropriate discount rate. a. after-tax cost of new debt b. firm's marginal cost of capital c. weighted average cost of capital d. both b and c ANS: A PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding analysis

5. Bond _____ occurs when a firm exercises its option to redeem a callable bond issue and replaces it with a lower (interest) cost issue.

a. b. c. d.

redemption retirement recall refunding

ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding

6. If Alliant can issue a $110 million 20-year refunding bond at 7.45% and call an older $110 million issue with 20-years to maturity that had a coupon of 8.80%, what is the present value of the interest savings? Assume a 40% tax rate. a. $11,620,259 b. $17,820,000 c. $ 9,117,935 d. $29,561,100 ANS: A Solution: Old interest = $110(.088).6 New interest=$110(.0745).6

=$5.808 million =$4.917 $ .891 million

PV = $891,000(PVIFA.0447.20) =$11,620,259 (by calculator) N= 20 I = 7.45 x .6 Pmt = 891,000 PV = $11,620,259.03 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond refunding 7. Demetres is refunding an outstanding $75 million, 9.35% debenture with a $75 million 7.80% debenture. Both issues will be outstanding for a 3-week period. If Demetres' marginal tax rate is 40%, what is the overlapping interest? a. $337,500 b. $242,740 c. $404,567 d. $202,500 ANS: B Solution: Overlapping interest = $75(.0935)(.6)(3/52) = $242,740 PTS: 1 OBJ: TYPE: E. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Overlapping interest 8. Wood River Power Company is considering refunding a $100 million 12% coupon debenture issue with a 9% coupon, 20-year debenture. The 12% issue also matures in 20 years and is now callable at 109% of par. The unamortized flotation cost on the old issue is $360,000 and the flotation cost of the new issue is 0.775%. Wood River estimated that there would be a 4 week period where both bonds would be outstanding. The company has a weighted cost of capital of 11% and a 40% marginal tax rate. Should Wood River sell the refunding issue? (Note: PVIFA0.054,20 = 12.050) a. yes, NPV is approximately $15.21 million b. yes, NPV is approximately $9.86 c. yes, NPV is approximately 6.485 million

d. No, NPV is negative $0.554 million ANS: A Solution: Interest saved = $100(0.03)(0.6) = $1.8 million per year PV interest saved = $1.8(12.050) = $21.69 million A.T. call premium = $100(0.09)(0.6) = $5.4 million PV flotation cost = $100(0.00775) - ($0.775/20)(0.4)(12.050) = $0.588 million PV flotation, old issue = ($0.360/20)(0.4)12.050 - $0.360(0.4) = $0.0572 million Overlapping interest after-tax = $100(0.072)(4/52) = $0.554 million Net investment = $5.4 + $0.588 - $0.0572 + $0.554 = $6.485 million NPV of refunding = $21.69 - $6.485 = $15.21 million PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond refunding analysis 9. Clinch River Power is considering refunding a $150 million 12% coupon bond with a 10% coupon bond, 20 year bond. The current bond also matures in 20 years and is now callable at 110% of par. The unamortized flotation cost on the old issue is $540,000 and the flotation cost of the new issue is 0.925%. Clinch River estimates that there would be a 4 week period where both bonds would be outstanding. The company has a weighted cost of capital of 11% and a 40% marginal tax rate. Should Clinch River sell the refunding issue? a. Yes, NPV is approximately $9.838 million b. Yes, NPV is approximately $9.930 million c. Yes, NPV is approximately $9.655 million d. Yes, NPV is approximately $10.808 million ANS: A Solution: PV Interest saved = $150(0.02)(0.6)(11.47) A.T. call premium = $150(0.10)(0.6) PV flotation = $150(0.00925) - ($1.3875/20) (0.4)(11.47) PV, old issue = ($0.54/20)(0.4)(11.47) - $0.54(0.4) Overlapping interest = $150(0.072)(4/52) Net investment NPV of refunding = $20,646,000 - 10,807,853

