Test Bank for Fundamentals of Financial Management 17th Edition By Eugene Brigham, Joel Houston (All

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in multiple-choice questions.

Multiple Choice: True/False 1. In most corporations, the CFO ranks under the CEO. a. True b. False ANSWER: True 2. The Chairman of the Board must also be the CEO. a. True b. False ANSWER: False 3. The board of directors is the highest-ranking body in a corporation, and the chairman of the board is the highest-ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but they can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. a. True b. False ANSWER: True 4. Partnerships and proprietorships generally have a tax advantage over corporations. a. True b. False ANSWER: True 5. A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to personal liabilities in the event of bankruptcy than are investors in a typical partnership. a. True b. False ANSWER: False 6. An advantage of the corporate form of organization is that corporations are generally less highly regulated than proprietorships and partnerships. a. True b. False ANSWER: False 7. Some partners in a partnership may have different rights, privileges, and responsibilities than other partners. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management 8. One advantage of the corporate form of organization is that it avoids double taxation. a. True b. False ANSWER: False 9. It is generally harder to transfer one's ownership interest in a partnership than in a corporation. a. True b. False ANSWER: True 10. One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt.

This problem would be avoided if you formed a corporation to operate the business. a. True b. False ANSWER: True 11. If a corporation elects to be taxed as an S corporation, then it can avoid the corporate tax. However, its stockholders will have to pay personal taxes on the firm's net income. a. True b. False ANSWER: True 12. If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. a. True b. False ANSWER: False 13. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required. a. True b. False ANSWER: False 14. The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation. a. True b. False ANSWER: True 15. One disadvantage of forming a corporation rather than a partnership is that this makes it more difficult for the firm's investors to transfer their ownership interests. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management 16. Organizing as a corporation makes it easier for the firm to raise capital. This is because corporations' stockholders are not subject to personal liabilities if the firm goes bankrupt and also because it is easier to transfer shares of stock than partnership interests. a. True b. False ANSWER: True 17. In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price in the long run, or the stock's "intrinsic value." a. True b. False ANSWER: True 18. If management operates in a manner designed to maximize the firm's expected profits for the current year, this will also maximize the stockholders' wealth as of the current year. a. True b. False ANSWER: False 19. In order to maximize its shareholders' value, a firm's management must attempt to maximize the expected EPS. a. True b. False ANSWER: False 20. In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price on a specific target date. a. True b. False ANSWER: False 21. As a result of financial scandals occurring during the past decade, there has been a strong push to improve business ethics. a. True b. False ANSWER: True 22. There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to banks and to stockholders. It is illegal to provide such information to banks, but it is not illegal to provide it to stockholders because they are the owners of the firm, not outsiders. a. True b. False ANSWER: False 23. A stock's market price would equal its intrinsic value if all investors had all the information that is available about the stock. In this case, the stock's market price would equal its intrinsic value. a. True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management b. False ANSWER: True 24. If a stock's market price is above its intrinsic value, then the stock can be thought of as being undervalued, and it would be a good buy. a. True b. False ANSWER: False 25. If a stock's intrinsic value is greater than its market price, then the stock is overvalued and should be sold. a. True b. False ANSWER: False 26. For a stock to be in equilibrium as the book defines it, its market price should exceed its intrinsic value. a. True b. False ANSWER: False 27. The term "marginal investor" means an investor who is active in the market and would tend to buy a stock if its price fell and sell it if it rose, barring any new information coming out about the stock. It is the "marginal investor" who determines the actual stock price. a. True b. False ANSWER: True 28. Managers always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible. a. True b. False ANSWER: False 29. A hostile takeover is said to occur when another corporation or group of investors gains voting control over a firm and replaces the old managers. If the old managers were managing the firm inefficiently, then hostile takeovers can improve the economy. However, hostile takeovers are controversial, and legislative actions have been taken to make them more difficult to undertake. a. True b. False ANSWER: True 30. If a lower-level person in a firm does something illegal, like "cooking the books" to understate costs and thereby increase profits above the correct profits because they were told to do so by a superior, the lower-level person cannot be prosecuted, but the superior can be prosecuted. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management 31. If someone deliberately understates costs and thereby increases profits, this can cause the stock price to rise above its intrinsic value. The stock price will probably fall in the future. Also, those who participated in the fraud can be prosecuted, and the firm itself can be penalized. a. True b. False ANSWER: True 32. If a firm's board of directors wants to maximize value for its stockholders in general (as opposed to some specific stockholders), it should design an executive compensation system whose focus is on the firm's long-term value. a. True b. False ANSWER: True 33. Because of the complexity of accounting, there is no need for accounting students to also know about finance. a. True b. False ANSWER: False Multiple Choice: Conceptual Please note that some of the answer choices, or answers that are very close, are used in different questions. This has caused us no difficulties, but please take this into account when you make up exams.

34. Which of the following statements is CORRECT? a. One of the disadvantages of incorporating your business is that you could become subject to the firm's liabilities in the event of bankruptcy. b. Proprietorships are subject to more regulations than corporations. c. In any partnership, every partner has the same rights, privileges, and liability exposure as every other partner. d. Corporations of all types are subject to the corporate income tax. e. Proprietorships and partnerships generally have a tax advantage over corporations.

ANSWER: e 35. Which of the following statements is CORRECT? a. One of the advantages of the corporate form of organization is that it avoids double taxation. b. It is easier to transfer one's ownership interest in a partnership than in a corporation. c. One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability. d. One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote." e. Corporations of all types are subject to the corporate income tax.

ANSWER: c 36. Which of the following statements is CORRECT? a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management b. Corporations face fewer regulations than proprietorships. c. One disadvantage of operating a business as a proprietor is that the firm is subject to double taxation because taxes are levied at both the firm level and the owner level. d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required. e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of their investment in the business.

ANSWER: a 37. Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business into a corporation.

Which of the following statements is CORRECT? a. Relaxant's shareholders (the ex-partners) will now be exposed to less liability. b. The company will probably be subject to fewer regulations and required disclosures. c. Assuming the firm is profitable, none of its income will be subject to federal income taxes. d. The firm's investors will be exposed to less liability, but they will find it more difficult to transfer their ownership. e. The firm will find it more difficult to raise additional capital to support its growth.

ANSWER: a 38. Which of the following statements is CORRECT? a. Corporations generally face fewer regulations than proprietorships. b. Corporate shareholders are exposed to unlimited liability. c. It is usually easier to transfer ownership in a corporation than in a partnership. d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. e. There is a tax disadvantage to incorporation, and there is no way any corporation can escape this disadvantage, even if it is very small.

ANSWER: c 39. Which of the following could explain why a business might choose to operate as a corporation rather than as a proprietorship or a partnership? a. Corporations generally face fewer regulations. b. Less of a corporation's income is generally subject to federal taxes. c. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. d. Corporate investors are exposed to unlimited liability. e. Corporations generally find it easier to raise large amounts of capital.

ANSWER: e 40. The primary operating goal of a publicly owned firm interested in serving its stockholders should be to a. maximize its expected total corporate income. b. maximize its expected EPS. c. minimize the chances of losses. d. maximize the stock price per share over the long run, which is the stock's intrinsic value. e. maximize the stock price on a specific target date.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management ANSWER: d 41. Which of the following statements is CORRECT? a. In most corporations, the CFO ranks above the CEO. b. By law in most states, the chairman of the board must also be the CEO. c. The board of directors is the highest-ranking body in a corporation, and the chairman of the board is the highest-ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but they can endeavor to have the board voted out and a new board voted in should a conflict arise.

It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller. e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but they are not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

ANSWER: c 42. Which of the following statements is CORRECT? a. One drawback of forming a corporation is that it generally subjects the firm to additional regulations. b. One drawback of forming a corporation is that it subjects the firm's investors to increased personal liabilities. c. One drawback of forming a corporation is that it makes it more difficult for the firm to raise capital. d. One advantage of forming a corporation is that it subjects the firm's investors to fewer taxes. e. One disadvantage of forming a corporation is that it is more difficult for the firm's investors to transfer their ownership interests.

ANSWER: a 43. Which of the following statements is CORRECT? a. If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. b. The more capital a firm is likely to require, the smaller the probability that it will be organized as a corporation. c. It is generally easier to transfer one's ownership interest in a partnership than in a corporation. d. One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business. e. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

ANSWER: d 44. Which of the following statements is CORRECT? a. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations. b. Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over proprietorships and partnerships.

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management c. Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment. d. Large corporations are taxed more favorably than proprietorships. e. Corporate stockholders are exposed to unlimited liability.

ANSWER: c 45. Which of the following statements is CORRECT? a. A hostile takeover is the main method of transferring ownership interest in a corporation. b. A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers. c. Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization. d. Limited liability is an advantage of the corporate form of organization to its owners (stockholders), but corporations have more trouble raising money in financial markets because of the complexity of this form of organization. e. Although the stockholders of the corporation are insulated by limited legal liability, the legal status of the corporation does not protect the firm's managers in the same way, i.e., bondholders can sue the firm’s managers if the firm defaults on its debt.

ANSWER: b 46. Which of the following statements is CORRECT? a. In a typical partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. b. In a limited partnership, the limited partners have voting control, while the general partner has operating control over the business, and the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. c. A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster-growing company. d. Partnerships have more difficulty attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests. e. A major disadvantage of a partnership relative to a corporation is the fact that federal income taxes must be paid by the partners rather than by the firm itself.

ANSWER: d 47. The primary operating goal of a publicly owned firm trying to best serve its stockholders should be to a. maximize managers' own interests, which are, by definition, consistent with maximizing shareholders' wealth. b. maximize the firm's expected EPS, which must also maximize the firm's price per share. c. minimize the firm's risks because most stockholders dislike risk. In turn, this will maximize the firm's stock price. d. maximize the long-run value of a public company’s common stock. e. maximize the intrinsic value of a company’s stock.

ANSWER: d 48. Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management shareholders? a. Decrease the use of restrictive covenants in bond agreements. b. Take actions that reduce the possibility of a hostile takeover. c. Elect a board of directors that allows managers greater freedom of action. d. Offer reasonable compensation packages, fire poorly performing managers, and avoid the threat of hostile takeovers. e. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock.

ANSWER: d 49. Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders? a. The percentage of executive compensation that comes in the form of cash is increased, and the percentage coming from long-term stock options is reduced. b. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. c. The company offers effective compensation plans that include useful motivational tools. d. The firm's founder, who is also president and chairman of the board, sells 90% of their shares. e. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval.

ANSWER: c 50. Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders? a. Compensating managers with stock options b. Financing risky projects with additional debt c. The threat of hostile takeovers d. The use of covenants in bond agreements that limit the firm’s use of additional debt and constrain managers’ actions e. Abolishing the Security and Exchange Commission ANSWER: d 51. Which of the following actions would be most likely to reduce potential conflicts between stockholders and bondholders? a. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders) b. Compensating managers with more stock options and less cash income c. The passage of laws that make it harder for hostile takeovers to succeed d. A government regulation that banned the use of convertible bonds e. The firm begins to use only long-term debt, e.g., debt that matures in 30 years or more, rather than debt that matures in less than one year ANSWER: a 52. Which of the following statements is CORRECT? a. If a lower-level person in a firm does something illegal, like "cooking the books" to understate costs and thereby artificially increase profits because they were ordered to do so by a superior, the lower-level person Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management cannot be prosecuted, but the superior can be prosecuted. b. There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders because they are the owners of the firm. c. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. d. Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business. e. Ethics is not an important consideration in business and in business schools.

ANSWER: c 53. With which of the following statements would most people in business agree? a. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. b. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. c. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. d. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. e. It is useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.

ANSWER: e 54. Which of the following statements is CORRECT? a. One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. b. The threat of takeover generally increases potential conflicts between stockholders and managers. c. Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. d. The threat of takeovers tends to reduce potential conflicts between stockholders and managers. e. The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders.

ANSWER: d 55. Which of the following statements is CORRECT? a. Corporations are taxed more favorably than proprietorships. b. Corporations have unlimited liability. c. Because of their size, large corporations face fewer regulations than smaller corporations and proprietorships. d. Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interests. e. Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders.

ANSWER: e 56. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management a. A good goal for a firm's management is the maximization of expected EPS. b. Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment. c. Conflicts can exist between stockholders and managers, but potential conflicts are reduced by the possibility of hostile takeovers. d. Corporations and partnerships have an advantage over proprietorships because a proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited. e. For a stock to be in equilibrium, its intrinsic value must be greater than the actual market price.

ANSWER: c 57. Which of the following statements is CORRECT? a. One disadvantage of organizing a business as a corporation rather than a partnership is that the equity investors in a corporation are exposed to unlimited liability. b. Using restrictive covenants in debt agreements is an effective way to reduce conflicts between stockholders and managers. c. Managers generally welcome hostile takeovers since the "raider" generally offers a price for the stock that is higher than the price before the takeover action started. d. The Sarbanes-Oxley Act of 2002 penalized executives who signed financial statements that later turned out to be false. e. Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment.

ANSWER: d 58. Which of the following statements is CORRECT? a. Well-designed bond covenants are useful for reducing potential conflicts between stockholders and managers. b. The bid price in a hostile takeover is generally above the price before the takeover attempt is announced because, otherwise, there would be no incentive for the stockholders to sell to the hostile bidder, and the takeover attempt would probably fail. c. Stockholders in general would be better off if managers never disclosed favorable events and, therefore, caused the price of the firm's stock to sell at a price below its intrinsic value. d. Takeovers are most likely to be attempted if the target firm's stock price is above its intrinsic value. e. The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden.

ANSWER: b 59. Which of the following statements is CORRECT? a. Hostile takeovers are most likely to occur when a firm's stock is selling below its intrinsic value as a possible result of poor management. b. The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden. c. The managers of established, stable companies sometimes attempt to get their state legislatures to remove rules that make it more difficult for raiders to succeed with hostile takeovers. d. In general, it is more in bondholders' interests than stockholders' interests for a firm to shift its investment focus away from safe, stable investments and into risky investments, especially those that primarily involve research and development. e. Stockholders in general would be better off if managers never disclosed favorable events and, therefore, Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management caused the price of the firm's stock to sell at a price below its intrinsic value.

ANSWER: a 60. Which of the following statements is CORRECT? a. One disadvantage of operating as a corporation rather than as a partnership is that corporate shareholders are exposed to more personal liability than are partners. b. Relative to proprietorships, corporations generally face fewer regulations, and they also find it easier to raise capital. c. There is no good reason to expect a firm's stockholders and bondholders to react differently to the types of assets in which it invests. d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns. e. Stockholders in general would be better off if managers never disclosed favorable events and, therefore, caused the price of the firm's stock to sell at a price below its intrinsic value.

ANSWER: d 61. Which of the following statements is CORRECT? a. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high-risk/high-return projects rather than low-risk/low-return projects. b. Since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. However, they do share in the losses if risky projects fail and drive the firm into bankruptcy.

Therefore, bondholders generally prefer to see corporate managers invest in low-risk/low-return projects rather than high-risk/high-return projects. c. One advantage of operating a business as a corporation is that stockholders can deduct their pro rata share of the taxes the firm pays, thereby eliminating the double taxation investors would face in a partnership. d. One drawback of forming a corporation is that you lose the limited liability that you would otherwise receive as a proprietor. e. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

ANSWER: b 62. Which of the following statements is CORRECT? a. Corporations face few regulations and more favorable tax treatment than do proprietorships and partnerships. b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value compared to managers who do not face the threat of hostile takeovers. c. Bond covenants are an effective way to resolve conflicts between shareholders and managers. d. Because of their simplified organization, it is easier for proprietors and partnerships to raise large amounts of outside capital than it is for corporations. e. One advantage to forming a corporation is that the owners of the firm have limited liability.

ANSWER: e 63. Which of the following departments in a company would most likely be evaluating proposed decisions and analyzing how those decisions may affect stock price? a. Accounting b. Marketing Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management c. Human Resources d. Legal e. Finance ANSWER: e 64. Which specific type of corporation recognizes the broader needs of society by putting employees, customers, and the community on equal footing with shareholders? a. S Corporation b. C Corporation c. Closed Corporation d. B Corporation e. Limited Liability Corporation ANSWER: d Multiple Choice: Problems 65. New Business is just being formed by 10 investors, each of whom will own 10% of the business. The firm is expected to earn $1,500,000 before taxes each year. The corporate tax rate is 34% and the personal tax rate for the firm's investors is 35%. The firm does not need to retain any earnings, so all of its after-tax income will be paid out as dividends to its investors. The investors will have to pay personal taxes on whatever they receive. How much additional spendable income will each investor have if the business is organized as a partnership rather than as a corporation? a. $33,150 b. $33,482 c. $30,830 d. $32,156 e. $39,117 ANSWER: a 66. Assume that the corporate tax rate is 34% and the personal tax rate is 32%. The founders of a newly formed business are debating between setting up the firm as a partnership versus a corporation. The firm will not need to retain any earnings, so all of its after-tax income will be paid out to its investors, who will have to pay personal taxes on whatever they receive. What is the difference in the percentage of the firm's pre-tax income that investors actually receive and can spend under the corporate and partnership forms of organization? a. 22.20% b. 23.12% c. 26.13% d. 19.19% e. 19.42% ANSWER: b 67. Charleston Corporation (CC) now operates as a "regular" corporation, but it is considering a switch to S Corporation status. CC is owned by 100 stockholders who each hold 1% of the stock, and each faces a personal tax rate of 35%. The firm earns $2,000,000 per year before taxes, and since it has no need for retained earnings, it pays out all of its earnings as dividends. Assume that the corporate tax rate is 34% and the personal tax rate is 35%. How much more (or less) spendable income would each stockholder have if the firm elected S Corporation status?

Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 1 - An Overview of Financial Management a. $4,774 b. $4,376 c. $4,420 d. $4,597 e. $4,641 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions True / False Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in multiple-choice questions.

Multiple Choice: True/False 1. A financial intermediary is a corporation that takes funds from investors and then provides those funds to those who need capital. A bank that takes in demand deposits and then uses that money to make long-term mortgage loans is one example of a financial intermediary. a. True b. False ANSWER: True 2. The NYSE is defined as a "spot" market purely and simply because it has a physical location. The NASDAQ, on the other hand, is not a spot market because it has no one central location. a. True b. False ANSWER: False 3. The NYSE is defined as a "primary" market because it is one of the largest and most important stock markets in the world. a. True b. False ANSWER: False 4. Primary markets are large and important, while secondary markets are smaller and less important. a. True b. False ANSWER: False 5. Private markets are those like the NYSE, where transactions are handled by members of the organization, while public markets are those like the NASDAQ, where anyone can make transactions. a. True b. False ANSWER: False 6. A share of common stock is not a derivative, but an option to buy the stock is a derivative because the value of the option is derived from the value of the stock. a. True b. False ANSWER: True 7. Financial institutions are more diversified today than they were in the past, when federal laws kept investment banks, commercial banks, insurance companies, and similar organizations quite separate. Today, the larger financial services corporations offer a variety of services, ranging from checking accounts, to insurance, to underwriting securities, to stock Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions brokerage. a. True b. False ANSWER: True 8. Hedge funds are somewhat similar to mutual funds. The primary differences are that hedge funds are less highly regulated, have more flexibility regarding what they can buy, and restrict their investors to wealthy, sophisticated individuals and institutions. a. True b. False ANSWER: True 9. Trades on the NYSE are generally completed by having a brokerage firm acting as a "dealer" buying securities and adding them to its inventory or selling from its inventory. The NASDAQ, on the other hand, operates as an auction market, where buyers offer to buy and sellers to sell, and the price is negotiated on the floor of the exchange. a. True b. False ANSWER: False 10. The "over-the-counter" market received its name years ago because brokerage firms would hold inventories of stocks and then sell them by literally passing them over the counter to the buyer. a. True b. False ANSWER: True 11. If you decide to buy 100 shares of Google, you would probably do so by calling your broker and asking them to execute the trade for you. This would be defined as a secondary market transaction, not a primary market transaction. a. True b. False ANSWER: True 12. The term IPO stands for "individual purchase order," as when an individual (as opposed to an institution) places an order to buy a stock. a. True b. False ANSWER: False 13. In a "Dutch auction" for new stock, individual investors place bids for shares directly. Each potential bidder indicates the price they are willing to pay and how many shares they will purchase at that price. The highest price that permits the company to sell all the shares it wants to sell is determined, and this is the "market clearing price." All bidders who specified this price or higher are allowed to purchase their shares at the market clearing price. a. True b. False ANSWER: True 14. When a corporation's shares are owned by a few individuals who are associated with the firm's management, we say Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions that the stock is closely held. a. True b. False ANSWER: True 15. A publicly owned corporation is a company whose shares are held by the investing public, which may include other corporations as well as institutional investors. a. True b. False ANSWER: True 16. If you wanted to know what rate of return stocks have provided in the past, you could examine data on the Dow Jones Industrial Index, the S&P 500 Index, or the NASDAQ Index. a. True b. False ANSWER: True 17. The price at which a stock would sell if investors had all knowledge and information about a stock is known as its market price. a. True b. False ANSWER: False 18. When the market price of a stock is close to its intrinsic value, the market is said to be efficient. a. True b. False ANSWER: True Multiple Choice Multiple Choice: Conceptual 19. You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion, your brother gave you a check for the stock, and you gave your brother the stock certificates. Which of the following best describes this transaction? a. This is an example of a direct transfer of capital. b. This is an example of a primary market transaction. c. This is an example of an exchange of physical assets. d. This is an example of a money market transaction. e. This is an example of a derivative market transaction.

ANSWER: a 20. Which of the following statements is CORRECT? a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift. c. Capital market instruments include both long-term debt and common stocks. d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction. e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

ANSWER: c 21. Which of the following is a primary market transaction? a. You sell 200 shares of IBM stock on the NYSE through your broker. b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker; you just give him cash, and he gives you the stock. c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker. d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction. e. IBM sells 2,000,000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

ANSWER: c 22. Which of the following is an example of a capital market instrument? a. Commercial paper b. Preferred stock c. U.S. Treasury bills d. Banker's acceptances e. Money market mutual funds ANSWER: b 23. Money markets are markets for a. foreign currencies. b. consumer automobile loans. c. common stocks. d. long-term bonds. e. short-term debt securities, such as Treasury bills and commercial paper.

ANSWER: e 24. Which of the following statements is CORRECT? a. If you purchase 100 shares of Disney stock from your brother-in-law, this is an example of a primary market transaction. b. If Disney issues additional shares of common stock through an investment banker, this would be a secondary market transaction. c. The NYSE is an example of an over-the-counter market. d. Only institutions, and not individuals, can engage in derivative market transactions. e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions ANSWER: e 25. You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of: a. a money market transaction. b. a primary market transaction. c. a secondary market transaction. d. a futures market transaction. e. an over-the-counter market transaction.

ANSWER: c 26. Which of the following statements is CORRECT? a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States. b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia. c. Hedge funds have more in common with investment banks than with any other type of financial institution. d. Hedge funds have more in common with commercial banks than with any other type of financial institution. e. Hedge funds are not as highly regulated as most other types of financial institutions. The justification for this light regulation is that only "sophisticated" investors (i.e., those with high net worths and high incomes) are permitted to invest in these funds, and these investors supposedly can do any necessary "due diligence" on their own rather than have it done by the SEC or some other regulator.

ANSWER: e 27. Which of the following statements is CORRECT? a. While the distinctions are becoming blurred, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties. b. The NYSE operates as an auction market, whereas NASDAQ is an example of a dealer market. c. Money market mutual funds usually invest their money in a well-diversified portfolio of liquid common stocks. d. Money markets are markets for long-term debt and common stocks. e. A liquid security is a security whose value is derived from the price of some other "underlying" asset.

ANSWER: b 28. Which of the following statements is CORRECT? a. The New York Stock Exchange is an auction market, and it has a physical location. b. Home mortgage loans are traded in the money market. c. If an investor sells shares of stock through a broker, then it would be a primary market transaction. d. Capital markets deal only with common stocks and other equity securities. e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

ANSWER: a 29. Which of the following statements is CORRECT? a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public. b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell.

The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay. d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed. e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

ANSWER: c 30. Which of the following statements is CORRECT? a. The most important difference between spot markets versus futures markets is the maturity of the instruments that are traded. Spot market transactions involve securities that have maturities of less than one year, whereas futures markets transactions involve securities with maturities greater than one year. b. Capital market transactions involve only preferred stock or common stock. c. If General Electric were to issue new stock this year, this would be considered a secondary market transaction since the company already has stock outstanding. d. Both NASDAQ dealers and "specialists" on the NYSE hold inventories of stocks. e. Money market transactions do not involve securities denominated in currencies other than the U.S. dollar.

ANSWER: d 31. Which of the following statements is NOT CORRECT? a. When a corporation's shares are owned by a few individuals, we say that the firm is "closely, or privately, held." b. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. c. The stock of publicly owned companies must generally be registered with and reported to a regulatory agency such as the SEC. d. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public, or an IPO," and the market for such stock is called the new issue or IPO market. e. It is possible for a firm to go public and yet not raise any additional new capital for the firm itself.

ANSWER: b 32. A stock price is said to be at equilibrium when a. the stock price is equal to its intrinsic value. b. the stock price is relatively stable until new information emerges about the company. c. the stock price is equal to its initial public offering price. d. the stock price is equal to its current price. e. the stock price sells at its par value.

ANSWER: b 33. The theory that assets are about equal to their intrinsic values is known as the: a. theory of behavioral finance. b. intrinsic markets theory. c. equilibrium markets theory.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 2 - Financial Markets and Institutions d. efficient markets hypothesis. e. effective markets hypothesis.

ANSWER: d

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes This chapter has a lot of definitions. They are important, but we don't like to make students memorize too many of them early in the course. We let our students use the formula sheet that includes the key definitions.

Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in multiple-choice questions.

Multiple Choice: True/False 1. The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and the statement of stockholders' equity. a. True b. False ANSWER: True 2. On the balance sheet, total assets must always equal the sum of total liabilities and equity. a. True b. False ANSWER: True 3. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends and the riskiness of those cash flows. a. True b. False ANSWER: True 4. Companies typically provide four basic financial statements: the fixed income statement, the current income statement, the balance sheet, and the cash flow statement. a. True b. False ANSWER: False 5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the amounts at which the assets are carried on the books. a. True b. False ANSWER: True 6. The balance sheet represents a snapshot in time, whereas the income statement reports on operations over a period of time. a. True b. False ANSWER: True 7. EBIT, often referred to as operating income, stands for "earnings before interest and taxes." a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 8. EBITDA stands for "earnings before interest, taxes, debt, and assets." a. True b. False ANSWER: False 9. Consider the following balance sheet for Games Inc. Because Games has $800,000 of retained earnings, we know that the company would be able to pay cash to buy an asset with a cost of $200,000.