$20,646,000 $ 9,000,000 1,069,208 -92,124 830,769 $10,807,853 $ 9,838,147

PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond refunding analysis 10. Cutech issued a $150 million of a 20-year, 10.5% debt 5 years ago. Since then Cutech's financial conditions have improved and management believes that they could refund the old issue with a new 15-year, 7.5% issue. The old debt is now callable at 104 percent of par and issuance costs on the new issue would be 0.6 percent. The unamortized issuance costs on the old issue are $675,000. If Cutech calls the old issue and refunds it, both issues would be outstanding for a two-week period. If the company's marginal tax rate is 40%, should Cutech refund the old issue? a. Yes, NPV = $43,645,599 b. Yes, NPV = $43,798,975 c. Yes, NPV = $44,364,538 d. No, NPV is negative ANS: B Solution: Old interest = $150(.105) New interest =$150(.075)

= $15.75 million = 11.25

Interest saved

$ 4.50 million

PV of savings = $4.50(PVIFA,045.15)=$48,328 million Call premium = $6(1-.4) = $3.6 million PV issuance = 900,000 - (900,000/15)(.4)(PVIFA,045.15) =900,000 - 257,749 = $642,251 PV old issuance = (675,000/15)(.4)(PVIFA) - 675,000(.4) =193,312 - 270,000 = -$76,688 Overlapping int.= $150(.063)(2/52) = $363,462 Net investment = 3,600,000 + 642,251 - 76,688 + 363,462 = 4,529,025 NPV refunding = 48,328,000 - 4,529,025 = $43,798,975 PTS: 1 OBJ: TYPE: C. Prob.

NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond refunding 11. In considering the bond refunding analysis, which of the following statements is/are correct?

I. The marginal rate of return is used as the discount rate II. Bond refunding is most prevalent during a period of high inflation. a. I only b. II only c. Both I and II d. Neither I nor II ANS: D PTS: 1 LOC: Understand stocks and bonds

OBJ: TYPE: Fact NAT: Reflective thinking TOP: Bond refunding

12. Waste Deep Disposal Services are considering refunding a $525,000,000 bond issue. The old bonds have a 7.25% coupon rate. The new bonds will have a 6% coupon rate. Both issues will be outstanding for about four weeks. What is the overlapping interest if the company is in the 38% tax bracket (rounded)? a. $1,517,465 b. $1,815,288 c. $1,357,642 d. $1,225,427 ANS: B 525,000,000(.0725)(.62)(4/52) =$1,815,288.46 PTS: 1 OBJ: TYPE: E Prob NAT: Analytic skill LOC: Understand stocks and bonds TOP: Bond refunding analysis 13. Midget Digit Toe Doctors is planning to refund a 30 year bond issue. They will replace $1,500,000 of 10.25% bonds with 6.25% bonds. The firm is in the 40% tax bracket. What is the savings on the refunding? a. $515,100 b. $646,310 c. $725,600 d. $815,170 ANS: B Solution: Old issue New issue

1,500,000(.1025)(.6) 1,500,000(.0625)(.6)

$92,250 $56,250 $36,250

Using a calculator: N = 30 I = 6.25 x .6 Pmt = 36,250 PV = $646,310.14 PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills LOC: Understand stocks and bonds TOP: Bond refunding analysis ESSAY 1. Why would a corporation consider bond refunding?

ANS: Bond refunding occurs when a company exercises its option to redeem a callable issue and sells a lower-cost issue to take its place. The decision to refund is based on capital budgeting analysis If the present value of the after-tax interest savings over the life of the issue exceeds the cash outflow at the time of refunding, principally consisting of the call premium and flotation costs, then the corporation generally decides in favor of refunding. Bond refunding becomes important when interest rates decline substantially from earlier levels.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Bond refunding

2. What is the principal inflow and what is the principal outflow from a bond refunding situation?

ANS: Bond refunding is usually considered based on capital budgeting analysis. Bond refunding has a principal inflow which is the present value of the after-tax interest savings over the like of the issue. The principal outflow consists of primarily of the call premium and the issuance or flotation costs of the new debt.

PTS: 1 OBJ: TYPE: Fact LOC: Understand stocks and bonds

NAT: Reflective thinking TOP: Bond refunding analysis