Cash

$50,000

Accounts payable

$100,000

Inventory

$200,000

Accruals

$100,000

Accounts receivable

$250,000

Total CL

$200,000

Total CA

$500,000

Long-term debt

$200,000

Net fixed assets

$900,000

Common stock

$200,000

Retained earnings

$800,000

Total L & E

$1,400,000

Total assets

$1,400,000

a. True b. False ANSWER: False 10. Typically, the statement of stockholders' equity starts with total stockholders' equity at the beginning of the year, adds net income, subtracts dividends paid, and ends with total stockholders' equity at the end of the year. Over time, a profitable company will have earnings in excess of the dividends it pays out, resulting in a substantial amount of retained earnings shown on the balance sheet. a. True b. False ANSWER: True 11. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations. a. True b. False ANSWER: True 12. The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows a business is able to provide to its investors is its free cash flow. This is the reason that FCF is so important in finance. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 13. If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow. a. True b. False ANSWER: False 14. The fact that interest income received by corporations is excluded from its taxable income encourages firms to finance with more debt than they would in the absence of this tax law provision. a. True b. False ANSWER: False 15. Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm's taxes. a. True b. False ANSWER: False 16. The balance sheet measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time. a. True b. False ANSWER: False 17. Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors. a. True b. False ANSWER: False 18. Net operating working capital is equal to current assets less excess cash minus the difference between current liabilities and notes payable. a. True b. False ANSWER: True 19. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called "the bottom line." a. True b. False ANSWER: False 20. The statement of cash flows has four main sections, one each for operating, investing, and financing activities, and one that shows a summary of the cash and cash equivalents at the end of the year.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes a. True b. False ANSWER: True 21. An increase in accounts payable represents an increase in net cash provided by operating activities, an effect similar to taking out a new bank loan. However, these two items show up in different sections of the statement of cash flows to reflect the difference between operating and financing activities. a. True b. False ANSWER: True 22. An increase in accounts receivable represents an increase in net cash provided by operating activities because receivables will produce cash when they are collected. a. True b. False ANSWER: False 23. The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section is "Net Income." Then, also in the first section, we show some items that represent increases or decreases to cash, and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt. a. True b. False ANSWER: False 24. To estimate the cash flow from operations, depreciation must be added back to net income because depreciation is a non-cash charge that has been deducted from revenue in the net income calculation. a. True b. False ANSWER: True 25. Two metrics that are used to measure a company's financial performance are net income and cash flow. Accountants emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on cash flows as they do on net income. a. True b. False ANSWER: True 26. Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. If the firm has sufficient retained earnings, it can purchase assets and pay for them with cash from retained earnings. a. True b. False ANSWER: False 27. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes stockholders' claim against the firm's existing assets. Put another way, retained earnings are stockholders' reinvested earnings. a. True b. False ANSWER: True 28. In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and changes in net operating working capital. a. True b. False ANSWER: True 29. Free cash flow is the amount of cash that, if withdrawn, would harm the firm's ability to operate and to produce future cash flows. a. True b. False ANSWER: False 30. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False ANSWER: True 31. Because the U.S. tax system is a progressive tax system, a taxpayer's marginal and average tax rates are the same. a. True b. False ANSWER: False 32. The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions. a. True b. False ANSWER: True 33. The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects specific changes in accounts over that period of time. a. True b. False ANSWER: True 34. The Sarbanes-Oxley Act of 2002 was passed by Congress after the Enron and WorldCom financial statement frauds. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes ANSWER: True 35. When managers decide which capital projects to accept, they should focus on accounting income instead of cash flows. a. True b. False ANSWER: False Multiple Choice: Conceptual Please note that some of the answer choices, or answers that are very close, are used in different questions. This has caused us no difficulties, but please take this into account when you make up exams.

36. Which of the following statements is CORRECT? a. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders' equity. b. The balance sheet gives us a picture of the firm’s financial position at a point in time. c. The income statement gives us a picture of the firm’s financial position at a point in time. d. The statement of cash flows tells us how much cash the firm must pay out in interest during the year. e. The statement of cash flows tells us how much cash the firm will require during some future period, generally a month or a year.

ANSWER: b 37. Which of the following statements is CORRECT? a. Assets other than cash are expected to produce cash over time, and the amounts of cash they eventually produce should be exactly the same as the amounts at which the assets are carried on the books. b. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends and the riskiness of those cash flows. c. The annual report is an internal document prepared by a firm's managers solely for the use of its creditors/lenders. d. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders' equity. e. Prior to the Enron scandal in the early 2000s, companies would put verbal information in their annual reports along with the financial statements. That verbal information was often misleading, so today, annual reports can contain only quantitative information—audited financial statements.

ANSWER: b 38. Which of the following statements is CORRECT? a. The balance sheet for a given year is designed to give us an idea of what happened to the firm during that year. b. The balance sheet for a given year tells us how much money the company earned during that year. c. The difference between the total assets reported on the balance sheet and the liabilities reported on this statement tells us the current market value of the stockholders' equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP). d. If a company's statements were prepared in accordance with generally accepted accounting principles (GAAP), the market value of the stock equals the book value of the stock as reported on the balance sheet. e. The assets section of a typical company’s balance sheet begins with cash, then lists the assets in the order in Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes which they will probably be converted to cash, with the longest-lived assets listed last.

ANSWER: e 39. Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet? a. The company repurchases common stock. b. The company pays a dividend. c. The company issues new common stock. d. The company gives customers more time to pay their bills. e. The company purchases a new piece of equipment.

ANSWER: c 40. Which of the following items is NOT normally considered a current asset? a. Accounts receivable b. Inventory c. Bonds d. Cash e. Short-term, highly liquid, marketable securities ANSWER: c 41. Which of the following items cannot be found on a firm’s balance sheet under current liabilities? a. Accounts payable b. Short-term notes payable to the bank c. Accrued wages d. Cost of goods sold e. Accrued payroll taxes ANSWER: d 42. Which of the following statements is CORRECT? a. The focal point of the income statement is the cash account because that account cannot be manipulated by “accounting tricks.” b. The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow generally accepted accounting principles (GAAP). c. The reported income of two otherwise identical firms must be identical if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC). d. If a firm follows generally accepted accounting principles (GAAP), then its reported net income will be identical to its reported cash flow. e. The income statement for a given year is designed to give us an idea of how much the firm earned during that year.

ANSWER: e 43. Below are the 2025 and 2026 year-end balance sheets for Tran Enterprises:

Assets: Copyright Cengage Learning. Powered by Cognero.

2025

2026 Page 7

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets Liabilities and equity:

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

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

Accounts payable Notes payable to bank Total current liabilities Long-term debt Common stock Retained earnings Total common equity Total liabilities and equity

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

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

The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year, non-callable, long-term debt in 2024. As of the end of 2026, none of the principal on this debt had been repaid. Assume that the company’s sales in 2025 and 2026 were the same. Which of the following statements must be CORRECT? a. The firm increased its short-term bank debt in 2026. b. The firm issued long-term debt in 2026. c. The firm issued new common stock in 2026. d. The firm repurchased some common stock in 2026. e. The firm had negative net income in 2025.

ANSWER: c 44. Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets:

Common stock Retained earnings Total common equity

2026 2,000 2,000 $4,000

2025 1,000 2,340 $3,340

The firm has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? a. The company’s net income in 2026 was higher than in 2025. b. The firm issued common stock in 2026. c. The market price of the firm's stock doubled in 2026. d. The firm had positive net income in both 2025 and 2026, but its net income in 2026 was lower than it was in 2025. e. The company has more equity than debt on its balance sheet.

ANSWER: b 45. Which of the following statements is CORRECT? a. Typically, a firm’s DPS should exceed its EPS. b. Typically, a firm’s net income should exceed its EBIT. c. If a firm is more profitable than average, we would normally expect to see its stock price exceed its book value per share.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes d. If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation. e. The more depreciation a firm has in a given year, the higher its EPS, other things held constant.

ANSWER: c 46. On its 12/31/26 balance sheet, Barnes Inc. showed $510 million of retained earnings, and exactly that same amount was shown the previous year. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. If the company lost money in 2026, it must have paid dividends. b. The company must have had zero net income in 2026. c. The company must have paid out half of its 2026 earnings as dividends. d. The company must have paid no dividends in 2026. e. Dividends could have been paid in 2026, but they would have had to equal the earnings for the year.

ANSWER: e 47. Which of the following statements is CORRECT? a. The more depreciation a firm reports, the higher its tax bill, other things held constant. b. Because a firm’s cash flow is shown as the lowest entry on the income statement, people often call it "the bottom line.” c. Depreciation reduces a firm’s cash balance, so an increase in depreciation would normally lead to a reduction in the firm’s cash flow. d. Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues less Operating costs. Operating costs do not include interest or taxes. e. Depreciation is not a cash charge, so it does not have an effect on a firm’s reported profits.

ANSWER: d 48. Which of the following factors would explain how a company's cash balance could have increased even though the company had a negative cash flow last year? a. The company sold a new issue of bonds. b. The company made a large investment in a new plant and equipment. c. The company paid a large dividend. d. The company had high depreciation expenses. e. The company repurchased 20% of its common stock.

ANSWER: a 49. Relative to the previous year, a company's net cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation? a. The company cut its dividend. b. The company made large investments in fixed assets. c. The company sold a division and received cash in return. d. The company issued new common stock. e. The company issued new long-term debt.

ANSWER: b 50. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes provided from operations declined. Which of the following could explain this performance? a. The company’s dividend payment to common stockholders declined. b. The company’s expenditures on fixed assets declined. c. The company’s cost of goods sold increased. d. The company’s depreciation expense declined. e. The company’s interest expense increased.

ANSWER: d 51. Which of the following statements is CORRECT? a. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. b. The statement of cash flows shows where the firm’s cash is located; indeed, it provides a listing of all banks and brokerage houses where cash is on deposit. c. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital. d. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect cash obtained by selling new common stock. e. The statement of cash flows shows how much the firm’s cash—the total of currency, bank deposits, and shortterm liquid securities (or cash equivalents)—increased or decreased during a given year.

ANSWER: e 52. Which of the following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is subtracted from net income in the operating activities section. b. Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a decrease in accounts payable is subtracted from net income in the operating activities section. d. In the statement of cash flows, depreciation is subtracted from net income in the operating activities section. e. In the statement of cash flows, a decrease in inventories is subtracted from net income in the operating activities section.

ANSWER: c 53. Which of the following statements is CORRECT? a. Most rapidly growing companies have positive free cash flows because cash flows from existing operations generally exceed fixed asset purchases and changes to net operating working capital. b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as follows: FCF = [EBIT(1 – T) + Depreciation and amortization] – [Capital expenditures + Changes in net operating working capital]. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 – T) + Capital expenditures. e. Managers should be less concerned with free cash flow than with accounting net income. Accounting net income is the "bottom line" and represents how much the firm can distribute to all its investors—both creditors and stockholders.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 54. Which of the following statements is CORRECT? a. Actions that increase reported net income will always increase cash flow. b. One way to increase EVA is to generate the same level of operating income but with less total invested capital. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA is to achieve the same level of operating income but with more total invested capital obtained at a higher cost of capital. e. If a firm reports positive net income, its EVA must also be positive.

ANSWER: b 55. Which of the following statements is CORRECT? a. MVA stands for "market value added" and is defined as follows: MVA = (Shares outstanding)(Stock price) + Book value of common equity. b. The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses. c. MVA gives us an idea about how much value a firm’s management has added during the last year. d. EVA gives us an idea about how much value a firm’s management has added over the firm’s life. e. EVA stands for "economic value added" and is defined as follows: EVA = NOPAT – (Total invested capital) × (After-tax percentage cost of capital).

ANSWER: e 56. Which of the following statements is CORRECT? a. Corporations are allowed to exclude 50% of their interest income from corporate taxes. b. Corporations are allowed to exclude 50% of their dividend income from corporate taxes. c. Individuals pay taxes on only 30% of the income realized from municipal bonds. d. Individuals are allowed to exclude 50% of their interest income from their taxes. e. Individuals are allowed to exclude 50% of their dividend income from their taxes.

ANSWER: b 57. A loss incurred by a corporation a. must be carried back 2 years before being carried forward for 5 years. b. can be carried forward indefinitely. c. can be carried back 5 years and forward 3 years. d. cannot be used to reduce taxes in other years except with special permission from the IRS. e. can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.

ANSWER: b 58. Which of the following statements is CORRECT? a. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible. b. The maximum tax rate for qualified dividends is 20% for taxpayers in the 39.6% tax bracket, but qualified dividends received are taxed at a maximum rate of 15% for most individuals. c. The federal corporate tax rate on corporate income in 2024 is 40%.

Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes d. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes. e. The maximum federal tax rate on personal income in 2024 was 50%.

ANSWER: b 59. Which of the following statements is CORRECT? a. Retained earnings, as reported on the balance sheet, represent the amount of cash a company has available to pay out as dividends to shareholders. b. Fifty percent of the interest received by corporations is excluded from taxable income. c. Fifty percent of the dividends received by corporations is excluded from taxable income. d. Because taxes on long-term capital gains are not paid until the gain is realized, investors must pay the top individual tax rate on that gain. e. The corporate tax system favors equity financing, as dividends paid are deductible from corporate taxes.

ANSWER: c 60. Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? a. The company had a sharp increase in its inventories. b. The company had a sharp increase in its accrued liabilities. c. The company sold a new issue of common stock. d. The company made a large capital investment early in the year. e. The company had a sharp increase in depreciation expenses.

ANSWER: c 61. Which of the following would be most likely to occur in a year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates were not affected, and assume that the same depreciation method was used for tax and stockholder reporting purposes. a. Companies’ after-tax operating profits would decline. b. Companies’ physical stocks of fixed assets would increase. c. Companies’ cash flows would increase. d. Companies’ cash positions would decline. e. Companies’ reported net incomes would decline.

ANSWER: d 62. Assume that Congress recently passed a provision that will enable Bev's Beverages Inc. (BBI) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or the tax rate. Prior to the new provision, BBI’s net income was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BBI’s financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. The provision will reduce the company’s cash flow. b. The provision will increase the company’s tax payments. c. The provision will increase the firm's operating income (EBIT). d. The provision will increase the company’s net income.

Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes e. Net fixed assets on the balance sheet will decrease.

ANSWER: e 63. The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. Nantell’s taxable income will be lower. b. Nantell’s operating income (EBIT) will increase. c. Nantell’s cash position will improve (increase). d. Nantell’s reported net income for the year will be lower. e. Nantell’s tax liability for the year will be lower.

ANSWER: b 64. Assume that Besley Golf Equipment commenced operations on January 1, 2025, and was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in December 2025, management realized that the assets would last for only 10 years.

The firm's accountants plan to report the 2025 financial statements based on this new information. How would the new depreciation assumption affect the company’s financial statements? a. The firm’s reported net fixed assets would increase. b. The firm’s EBIT would increase. c. The firm’s reported 2025 earnings per share would increase. d. The firm’s cash position in 2025 would increase. e. The provision will increase the company's tax payments.

ANSWER: d 65. A start-up firm is making an initial investment in a new plant and equipment. Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change? a. The firm’s operating income (EBIT) would increase. b. The firm’s taxable income would increase. c. The firm’s cash flow would increase. d. The firm’s tax payments would increase. e. The firm’s reported net income would increase.

ANSWER: c 66. Which of the following statements is CORRECT? a. Dividends paid reduce the net income that is reported on a company’s income statement. b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, its current assets as shown on the balance sheet will decline. c. If a company issues new long-term bonds to purchase fixed assets during the current year, its reported current assets and current liabilities at the end of the year will increase. d. Accounts receivable are reported as a current liability on the balance sheet. e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes balance sheet will decline from the previous year's balance.

ANSWER: e 67. For managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial statements as prepared by accountants under generally accepted accounting principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm's operations. Related to these modifications, which of the following statements is CORRECT? a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements. b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, the firm's value is based on its future cash flows because future cash flows indicate how much the firm can distribute to its investors. c. The standard statements provide useful information on the firm’s individual operating units, but management needs more information on the firm’s overall operations than the standard statements provide. d. The standard statements focus on cash flows, but managers should be less concerned with cash flows than with accounting income as defined by GAAP. e. The best feature of standard statements is that if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to “adjust” the results to make earnings look better.

ANSWER: b 68. Which of the following statements is CORRECT? a. Since depreciation increases the firm's net cash provided by operating activities, the more depreciation a company has, the larger its retained earnings will be, other things held constant. b. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. c. Common equity includes common stock and retained earnings, less accumulated depreciation. d. The retained earnings account as reported on the balance sheet shows the amount of cash that is available for paying dividends. e. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative.

ANSWER: b 69. Last year, Besset Company’s operations provided a negative cash flow, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company’s financial statements were prepared under generally accepted accounting principles (GAAP)? a. The company repurchased some of its common stock. b. The company dramatically increased its capital expenditures. c. The company retired a large amount of its long-term debt. d. The company sold some of its fixed assets. e. The company had high depreciation expenses.

ANSWER: d 70. The CFO of Daves Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of the company's outstanding bonds that carry a 7% interest rate. Assume that the company, which does not pay any dividends, takes this action and that total assets, operating income (EBIT), and tax rate all remain constant. Which of the following would occur?

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes a. The company’s taxable income would fall. b. The company’s interest expense would remain constant. c. The company would have less common equity than before. d. The company’s net income would increase. e. The company would have to pay less taxes.

ANSWER: d 71. Which of the following statements is CORRECT? a. Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations two years ago with $1 million of identical fixed assets, and neither firm either sold any of those assets or purchased any new fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as those statements are presented to investors. b. Assets other than cash are expected to produce cash over time, and the amount of cash they eventually produce must be the same as the amounts at which the assets are carried on the books. c. The income statement shows the difference between a firm's income and its costs—i.e., its profits—during a specified period of time. However, all reported income comes in the form of cash, and reported costs likewise are consistent with cash outlays. Therefore, there will not be a substantial difference between a firm's reported profits and its actual cash flow for the same period. d. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends and the riskiness of those cash flows. e. EPS stands for "earnings per share," while DPS stands for "dividends per share." We would normally expect to see DPS exceed EPS. ANSWER: d 72. Which of the following statements is CORRECT? a. An increase in accounts receivable is added to net income in the operating activities section because if accounts receivable increase, then when they are collected cash will come into the firm. b. In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and the change in net operating working capital. Free cash flow is the amount of cash that could be withdrawn without harming the firm's ability to operate and to produce future cash flows. c. The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section is "Net Income." Then, also in the first section, we show some items that add to or subtract from cash, and the last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt. d. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called "the bottom line." e. Most rapidly growing companies have positive free cash flows because cash flows from existing operations will exceed fixed assets and working capital needed to support the growth.

ANSWER: b 73. Which of the following statements is CORRECT? a. Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations. b. After-tax operating income is calculated as EBIT(1 – T) + Depreciation.

Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes c. Two firms with identical sales and operating costs but with different amounts of debt and tax rates will have different operating incomes by definition. d. If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow. e. Retained earnings as reported on the balance sheet represent cash and are therefore available to distribute to stockholders as dividends or any other required cash payments to creditors and suppliers.

ANSWER: a 74. Which of the following statements is CORRECT? a. The current cash flow from existing assets is highly relevant to investors. However, since the value of the firm depends primarily upon its growth opportunities, accounting net income projections from those opportunities are the only relevant future flows with which investors are concerned. b. Two metrics that are used to measure a company's financial performance are net income and free cash flow.

Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on free cash flows as they do on net income. c. To estimate the net cash provided by operations, depreciation must be subtracted from net income because depreciation is a non-cash charge that has been added to revenue. d. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to discourage the use of debt financing by corporations. e. If Congress changed depreciation allowances so that companies had to report higher depreciation levels for tax purposes in the next year, companies would have lower free cash flows in the next year.

ANSWER: b 75. When American corporations prepare their financial statements, which of the following rules must they adhere to? a. Internal Revenue Code (IRC) b. Generally Accepted Accounting Principles (GAAP) c. Generally Accepted Auditing Standards (GAAS) d. Public Company Accounting Oversight Board rules (PCAOB) e. International Financial Reporting Standards (IFRS) ANSWER: b Multiple Choice: Problems A good bit of relatively simple arithmetic is involved in some of these problems, and although the calculations are simple, it will take students some time to set up the problem and do the arithmetic. We allow for this when assigning problems for a timed test.

Also, students must use a number of definitions to answer some of the questions. To avoid excessive memorization, we provide students with a list of formulas and definitions for use on exams. Problems with * in the topic line are nonalgorithmic.

76. Bauer Software's current balance sheet shows total common equity of $5,125,000. The company has 450,000 shares of stock outstanding, and they sell at a price of $27.50 per share. By how much do the firm's market and book values per share differ? (Round your intermediate and final answers to two decimal places.) a. $15.31 b. $19.66 c. $14.50 Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes d. $16.11 e. $18.21 ANSWER: d 77. Brown Fashions Inc.'s December 31, 2024 balance sheet showed total common equity of $4,050,000 and 200,000 shares of stock outstanding. During 2025, the firm had $450,000 of net income, and it paid out $100,000 as dividends.

What was the book value per share at 12/31/25, assuming no common stock was either issued or retired during 2025?

(Round your final answer to two decimal places.) a. $23.10 b. $24.86 c. $19.58 d. $25.96 e. $22.00 ANSWER: e 78. Prezas Company's balance sheet showed total current assets of $4,000, all of which were required in operations. Its current liabilities consisted of $975 of accounts payable, $600 of 6% short-term notes payable to the bank, and $250 of accrued wages and taxes. What was its net operating working capital? a. $2,720 b. $2,331 c. $2,525 d. $2,165 e. $2,775 ANSWER: e 79. Rao Construction recently reported $19.50 million of sales, $12.60 million of operating costs other than depreciation, and $3.00 million of depreciation. It had $8.50 million of bonds outstanding that carry a 7.0% interest rate, and its federalplus-state income tax rate was 25%. What was Rao's operating income, or EBIT, in millions? a. $3.78 b. $3.63 c. $3.51 d. $3.90 e. $4.13 ANSWER: d 80. Brown Office Supplies recently reported $19,000 of sales, $8,250 of operating costs other than depreciation, and $1,750 of depreciation. It had $9,000 of bonds outstanding that carry a 7.0% interest rate, and its federal-plus-state income tax rate was 25%. How much were the firm's earnings before taxes (EBT)? a. $6,947 b. $6,278 c. $8,370 d. $8,537 e. $7,952 ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 81. Vasudevan Inc. recently reported operating income of $2.3 million, depreciation of $1.20 million, and had a tax rate of 25%. The firm's expenditures on fixed assets and net operating working capital totaled $0.60 million. How much was its free cash flow, in millions? a. $2.22 b. $2.06 c. $2.325 d. $2.44 e. $1.96 ANSWER: c 82. Wu Systems has the following balance sheet. Assume that all current assets are used in operations. How much net operating working capital does the firm have?

Cash Accounts receivable Inventory

$ 100 650 550

Current assets

$ 1,300

Net fixed assets

$ 1,000

Total assets

$ 2,300

Accounts payable Accruals Notes payable Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Common equity Total liab. & equity

$ 200 325 375 $ 900 600 $ 1,500 300 500 $ 800 $ 2,300

a. $775 b. $667 c. $806 d. $690 e. $791 ANSWER: a 83. Emery Mining Inc. recently reported $147,500 of sales, $75,500 of operating costs other than depreciation, and $10,200 of depreciation. The company had $16,500 of outstanding bonds that carry a 7.25% interest rate, and its federalplus-state income tax rate was 25%. How much was the firm's net income? The firm uses the same depreciation expense for tax and stockholder reporting purposes. (Round your intermediate and final answers to two decimal places.) a. $38,604.59 b. $36,634.97 c. $35,847.12 d. $47,664.85 e. $45,452.81 ANSWER: e 84. Over the years, O'Brien Corporation's stockholders have provided $20,000,000 of capital, when they purchased new issues of stock and allowed management to retain some of the firm's earnings. The firm now has 1,000,000 shares of common stock outstanding, and it sells at a price of $25.50 per share. How much value has O'Brien's management added to stockholder wealth over the years, i.e., what is O'Brien's MVA? Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes a. $6,600,000 b. $6,325,000 c. $6,050,000 d. $5,775,000 e. $5,500,000 ANSWER: e 85. Last year Almazan Software reported $10.500 million of sales, $6.250 million of operating costs other than depreciation, and $1.300 million of depreciation. The company had $5.000 million of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 25%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $.670 million. By how much will net income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes.

(Round your intermediate and final answers to 3 decimal places.) a. -$0.388 b. -$0.444 c. -$0.479 d. -$0.436 e. -$0.503 ANSWER: e 86. On 12/31/25, Hite Industries reported retained earnings of $515,000 on its balance sheet, and it reported that it had $135,000 of net income during the year. On its previous balance sheet, on 12/31/24, the company had reported $445,000 of retained earnings. No shares were repurchased during 2025. How much in dividends did the firm pay during 2025? a. $62,400 b. $70,850 c. $59,150 d. $76,700 e. $65,000 ANSWER: e 87. During 2024, Bascom Bakery paid out $33,525 of common dividends. It ended the year with $265,000 of retained earnings versus the prior year’s retained earnings of $159,600. How much net income did the firm earn during the year? a. $152,818 b. $126,422 c. $158,375 d. $138,925 e. $112,529 ANSWER: d 88. C. F. Lee Inc. has the following income statement. How much after-tax operating income does the firm have?

Sales Costs Depreciation EBIT Interest expense

$3,200.00 1,850.00 192.00 $1,158.00 285.00

Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes EBT Taxes (25%) Net income

$873.00 218.25 $654.75

a. $816.39 b. $772.97 c. $1,024.83 d. $868.50 e. $1,042.20 ANSWER: d 89. Kwok Enterprises has the following income statement. How much net operating income after taxes does the firm have?

Sales Costs Depreciation EBIT Interest expense EBT Taxes (25%) Net income

$1,900 1,400 250 $250 70 $180 45 $135

a. $188 b. $201 c. $227 d. $150 e. $216 ANSWER: a 90. Hartzell Inc. had the following data for 2024, in millions: Net income = $600; after-tax operating income [EBIT(1 – T)] = $700; and Total assets = $2,000. Information for 2025 is as follows: Net income = $825; after-tax operating income [EBIT(1 – T)] = $750; and Total assets = $2,500. Assume the firm had no excess cash. How much free cash flow did the firm generate during 2025? a. $293 b. $203 c. $225 d. $238 e. $250 ANSWER: e 91. Shrives Publishing recently reported $11,500 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 25%. During the year, the firm had expenditures on fixed assets and net operating working capital that totaled $1,550.

These expenditures were necessary for it to sustain operations and generate future sales and cash flows. What was its free cash flow? (Round your intermediate and final answers to whole dollar amount.) a. $3,457 Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes b. $2,593 c. $2,955 d. $3,263 e. $3,039 ANSWER: d 92. Houston Pumps recently reported $172,500 of sales, $140,500 of operating costs other than depreciation, and $9,250 of depreciation. The company had $35,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 25%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to spend $15,250 to buy new fixed assets and to invest $6,850 in net operating working capital. What was the firm's free cash flow? a. $4,213 b. $1,860 c. $5,354 d. $2,286 e. $1,978 ANSWER: a 93. Hayes Corporation has $300 million of common equity, with 6 million shares of common stock outstanding. If Hayes’ Market Value Added (MVA) is $116 million, what is the company’s stock price? (Round your final answer to two decimal places.) a. $69.33 b. $56.85 c. $71.41 d. $77.65 e. $53.39 ANSWER: a 94. Byrd Lumber has 2 million shares of common stock outstanding that sell for $17 a share. If the company has $25 million of common equity on its balance sheet, what is the company’s Market Value Added (MVA)? Answer options are provided in whole dollar. a. $9,000,000 b. $9,900,000 c. $8,100,000 d. $11,250,000 e. $7,650,000 ANSWER: a 95. Scranton Shipyards has $8.5 million in total invested operating capital, and its cost of capital is 10%. Scranton has the following income statement: Sales Operating costs Operating income (EBIT) Interest expense Earnings before taxes (EBT) Copyright Cengage Learning. Powered by Cognero.

$10.0 million 6.0 million $ 4.0 million 2.0 million $ 2.0 million Page 21

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes Taxes (25%) Net income

0.5 million $ 1.5 million

What is Scranton’s EVA? Answer options are provided in whole dollar. a. $1,937,500 b. $1,860,000 c. $2,150,000 d. $1,472,500 e. $2,956,500 ANSWER: c 96. Casey Motors recently reported the following information: ∙ Net income = $1,000,000. ∙ Tax rate = 25%. ∙ Interest expense = $200,000. ∙ Total invested capital employed = $9 million. ∙ After-tax cost of capital = 10%.

What is the company’s EVA? a. $285,000 b. $220,000 c. $197,500 d. $250,000 e. $302,500 ANSWER: d 97. Your corporation has the following cash flows: Operating income Interest received Interest paid Dividends received Dividends paid

$250,000 $10,000 $45,000 $22,000 $50,000

If the applicable income tax rate is 25% (federal and state combined), and if 50% of dividends received are exempt from taxes, what is the corporation's tax liability? a. 106,368 b. $56,500 c. $84,208 d. $100,163 e. $105,482 ANSWER: b 98. Your corporation has a marginal tax rate of 25% and has purchased preferred stock in another company. The beforetax dividend yield on the preferred stock is 7.50%. What is the company's after-tax return on the preferred, assuming a 50% dividend exclusion? (Round your final answer to two decimal places.) a. 6.30% Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes b. 6.56% c. 7.61% d. 5.18% e. 6.10% ANSWER: b 99. Lovell Co. purchased preferred stock in another company. The preferred stock’s before-tax yield was 7.80%. The corporate tax rate is 25%. What is the after-tax return on the preferred stock, assuming a 50% dividend exclusion? (Round your final answer to two decimal places.) a. 6.83% b. 6.76% c. 7.10% d. 5.73% e. 6.01% ANSWER: a 100. A company with a 25% tax rate buys preferred stock in another company. The preferred stock has a before-tax yield of 6.00%. Assume a 50% dividend exclusion for tax on dividends. What is the preferred stock’s after-tax return? (Round your final answer to two decimal places.) a. 4.52% b. 4.36% c. 5.25% d. 4.31% e. 5.85% ANSWER: c 101. Van Dyke Corporation has a corporate tax rate equal to 25%. The company recently purchased preferred stock in another company. The preferred stock has an 8% before-tax yield. What is Van Dyke’s after-tax yield on the preferred stock? Assume a 50% dividend exclusion for tax on dividends. (Round your final answer to two decimal places.) a. 5.25% b. 6.51% c. 6.93% d. 7.00% e. 6.37% ANSWER: d 102. Granville Co. recently purchased several shares of Kalvaria Electronics’ preferred stock. The preferred stock has a before-tax yield of 8.60%. If the company’s tax rate is 25%, what is Granville Co.’s after-tax yield on the preferred stock?

Assume a 50% dividend exclusion for tax on dividends. (Round your final answer to two decimal places.) a. 5.72% b. 7.53% c. 6.47% d. 8.13% e. 7.68% ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 103. In 2024, Appalachian Airlines had taxable income of -$3,000,000. In 2025, the company has taxable income of $5,000,000 and its corporate tax rate is 25%. Assume that the company takes full advantage of the Tax Code’s carryforward provision. How much will the company pay in taxes in 2025? a. $1,452,000 b. $500,000 c. $950,000 d. $1,600,000 e. $200,500 ANSWER: b 104. In 2024, Garner Grocers had taxable income of -$2,000,000. The corporate tax rate is 25%. Assume that the company takes full advantage of the Tax Code’s carry-forward provision. In 2025, Garner has taxable income of $1,000,000. What is the amount of taxes the company paid in 2025? a. $586,500 b. $90,000 c. $20,000 d. $0 e. $8,000 ANSWER: d 105. A corporation recently purchased some preferred stock that has a before-tax yield of 5.75%. The company has a tax rate of 25%. What is the after-tax return on the preferred stock? Assume a 50% dividend exclusion for tax on dividends.

(Round your final answer to two decimal places.) a. 3.97% b. 5.03% c. 4.33% d. 4.98% e. 5.99% ANSWER: b 106. A corporate bond currently yields 8.20%. Municipal bonds with the same risk, maturity, and liquidity currently yield 5.50%. At what tax rate would investors be indifferent between the two bonds? (Round your final answer to two decimal places.) a. 27.33% b. 38.85% c. 32.93% d. 39.51% e. 38.20% ANSWER: c 107. A 7-year municipal bond yields 4.80%. Your marginal tax rate (including state and federal taxes) is 32.00%. What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax return? (Round your final answer to two decimal places.) a. 8.47% Copyright Cengage Learning. Powered by Cognero.

Page 24

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes b. 5.51% c. 5.72% d. 5.58% e. 7.06% ANSWER: e 108. A bond issued by the State of Pennsylvania provides a 10.00% yield. What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 35.00% tax bracket? a. 18.62% b. 12.46% c. 15.38% d. 16.62% e. 17.54% ANSWER: c 109. Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6.00%, and Carter’s marginal income tax rate is 25.00%, what yield on the Chicago municipal bonds would make Carter’s treasurer indifferent between the two? a. 4.55% b. 4.37% c. 4.50% d. 5.45% e. 5.63% ANSWER: c 110. A 5-year corporate bond yields 10.60%. A 5-year municipal bond of equal risk yields 6.50%. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds? (Round your final answer to two decimal places.) a. 39.84% b. 46.42% c. 32.88% d. 46.03% e. 38.68% ANSWER: e 111. Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.50% interest rate, and its federal-plus-state income tax rate was 25.00%. During last year, the firm had expenditures on fixed assets and net operating working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $1,250. By how much will the depreciation change cause (1) the firm's net income and (2) its free cash flow to change?

Note that the company uses the same depreciation for tax and stockholder reporting purposes. Do not round the intermediate calculations.

Net Income

Free Cash Flow

Copyright Cengage Learning. Powered by Cognero.

Page 25

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes a. -$937.50; $312.50 b. -$750.00; $375.00 c. -$1,050.00; $353.13 d. -$740.63; $240.63 e. -$853.13; $268.75 ANSWER: a 112. Watson Oil recently reported (in millions) $8,250 of sales, $5,750 of operating costs other than depreciation, and $1,100 of depreciation. The company had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plusstate income tax rate was 25%. In order to sustain its operations and thus generate future sales and cash flows, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital. By how much did the firm's net income exceed its free cash flow? Do not round the intermediate calculations. a. $373 b. $330 c. $320 d. $396 e. $248 ANSWER: b 113. For 2025, Bargain Basement Stores reported $11,500 of sales and $5,000 of operating costs (including depreciation).

The company has $20,500 of total invested capital, the weighted average cost of that capital (the WACC) was 11%, and the federal-plus-state income tax rate was 25%. What was the firm's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during 2025? a. $1,727 b. $1,398 c. $3,256 d. $2,101 e. $2,620 ANSWER: e 114. Allen Corporation can (1) build a new plant that should generate a before-tax return of 10.00%, or (2) invest the same funds in the preferred stock of Florida Power & Light (FPL), which should provide Allen with a before-tax return of 9.00%, all in the form of dividends. Assume that Allen’s marginal tax rate is 25.00%, and that 50.00% of dividends received are excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximize Allen’s effective return on the money invested? (Round your final answer to two decimal places.) a. All in FPL preferred stock b. 60% in FPL; 40% in the project c. All in the plant project d. 60% in the project; 40% in FPL e. 50% in each ANSWER: a 115. Solarcell Corporation has $20,000 that it plans to invest in marketable securities. It is choosing between AT&T bonds that yield 11.50%, State of Florida municipal bonds that yield 11.00%, and AT&T preferred stock with a dividend Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes yield of 9.00%. Solarcell’s corporate tax rate is 25%, and 70.00% of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security. a. 8.63% b. 8.28% c. 8.97% d. 7.50% e. 9.49% ANSWER: a 116. A corporation can earn 7.50% if it invests in municipal bonds. The corporation can also earn 8.15% (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate that makes the corporation indifferent between the two investments? Assume a 50.00% dividend exclusion for tax on dividends. (Do not round your intermediate answer and round your final answer to two decimal places.) a. 24.72% b. $22.60% c. 15.95% d. 25.52% e. 31.64% ANSWER: c 117. Mantle Corporation is considering two equally risky investments: ∙ A $5,000 investment in preferred stock that yields 6.35%. ∙ A $5,000 investment in a corporate bond that yields 10.00%.

What is the breakeven corporate tax rate that makes the company indifferent between the two investments? Assume a 50.00% dividend exclusion for tax on dividends. (Do not round your intermediate answer and round your final answer to two decimal places.) a. 63.64% b. 44.39% c. 60.97% d. 53.48% e. 51.34% ANSWER: d 118. Westvo Corporation has $50,000 that it plans to invest in marketable securities. The corporation is choosing between the following three equally risky securities: Alack County tax-free municipal bonds yielding 8.50%; Evern Auto bonds yielding 10.50%; and AM preferred stock with a dividend yield of 9.80%. Westvo’s corporate tax rate is 25.00%. What is the after-tax return on the best investment alternative? Assume a 50.00% dividend exclusion for tax on dividends.

(Assume the company chooses on the basis of after-tax returns. Round your final answer to 3 decimal places.) a. 10.606% b. 10.878% c. 10.787% d. 8.575% e. 10.969% ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 27

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes 119. Arvo Corporation is trying to choose between three alternative investments. The three securities that the company is considering are as follows: ∙ ∙ ∙

Tax-free municipal bonds with a return of 8.80%.

Wooli Corporation bonds with a return of 11.70%.

CFI Corp. preferred stock with a return of 9.80%.

The company’s tax rate is 25.00%. What is the after-tax return on the best investment alternative? Assume a 50.00% dividend exclusion for tax on dividends. (Round your final answer to 3 decimal places.) a. 8.800% b. 10.296% c. 8.888% d. 8.536% e. 10.560% ANSWER: a 120. In 2024, Collins Co. had taxable income of -$7,500,000. In 2025, the firm has taxable income of $10,000,000.

Its corporate tax rate is 25%. Assume that the company takes full advantage of the Tax Code’s carry-forward provision.

What is Collins’ tax liability for 2025? a. $453,220 b. $511,190 c. $621,860 d. $627,130 e. $625,000 ANSWER: e 121. In 2024, Salinger Software’s EBIT was -$225,000,000. In 2025, its EBIT is $300,000,000. The company has no debt, so operating income equals earnings before taxes. Its corporate tax rate is 25%. Assume that the company takes full advantage of the carry-forward provision in the Tax Code. How much tax did the company pay in 2025? a. $84,262,500 b. $60,637,500 c. $85,837,500 d. $18,750,000 e. $20,050,000 ANSWER: d 122. In 2024, Bradshaw Beverages had taxable income of -$800,000. In 2025, its taxable income is $1,250,000. Its corporate tax rate is 25%.

Assume that the company takes full advantage of the Tax Code’s carry-forward provision. How much did the company pay in taxes during 2025? a. $392,400 b. $112,500 c. $120,000 d. $108,400 e. $234,000 Copyright Cengage Learning. Powered by Cognero.

Page 28

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes ANSWER: b 123. In 2024, Uniontown Books had EBIT equal to -$1,200,000. In 2025, its EBIT was $1,800,000.

The company has no debt, and therefore, pays no interest expense. Its corporate tax rate is 25%. What was Uniontown’s tax liability for 2025? (Assume that the company takes full advantage of the carry-forward provision.) a. $75,000 b. $950,000 c. $300,000 d. $150,000 e. $225,000 ANSWER: d 124. In 2024, Mays Industries taxable income was -$85,000. In 2025, its taxable income was $120,000.

Its corporate tax rate is 25%. Assume that the company takes full advantage of the Tax Code’s carry-forward provision.

What is the company’s tax liability for 2025? a. $14,400 b. $10,500 c. $8,750 d. $12,480 e. $13,650 ANSWER: c 125. Moose Industries has a corporate tax rate of 25%. Last year the company realized $14,000,000 in operating income (EBIT). Its annual interest expense is $1,500,000. What was the company’s net income for the year? a. $6,497,750 b. $9,375,000 c. $8,883,000 d. $9,705,500 e. $10,280,250 ANSWER: b 126. Last year, Martyn Company had $340,000 in taxable income from its operations, $50,000 in interest income, and $100,000 in dividend income. Its corporate tax rate is 25%. What was the company’s tax liability for the year?

Assume a 50% dividend exclusion for taxes on dividends. a. $110,000 b. $150,100 c. $125,000 d. $108,522 e. $162,792 ANSWER: a 127. Lintner Beverage Corp. reported the following information from their financial statements: Copyright Cengage Learning. Powered by Cognero.

Page 29

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes Operating income (EBIT) = $9,000,000 Interest payments on long-term debt = $1,750,000 Dividend income = $1,000,000 Corporate tax rate = 25% Assume a 50% dividend exclusion for tax on dividends. What is the firm’s total tax liability? a. $2,412,980 b. $2,361,640 c. $3,106,070 d. $2,156,280 e. $1,937,500 ANSWER: e 128. Company Z has $90,000 of taxable income from its operations, $5,000 of interest income, and $30,000 of dividend income from preferred stock it holds in other corporations. Its corporate tax rate is 25%. What is Company Z’s tax liability? Assume a 50% dividend exclusion for tax on dividends. a. $27,500 b. $51,300 c. $25,000 d. $5,100 e. $60,100 ANSWER: a 129. Griffey Communications recently realized $120,000 in operating income. The company had interest income of $25,000 and realized $70,000 in dividend income. The company’s interest expense was $40,000. Its corporate tax rate is 25%. Griffey is a small company, so it is not subject to the interest expense deduction limitation. Assume a 50% dividend exclusion for tax on dividends. What is the company’s tax liability? a. $37,000 b. $35,950 c. $35,000 d. $32,000 e. $40,400 ANSWER: c 130. Maureen Smith is a single individual. She claims a standard deduction of $12,400. Her salary for the year was $134,750. What is her taxable income? a. $105,698 b. $122,350 c. $129,324 d. $121,863 e. $120,620 ANSWER: b 131. Maureen Smith is a single individual. She claims a standard deduction of $12,000. Her salary for the year was $188,000. Assume the following tax table is applicable.

Copyright Cengage Learning. Powered by Cognero.

Page 30

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes Single Individuals If Your Taxable Income Is Up to $9,875 $9,875-$38,700 $40,125-$85,525 $85,525-$163,300 $163,300-$207,350 $207,350-$518,400 Over $518,400

You Pay This Amount on the Base of the Bracket $0.00 987.50 4,617.50 14,605.50 33,271.50 47,367.50 156,235.00

Plus This Percentage on the Excess over the Base 10.0% 12.0 22.0 24.0 32.0 35.0 37.0

Average Tax Rate at Top of Bracket 10.0% 11.5 17.1 20.4 22.8 30.1 37.0

What is her marginal tax rate? a. 35.0% b. 24.0% c. 32.0% d. 22.0% e. 12.0% ANSWER: c 132. Maureen Smith is a single individual. She claims a standard deduction of $12,400. Her salary for the year was $177,100. Assume the following tax table is applicable.

Single Individuals

If Your Taxable Income Is Up to $9,875 $9,875-$38,700 $40,125-$85,525 $85,525-$163,300 $163,300-$207,350 $207,350-$518,400 Over $518,400

You Pay This Amount on the Base of the Bracket $0.00 987.50 4,617.50 14,605.50 33,271.50 47,367.50

156,235.00

Plus This Percentage on the Excess over the Base 10.0% 12.0 22.0 24.0 32.0 35.0 37.0

Average Tax Rate at Top of Bracket 10.0% 11.5 17.1 20.4 22.8 30.1 37.0

What is her federal tax liability? a. $30,536.25 b. $45,210.75 c. $33,719.50 d. $40,054.75 e. $30,140.25 ANSWER: c 133. Alan and Sara Winthrop are a married couple who file a joint income tax return. They have two children, and they Copyright Cengage Learning. Powered by Cognero.

Page 31

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes have legitimate itemized deductions totaling $25,750. Their total income from wages is $288,800. What is the couple’s taxable income? a. $263,050 b. $249,300 c. $192,550 d. $214,800 e. $207,400 ANSWER: a 134. Alan and Sara Winthrop are a married couple who file a joint income tax return. They have two children, and they have legitimate itemized deductions totaling $25,750. Their total income from wages is $251,400. Assume the following tax table is applicable: Married Couples Filing Joint Returns You Pay This Plus This Percentage Average Tax If Your Taxable Amount on the on the Excess over the Rate at Income Is Base of the Bracket Base Top of Bracket Up to $19,050 $0.00 $19,050-$77,400 1,905.00 $77,400-$165,000 8,907.00 $165,000-$315,000 28,179.00 $315,000-$400,000 64,179.00 $400,000-$600,000 91,379.00 Over $600,000 161,379.00 What is their marginal tax rate?

10.0% 12.0 22.0 24.0 32.0 35.0 37.0

10.0% 11.5 17.1 20.4 22.8 26.9 37.0

a. 32.0% b. 35.0% c. 10.0% d. 24.0% e. 12.0% ANSWER: d 135. Alan and Sara Winthrop are a married couple who file a joint income tax return. They have two children, and they have legitimate itemized deductions totaling $25,750. Their total income from wages is $357,600. Assume the following tax table is applicable: Married Couples Filing Joint Returns You Pay This Plus This Percentage Average Tax If Your Taxable Amount on the on the Excess over the Rate at Income Is Base of the Bracket Base Top of Bracket Up to $19,050 $19,050-$77,400 $77,400-$165,000 $165,000-$315,000 $315,000-$400,000

$0.00 1,905.00 8,907.00 28,179.00 64,179.00

Copyright Cengage Learning. Powered by Cognero.

10.0% 12.0 22.0 24.0 32.0

10.0% 11.5 17.1 20.4 22.8 Page 32

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes $400,000-$600,000 91,379.00 Over $600,000 161,379.00 What is their federal tax liability?

35.0 37.0

26.9 37.0

a. $49,048.50 b. $54,707.25 c. $52,820.50 d. $57,851.50 e. $69,571.00 ANSWER: e 136. Alan and Sara Winthrop are a married couple who file a joint income tax return. They have two children, and they have legitimate itemized deductions totaling $25,750. Their total income from wages is $169,100. Assume the following tax table is applicable: Married Couples Filing Joint Returns You Pay This Plus This Percentage Average Tax If Your Taxable Amount on the on the Excess over the Rate at Income Is Base of the Bracket Base Top of Bracket Up to $19,050 $0.00 $19,050-$77,400 1,905.00 $77,400-$165,000 8,907.00 $165,000-$315,000 28,179.00 $315,000-$400,000 64,179.00 $400,000-$600,000 91,379.00 Over $600,000 161,379.00 What is their average tax rate?

10.0% 12.0 22.0 24.0 32.0 35.0 37.0

10.0% 11.5 17.1 20.4 22.8 26.9 37.0

a. 16.33% b. 17.93% c. 19.21% d. 17.20% e. 14.64% ANSWER: a 137. Maureen Smith is a single individual. She claims a standard deduction of $12,000. Her salary for the year was $213,650. Assume the following tax table is applicable.

Single Individuals If Your Taxable Income Is

You Pay This Amount on the Base of the Bracket

Up to $9,525 $9,525-$38,700 $38,700-$82,500 $82,500-$157,500

$0.00 952.50 4,453.50 14,089.50

Copyright Cengage Learning. Powered by Cognero.

Plus This Percentage on the Excess over the Base

Average Tax Rate at Top of Bracket

10.0% 12.0 22.0 24.0

10.0% 11.5 17.1 20.4 Page 33

Name:

Class:

Date:

Chapter 3 - Financial Statements, Cash Flow, and Taxes $157,500-$200,000 32,089.50 $200,000-$500,000 45,689.50 Over $500,000 150,689.50 What is her average tax rate?

32.0 35.0 37.0

22.8 30.1 37.0

a. 24.34% b. 19.18% c. 22.94% d. 24.58% e. 27.29% ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 34

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements To keep this chapter from involving too much memorization, we provide our students with a formula sheet for use on exams. That makes a few of the questions trivially easy, but most require some thought, and some are downright challenging. Even the very easy ones make students think about the ratios. The challenging questions are labeled CHALLENGING, and most students will agree with that designation.

Some of these questions are just definitions, but others require real thought about the make-up of the ratios and relationships among the ratios. We tell our students that to answer some of these questions it is useful (1) to write out the relevant ratio or ratios, (2) then to think about how the ratios would change if the accounting data changed, and (3) occasionally to make up illustrative data to test their conclusions.

Note that there is some overlap between the True/False and the multiple choice questions, as some T/F statements are used in the MC questions.

1. Ratio analysis involves analyzing financial statements to help appraise a firm's financial position and strength. a. True b. False ANSWER: True 2. The current and quick ratios help us measure a firm's liquidity. The current ratio measures the relationship of the firm's current assets to its current liabilities, while the quick ratio measures the firm’s ability to pay off short-term obligations without relying on the sale of inventories. a. True b. False ANSWER: True 3. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easyto-use estimates of a firm's liquidity position. a. True b. False ANSWER: True 4. High current and quick ratios always indicate that the firm is managing its liquidity position well. a. True b. False ANSWER: False 5. If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline. a. True b. False ANSWER: False 6. If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would increase. a. True b. False ANSWER: True 7. If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements ratio would change. a. True b. False ANSWER: False 8. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets. a. True b. False ANSWER: True 9. A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid. a. True b. False ANSWER: False 10. In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock. a. True b. False ANSWER: False 11. The days sales outstanding ratio tells us how long it takes, on average, to collect after a sale is made. The DSO can be compared with the firm's credit terms to get an idea of whether customers are paying on time. a. True b. False ANSWER: True 12. If a firm's fixed assets turnover ratio is significantly higher than the average for its industry, then it could be that the firm uses its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets. a. True b. False ANSWER: True 13. The times-interest-earned ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. a. True b. False ANSWER: True 14. Profitability ratios show the combined effects of liquidity, asset management, and debt management on a firm's operating results. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements 15. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. a. True b. False ANSWER: False 16. The operating margin measures operating income per dollar of assets. a. True b. False ANSWER: False 17. The profit margin measures net income per dollar of sales. a. True b. False ANSWER: True 18. The return on invested capital measures the total return that a company has provided for its investors. a. True b. False ANSWER: True 19. The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed. a. True b. False ANSWER: True 20. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used the same or similar accounting methods. a. True b. False ANSWER: True 21. The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. False ANSWER: True 22. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all of the firms being compared have the same proportion of fixed assets to total assets. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements 23. Other things held constant, the more debt a firm uses, the lower the firm's profit margin will be. a. True b. False ANSWER: True 24. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's total debt to total capital ratio [measured as (Short-term debt + Long-term debt) / (Debt + Preferred stock + Common equity)] is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is likely better managed because the difference in debt, not better management, could be the cause of Firm A's higher profit margin. a. True b. False ANSWER: False 25. Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower profit margin. a. True b. False ANSWER: False 26. Other things held constant, the more debt a firm uses, the lower the firm's operating margin will be. a. True b. False ANSWER: False 27. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes. a. True b. False ANSWER: True 28. Other things held constant, the more debt a firm uses, the lower the firm's return on total assets will be. a. True b. False ANSWER: True 29. Since the ROA measures the firm's effective utilization of assets without considering how these assets are financed, two firms with the same EBIT must have the same ROA. a. True b. False ANSWER: False 30. The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA). a. True Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements b. False ANSWER: False 31. The return on invested capital (ROIC) differs from the return on assets (ROA). First, ROIC is based on total invested capital rather than total assets. Second, the numerator of the ROIC is after-tax operating income rather than net income. a. True b. False ANSWER: True 32. Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects. These ratios include the Price/Earnings, the Market/Book, and Enterprise Value/EBITDA ratios. a. True b. False ANSWER: True 33. In general, if investors believe that a company is relatively risky and/or has relatively poor growth prospects, then the company will have relatively high P/E, M/B, and EV/EBITDA ratios. a. True b. False ANSWER: False 34. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as less risky and/or more likely to enjoy higher growth in the future. a. True b. False ANSWER: True 35. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as less risky and/or more likely to enjoy higher growth in the future. a. True b. False ANSWER: True 36. Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. a. True b. False ANSWER: False 37. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and, therefore, an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use the funds to buy back stock, and raise the equity multiplier to 2.0. The size of the firm (assets) would not change. She thinks that Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably be a good move, as it would increase the ROE from 7.5% to 13.5%. a. True b. False ANSWER: True 38. Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of examining changes in a firm's performance over time. a. True b. False ANSWER: True 39. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if Firm A's quick ratio exceeds Firm B's, then we can be certain that Firm A's current ratio is also larger than Firm B's. a. True b. False ANSWER: False 40. Firms A and B have the same current ratio, 0.75, the same amount of sales, the same amount of cost of goods sold, and the same amount of current liabilities. However, Firm A has a higher inventory turnover ratio than Firm B. Therefore, we can conclude that Firm A's quick ratio must be smaller than Firm B's. a. True b. False ANSWER: False 41. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True b. False ANSWER: True 42. Suppose Firms A and B have the same amount of assets, total assets are equal to total invested capital, pay the same interest rate on their debt, have the same basic earning power (BEP), finance with only debt and common equity, and have the same tax rate. However, Firm A has a higher debt to capital ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio. a. True b. False ANSWER: True 43. If a firm's ROE is equal to 9% and its ROA is equal to 6%, its equity multiplier must be 1.5. a. True b. False ANSWER: True 44. A firm's ROE is equal to 9%, and its ROA is equal to 6%. The firm finances only with short-term debt, long-term Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements debt, and common equity, so assets equal total invested capital. The firm's total debt to total capital ratio must be 50%. a. True b. False ANSWER: False 45. One problem with ratio analysis is that relationships can sometimes be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to INCREASE. a. True b. False ANSWER: False 46. One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and, thus, make the firm look stronger. a. True b. False ANSWER: False 47. Liquidity ratios give information about how efficiently a company is using its assets. a. True b. False ANSWER: False 48. Market value ratios are important to investors to give them information about the prospects of the company. a. True b. False ANSWER: True Multiple Choice: Conceptual

49. Considered alone, which of the following would increase a company’s current ratio? a. An increase in net fixed assets b. An increase in accrued liabilities c. An increase in notes payable d. An increase in accounts receivable e. An increase in accounts payable ANSWER: d 50. Which of the following would generally indicate an improvement in a company’s financial position, holding other things constant? a. The TIE declines b. The DSO increases c. The quick ratio increases Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements d. The current ratio declines e. The total assets turnover decreases ANSWER: c 51. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? a. Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to purchase a new plant and equipment. b. Use cash to repurchase some of the company’s own stock. c. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. d. Issue new stock, then use some of the proceeds to purchase additional inventory and hold the remainder as cash. e. Use cash to increase inventory holdings.

ANSWER: d 52. Which of the following statements is CORRECT? a. A reduction in inventories will have no effect on the current ratio. b. An increase in inventories will have no effect on the current ratio. c. If a firm increases its sales and keeps the cost of goods sold as a percentage of sales the same while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. d. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. e. If a firm increases its sales while holding its inventories constant, then, other things held constant, its fixed assets turnover ratio will decline.

ANSWER: c 53. Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a higher price.

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

ANSWER: e 54. Which of the following actions is an example of "window dressing?" a. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt. b. Borrowing on a long-term basis and using the proceeds to retire short-term debt. c. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase fixed assets. d. Using some of the firm’s cash to reduce long-term debt. e. Any action that does not improve a firm’s fundamental long-run position and, thus, increases its intrinsic value ANSWER: b 55. Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company’s total assets or operating income. Which of the following effects occurred as a result of this action?

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements a. The company’s current ratio increased b. The company’s times interest earned ratio decreased c. The company’s basic earning power ratio increased d. The company’s equity multiplier increased e. The company’s total debt to total capital ratio increased ANSWER: a 56. A firm’s new president wants to strengthen the company’s financial position. Which of the following actions would make the company financially stronger? a. Increase accounts receivable while holding sales constant. b. Increase EBIT while holding sales and assets constant. c. Increase accounts payable while holding sales constant. d. Increase notes payable while holding sales constant. e. Increase inventories while holding sales constant.

ANSWER: b 57. If the CEO of a large and diversified firm were filling out a fitness report on a division manager (i.e., “grading” the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant. a. The division’s basic earning power ratio is above the average of other firms in its industry. b. The division’s total assets turnover ratio is below the average for other firms in its industry. c. The division’s total debt to total capital ratio is above the average for other firms in the industry. d. The division’s inventory turnover is 6×, whereas the average for its competitors is 8×. e. The division’s DSO (days’ sales outstanding) is 40 days, whereas the average for its competitors is 30 days.

ANSWER: a 58. Which of the following would indicate an improvement in a company’s financial position, holding other things constant? a. The inventory and total assets turnover ratios both decline. b. The total debt to total capital ratio increases. c. The profit margin declines. d. The times-interest-earned ratio declines. e. The current and quick ratios both increase.

ANSWER: e 59. If a bank loan officer were considering a company’s loan request, which of the following statements would be CORRECT, other things held constant? a. The lower the company’s inventory turnover ratio, the lower the interest rate the bank should charge. b. The higher the days sales outstanding ratio, the lower the interest rate the bank should charge. c. The lower the total debt to total capital ratio, the lower the interest rate the bank should charge. d. The lower the company’s TIE ratio, the lower the interest rate the bank should charge. e. The lower the current ratio, the lower the interest rate the bank should charge.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements 60. Which of the following statements is CORRECT? a. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. b. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. c. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. d. The numerator used in the TIE ratio is earnings before taxes (EBT). EBT is used because interest is paid with post-tax dollars, so the firm's ability to pay current interest is affected by taxes. e. Other things held constant, increasing the total debt to total capital ratio will increase the ROA. ANSWER: b 61. A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable. b. Issue new common stock and use the proceeds to increase inventories. c. Speed up the collection of receivables and use the cash generated to increase inventories. d. Use some of its cash to purchase additional inventories. e. Issue new common stock and use the proceeds to acquire additional fixed assets.

ANSWER: a 62. Amram Company’s current ratio is 2.0. Considered alone, which of the following actions would lower the current ratio? a. Borrow using short-term notes payable and use the proceeds to reduce accruals. b. Borrow using short-term notes payable and use the proceeds to reduce long-term debt. c. Use cash to reduce accruals. d. Use cash to reduce short-term notes payable. e. Use cash to reduce accounts payable.

ANSWER: b 63. Which of the following statements is CORRECT? a. If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry average and trending still higher, this would be interpreted as a sign of strength. b. A high average DSO indicates that none of the firm's customers are paying on time. In addition, it makes no sense to evaluate the firm's DSO with the firm's credit terms. c. There is no relationship between the days’ sales outstanding (DSO) and the average collection period (ACP).

These ratios measure entirely different things. d. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio. e. If a firm increases its sales while holding its accounts receivable constant, then its days’ sales outstanding will decline, other things held constant.

ANSWER: e 64. Which of the following statements is CORRECT? a. If one firm has a higher total debt to total capital ratio than another, we can be certain that the firm with the higher total debt to total capital ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.

Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements b. A firm's use of debt will have no effect on its profit margin. c. If two firms differ only in their use of debt—i.e., they have identical assets, identical total invested capital, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher total debt to total capital ratio, then the firm that uses more debt will have a lower profit margin on sales and a lower return on assets. d. The total debt to total capital ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable. e. If two firms differ only in their use of debt—i.e., they have identical assets, identical total invested capital, operating costs, and tax rates—but one firm has a higher total debt to total capital ratio, then the firm that uses more debt will have a higher operating margin and return on assets.

ANSWER: c 65. Which of the following statements is CORRECT? a. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be equal. b. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same. c. If Firms X and Y have the same earnings per share and market-to-book ratio, then they must have the same price/earnings ratio. d. If Firm X’s P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and/or be expected to grow at a faster rate. e. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same.

ANSWER: b 66. Which of the following statements is CORRECT? a. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. The firm finances using only debt and common equity, and total assets equal total invested capital. Under these conditions, the ROE will increase. b. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. The firm finances using only debt and common equity, and total assets equal total invested capital. Without additional information, we cannot tell what will happen to the ROE. c. The DuPont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. d. Other things held constant, an increase in the total debt to total capital ratio will result in an increase in the profit margin. e. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. The firm finances using only debt and common equity, and total assets equal total invested capital. Under these conditions, the ROE will decrease.

ANSWER: a 67. You observe that a firm’s ROE is above the industry average, but both its profit margin and equity multiplier are below the industry average. Which of the following statements is CORRECT? a. Its total assets turnover must be above the industry average. b. Its return on assets must equal the industry average. c. Its TIE ratio must be below the industry average.

Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements d. Its total assets turnover must be below the industry average. e. Its total assets turnover must equal the industry average.

ANSWER: a 68. Companies HD and LD are both profitable, and they have the same total assets (TA), total invested capital, sales (S), return on assets (ROA), and profit margin (PM). Both firms finance using only debt and common equity. However, Company HD has the higher total debt to total capital ratio. Which of the following statements is CORRECT? a. Company HD has a lower total assets turnover than Company LD. b. Company HD has a lower equity multiplier than Company LD. c. Company HD has a higher fixed assets turnover than Company LD. d. Company HD has a higher ROE than Company LD. e. Company HD has a lower operating income (EBIT) than Company LD. ANSWER: d 69. Taggart Technologies is considering issuing new common stock and using the proceeds to reduce its outstanding debt.

The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? a. The ROA will decline. b. Taxable income will decline. c. The tax bill will increase. d. Net income will decrease. e. The times-interest-earned ratio will decrease.

ANSWER: c 70. Which of the following statements is CORRECT? a. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio. b. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. c. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. d. An increase in the DSO, other things held constant, could be expected to increase the ROE. e. An increase in a firm’s total debt to total capital ratio, with no changes in its sales or operating costs, could be expected to lower its profit margin.

ANSWER: e 71. HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. Both firms finance using only debt and common equity, and total assets equal total invested capital. However, HD uses more debt than LD. Which of the following statements is CORRECT? a. Without more information, we cannot tell if HD or LD would have a higher or lower net income. b. HD would have the lower equity multiplier for use in the DuPont equation. c. HD would have to pay more in income taxes. d. HD would have the lower net income as shown on the income statement. e. HD would have the higher operating margin.

ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements 72. Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power.

Both firms finance using only debt and common equity, and total assets equal total invested capital. Both companies have positive net incomes. Company HD has a higher total debt to total capital ratio and therefore a higher interest expense.

Which of the following statements is CORRECT? a. Company HD pays less in taxes. b. Company HD has a lower equity multiplier. c. Company HD has a higher ROA. d. Company HD has a higher times-interest-earned (TIE) ratio. e. Company HD has more net income.

ANSWER: a 73. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Both firms finance using only debt and common equity, and total assets equal total invested capital.

Company HD has a higher total debt to total capital ratio and therefore a higher interest expense. Which of the following statements is CORRECT? a. Company HD has a lower equity multiplier. b. Company HD has more net income. c. Company HD pays more in taxes. d. Company HD has a lower ROE. e. Company HD has a lower times-interest-earned (TIE) ratio.

ANSWER: e 74. Which of the following statements is CORRECT? a. If a firm has high current and quick ratios, then it must be managing its liquidity position well. b. If a firm sold some inventory for cash and left the funds in its bank account, then its current ratio would probably not change much, but its quick ratio would decline. c. If a firm sold some inventory on credit, then its current ratio would probably not change much, but its quick ratio would decline. d. If a firm sold some inventory on credit as opposed to cash, then there is no reason to think that either its current or quick ratio would change. e. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets.

ANSWER: e 75. Which of the following statements is CORRECT? a. A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid. b. In general, it's better to have a low inventory turnover ratio than a high one, as a low one indicates that the firm has an adequate stock of inventory relative to sales and, thus, will not lose sales as a result of running out of stock. c. If a firm's fixed assets turnover ratio is significantly lower than the average for its industry, then it could be that the firm uses its fixed assets very efficiently or is operating at overcapacity and should probably add fixed assets. d. The more conservative a firm's management is, the higher the firm's total debt to total capital ratio is likely to be. e. The days sales outstanding ratio tells us how long it takes, on average, to collect after a sale is made. The DSO Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements can be compared with the firm's credit terms to get an idea of whether customers are paying on time.

ANSWER: e 76. Which of the following statements is CORRECT? a. Other things held constant, the more debt a firm uses, the higher its operating margin will be. b. Debt management ratios show the extent to which a firm's managers are attempting to magnify returns on owners' capital through the use of financial leverage. c. Other things held constant, the more debt a firm uses, the higher its profit margin will be. d. Other things held constant, the higher a firm's total debt to total capital ratio, the higher its TIE ratio will be. e. Debt management ratios show the extent to which a firm's managers are attempting to reduce risk through the use of financial leverage. The higher the total debt to total capital ratio, the lower the risk.

ANSWER: b 77. Which of the following statements is CORRECT? a. Other things held constant, the less debt a firm uses, the lower its return on total assets will be. b. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes. c. The return on common equity (ROE) is generally considered less significant, from a stockholder's viewpoint, than the return on total assets (ROA). d. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as more risky and/or less likely to enjoy higher future growth. e. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's total debt to total capital ratio is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A's higher profit margin.

ANSWER: b 78. Which of the following statements is CORRECT? a. In general, if investors regard a company as relatively risky and/or having relatively poor growth prospects, then it will have relatively high P/E and M/B ratios. b. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. c. The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed. d. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as more risky and/or less likely to enjoy higher future growth. e. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets.

ANSWER: c 79. Walter Industries’ current ratio is 0.5. Considered alone, which of the following actions would increase the company’s current ratio? a. Borrow using short-term notes payable and use the cash to increase inventories.

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements b. Use cash to reduce accruals. c. Use cash to reduce accounts payable. d. Use cash to reduce short-term notes payable. e. Use cash to reduce long-term bonds outstanding.

ANSWER: a 80. Guarantra’s current assets total to $20 million versus $10 million of current liabilities, while Vatefin’s current assets are $10 million versus $20 million of current liabilities. Both firms would like to “window dress” their end-of-year financial statements, and to do so, they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions? a. The transactions would improve Guarantra’s financial strength as measured by its current ratio but lower Vatefin’s current ratio. b. The transactions would lower Guarantra’s financial strength as measured by its current ratio but raise Vatefin’s current ratio. c. The transactions would have no effect on the firms’ financial strength as measured by their current ratios. d. The transactions would lower both firms’ financial strength as measured by their current ratios. e. The transactions would improve both firms’ financial strength as measured by their current ratios.

ANSWER: b 81. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. Both firms finance using only debt and common equity, and total assets equal total invested capital.

However, company HD has a higher total debt to total capital ratio. Which of the following statements is CORRECT? a. Given this information, LD must have the higher ROE. b. Company LD has a higher basic earning power ratio (BEP). c. Company HD has a higher basic earning power ratio (BEP). d. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE. e. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE. ANSWER: e 82. Which of the following statements is CORRECT? a. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of Firm A. However, if Firm A's quick ratio exceeds Firm B's, then we can be certain that Firm A's current ratio is also larger than Firm B's. b. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. c. Since the ROA measures the firm's effective utilization of assets without considering how these assets are financed, two firms with the same EBIT must have the same ROA. d. Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. e. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and, therefore, Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow funds using long-term debt, use the funds to buy back stock, and raise the equity multiplier to 2.0. The size of the firm (assets) would not change. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably not be a good move, as it would decrease the ROE from 7.5% to 6.5%.

ANSWER: b 83. Which category of ratios would be helpful to analyze if a company has excess inventory as a result of rapid expansion? a. Liquidity ratios b. Market value ratios c. Asset management ratios d. Debt management ratios e. Equity ratios ANSWER: c 84. Which category of ratios would be valuable to determine the ability of a company to continue its operations? a. Stability ratios b. Liquidity ratios c. Market value ratios d. Debt management ratios e. Asset management ratios ANSWER: b 85. In order to show their effects on return on common equity (ROE), profitability ratios combine which two categories of ratios? a. Asset management and debt management ratios b. Liquidity and debt management ratios c. Asset management and market value ratios d. Market value and liquidity ratios e. Debt management and market value ratios ANSWER: a Multiple Choice: Problems A good bit of relatively simple algebra is involved in these problems, and although the calculations are simple, it will take students some time to set up the problems and do the arithmetic. We allow for this when assigning problems for a timed test. Also, note that students must know the definitions of a number of ratios to answer the questions. We provide our students with a formula sheet on exams, using the relevant sections of Appendix C at the end of the text. Otherwise, they spend too much time trying to memorize things rather than trying to understand the issues.

The difficulty of the problems depends on (1) whether or not students are provided with a formula sheet and (2) the amount of time they have to work the problems. Our difficulty assessments assume that they have a formula sheet and a "reasonable" amount of time for the test. Note that a few of the problems are trivially easy if students have formula sheets.

To work some of the problems, students must transpose equations and solve for items that are normally inputs. For example, the equation for the profit margin is given as Profit margin = Net income / Sales. We might have a problem where sales and the profit margin are given and then require students to find the firm's net income. We explain to our students in class before the exam that they will have to transpose terms in the formulas to work some problems.

Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements Problems 84 through 114 are all stand-alone problems with individualized data. Problems 115 through 133 are all based on a common set of financial statements, and they require students to calculate ratios and find items like EPS, TIE, and the like using this data set. The financial statements can be changed algorithmically, and this changes the calculated ratios and other items.

86. Ryngard Corp's sales last year were $47,000, and its total assets were $16,000. What was its total assets turnover ratio (TATO)? a. 3.55 b. 3.64 c. 2.76 d. 3.44 e. 2.94 ANSWER: e 87. Beranek Corp has $580,000 of assets (which equal total invested capital), and it uses no debt—it is financed only with common equity. The new CFO wants to employ enough debt to raise the total debt to total capital ratio to 40%, using the proceeds from borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $176,320 b. $232,000 c. $285,360 d. $220,400 e. $271,440 ANSWER: b 88. Ajax Corp's sales last year were $480,000, its operating costs were $362,500, and its interest charges were $12,500.

What was the firm's times-interest-earned (TIE) ratio? a. 9.40 b. 11.47 c. 7.90 d. 10.25 e. 10.53 ANSWER: a 89. Royce Corp's sales last year were $430,000, and its net income was $23,000. What was its profit margin? a. 6.47% b. 6.04% c. 5.35% d. 4.55% e. 5.67% ANSWER: c 90. River Corp's total assets at the end of last year were $315,000 and its net income was $32,750. What was its return on total assets? a. 8.01% b. 10.29% Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements c. 10.40% d. 8.63% e. 8.42% ANSWER: c 91. X-1 Corp's total assets at the end of last year were $425,000 and its EBIT was $52,500. What was its basic earning power (BEP) ratio? a. 13.59% b. 12.60% c. 12.72% d. 14.70% e. 12.35% ANSWER: e 92. Zero Corp's total common equity at the end of last year was $490,000 and its net income was $70,000. What was its ROE? a. 17.00% b. 14.29% c. 11.29% d. 11.86% e. 12.71% ANSWER: b 93. Your sister is thinking about starting a new business. The company would require $325,000 of assets, and it would be financed entirely with common stock. She will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business? a. $37,294 b. $45,630 c. $51,773 d. $43,875 e. $33,345 ANSWER: d 94. Herring Corporation has operating income of $210,000 and a 25% tax rate. The firm has short-term debt of $144,000, long-term debt of $320,000, and common equity of $464,000. What is its return on invested capital? a. 15.72% b. 16.30% c. 16.97% d. 18.22% e. 19.07% ANSWER: c 95. Song Corp's stock price at the end of last year was $19.00 and its earnings per share for the year were $1.30. What was its P/E ratio?

Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements a. 15.93 b. 15.64 c. 14.18 d. 14.62 e. 14.91 ANSWER: d 96. Hoagland Corp's stock price at the end of last year was $31.50, and its book value per share was $25.00. What was its market/book ratio? a. 1.25 b. 1.26 c. 1.49 d. 1.41 e. 1.39 ANSWER: b 97. Precision Aviation had a profit margin of 7.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE? a. 18.99% b. 16.25% c. 23.49% d. 22.12% e. 19.58% ANSWER: e 98. Meyer Inc's total invested capital is $690,000, and its total debt outstanding is $185,000. The new CFO wants to establish a total debt to total capital ratio of 55%. The size of the firm will not change. How much debt must the company add or subtract to achieve the target debt to capital ratio? a. $161,435 b. $194,500 c. $151,710 d. $171,160 e. $149,765 ANSWER: b 99. Garcia Industries has sales of $132,500 and accounts receivable of $18,500, and it gives its customers 25 days to pay.

The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed up by this change, how would that affect its net income, assuming other things are held constant? Assume all sales to be on credit. Do not round your intermediate calculations. a. $793.32 b. $584.55 c. $695.89 d. $591.51 e. $647.18 Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements ANSWER: c 100. Faldo Corp sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were $305,000, and its year-end receivables were $60,000. If its DSO is less than the 45-day credit period, then customers are paying on time.

Otherwise, they are paying late. By how much are customers paying early or late? Base your answer on this equation: DSO – Credit Period = Days early or late, and use a 365-day year when calculating the DSO. A positive answer indicates late payments, while a negative answer indicates early payments. Assume all sales to be on credit. Do not round your intermediate calculations. a. 29.75 b. 21.44 c. 23.05 d. 26.80 e. 28.14 ANSWER: d 101. Han Corp's sales last year were $350,000, and its year-end receivables were $52,500. The firm sells on terms that call for customers to pay 30 days after the purchase, but some delay payment beyond Day 30. On average, how many days late do customers pay? Base your answer on this equation: DSO – Allowed credit period = Average days late, and use a 365day year when calculating the DSO. Assume all sales to be on credit. Do not round your intermediate calculations. a. 19.06 b. 25.00 c. 30.94 d. 24.75 e. 29.70 ANSWER: d 102. Wie Corp's sales last year were $220,000, and its year-end total assets were $355,000. The average firm in the industry has a total assets turnover ratio (TATO) of 2.4. The firm's new CFO believes the firm has excess assets that can be sold to bring the TATO down to the industry average without affecting sales. By how much must the assets be reduced to bring the TATO to the industry average, holding sales constant? Do not round your intermediate calculations. a. $263,333 b. $287,033 c. $250,167 d. $329,167 e. $265,967 ANSWER: a 103. A new firm is developing its business plan. It will require $585,000 of assets (which equals total invested capital), and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level, the bank will call in the loan and the firm will go bankrupt. The firm will use only debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total invested capital) the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt to capital ratio.) Do not round your intermediate calculations. a. 59.54% b. 64.42% Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements c. 54.13% d. 43.30% e. 51.97% ANSWER: c 104. Duffert Industries has total assets of $1,090,000 and total current liabilities (consisting only of accounts payable and accruals) of $120,000. Duffert finances using only long-term debt and common equity. The interest rate on its debt is 7%, and its tax rate is 25%. The firm's basic earning power ratio is 13%, and its debt-to capital rate is 40%. What are Duffert's ROE and ROIC? Do not round your intermediate calculations. a. 6.69%; 9.09% b. 8.33%; 9.75% c. 9.36%; 10.63% d. 10.29%; 10.96% e. 11.73%; 12.16% ANSWER: d 105. Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $585,000, and its net income was $25,000. Stockholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 15%. What profit margin would the firm need to achieve the 15% ROE, holding everything else constant? Do not round your intermediate calculations. a. 9.52% b. 10.58% c. 9.62% d. 7.21% e. 12.02% ANSWER: c 106. Last year Ann Arbor Corp had $155,000 of assets (which equals total invested capital), $305,000 of sales, $20,000 of net income, and a debt-to-total-capital ratio of 37.5%. The new CFO believes that a new computer program will enable the company to reduce costs and thus raise net income to $33,000. The firm finances using only debt and common equity.

Assets, total invested capital, sales, and the debt to capital ratio would not be affected. By how much would the cost reduction improve the ROE? Do not round your intermediate calculations. a. 16.51% b. 11.94% c. 10.87% d. 10.60% e. 13.42% ANSWER: e 107. Brookman Inc's latest EPS was $2.75, its book value per share was $22.75, it had 290,000 shares outstanding, and its debt/total invested capital ratio was 44%. The firm finances using only debt and common equity, and its total assets equal total invested capital. How much debt was outstanding? Do not round your intermediate calculations. a. $3,939,650 b. $5,131,913 c. $5,442,938 Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements d. $5,546,613 e. $5,183,750 ANSWER: e 108. Last year Harrington Inc. had sales of $325,000 and a net income of $19,000, and its year-end assets were $250,000.

The firm's total-debt-to-total-capital ratio was 65.0%. The firm finances using only debt and common equity, and its total assets equal total invested capital. Based on the DuPont equation, what was the ROE? Do not round your intermediate calculations. a. 20.85% b. 16.72% c. 21.71% d. 16.29% e. 20.41% ANSWER: c 109. Last year Rennie Industries had sales of $315,000, assets of $175,000 (which equals total invested capital), a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000 without affecting either sales or costs. The firm finances using only debt and common equity. Had it reduced its assets by this amount, and had the debt/total invested capital ratio, sales, and costs remained constant, how much would the ROE have changed? Do not round your intermediate calculations. a. 4.66% b. 4.38% c. 4.14% d. 3.77% e. 4.71% ANSWER: e 110. Last year Blease Inc had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its sales were $400,000 and its net income was $10,600. The firm finances using only debt and common equity, and its total assets equal total invested capital. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $10,250 without changing its sales, assets, or capital structure. Had it cut costs and increased its net income by this amount, how much would the ROE have changed? Do not round your intermediate calculations. a. 4.65% b. 6.02% c. 5.13% d. 6.26% e. 5.96% ANSWER: e 111. Last year Jandik Corp. had $270,000 of assets (which is equal to its total invested capital), $18,750 of net income, and a debt-to-total-capital ratio of 37%. Now suppose the new CFO convinces the president to increase the debt-to-totalcapital ratio to 48%. Sales, total assets and total invested capital will not be affected, but interest expenses would increase.

However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE? Do not round your intermediate calculations. a. 2.66% Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements b. 2.17% c. 2.49% d. 2.33% e. 2.82% ANSWER: d 112. Last year Kruse Corp had $435,000 of assets (which is equal to its total invested capital), $403,000 of sales, $28,250 of net income, and a debt-to-total-capital ratio of 39%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets and total invested capital to $252,500. The firm finances using only debt and common equity. Sales, costs, and net income would not be affected, and the firm would maintain the same capital structure (but with less total debt). By how much would the reduction in assets improve the ROE? Do not round your intermediate calculations. a. 7.69% b. 5.85% c. 7.93% d. 7.62% e. 6.31% ANSWER: a 113. Jordan Inc has the following balance sheet and income statement data: Cash Receivables Inventories Total CA Net fixed assets Total assets Sales Net income

$14,000 70,000 280,000 $364,000 126,000 $490,000 $280,000 21,000

Accounts payable Other current liabilities Total CL Long-term debt Common equity Total liab. and equity

$42,000 28,000 $70,000 140,000 280,000 $490,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.45, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change? Do not round your intermediate calculations. a. 16.67% b. 19.31% c. 15.18% d. 16.01% e. 16.50% ANSWER: e 114. Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end assets (which is equal to its total invested capital) of $355,000. The debt-to-total-capital ratio was 17%, the interest rate on the debt was 7.5%, and the firm's tax rate was 25%. The new CFO wants to see how the ROE would have been affected if the firm had used a 50% debt-to-total-capital ratio. Assume that sales, operating costs, total assets, total invested capital, and the tax rate would not be affected, but the interest rate would rise to 8.0%. By how much would the ROE change in response to the change in the capital structure? Do not round your intermediate calculations.

Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements a. 3.59% b. 3.91% c. 3.52% d. 3.55% e. 2.98% ANSWER: d 115. Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets (which is equal to its total invested capital) to be $200,000, and its tax rate to be 25%. Under Plan A, it would finance the firm using 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders, the TIE ratio would have to be maintained at or above 3.9.

Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, total invested capital, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? Do not round your intermediate calculations. a. 7.45% b. 6.65% c. 5.06% d. 5.72% e. 5.39% ANSWER: b Exhibit 4.1 The balance sheet and income statement shown below are for Koski Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

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

202X $6,000 15,000 15,000 $36,000 $24,000 $60,000 $17,292 8,908 8,000 $34,200 $9,000 $43,200 $5,040 11,760 $16,800 $60,000 202X Page 24

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements Net sales Operating costs except depreciation Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes (25%) Net income Other data: Shares outstanding (millions) Common dividends (millions of $) Int. rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$120,000 111,600 2,400 $6,000 1,020 $4,980 1,245 $3,735

500.00 $1,307.25 6% 25% $89.64

116. Refer to Exhibit 4.1. What is the firm's current ratio? Do not round your intermediate calculations. a. 1.27 b. 1.25 c. 0.94 d. 1.05 e. 1.20 ANSWER: d 117. Refer to Exhibit 4.1. What is the firm's quick ratio? Do not round your intermediate calculations. a. 0.68 b. 0.61 c. 0.66 d. 0.56 e. 0.72 ANSWER: b 118. Refer to Exhibit 4.1. What is the firm's days sales outstanding? Assume a 365-day year for this calculation. Do not round your intermediate calculations. a. 37.87 b. 49.28 c. 37.41 d. 53.38 e. 45.63 ANSWER: e 119. Refer to Exhibit 4.1. What is the firm's total assets turnover? Do not round your intermediate calculations. a. 2.14 b. 1.64 c. 2.00 Copyright Cengage Learning. Powered by Cognero.

Page 25

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements d. 2.48 e. 1.68 ANSWER: c 120. Refer to Exhibit 4.1. What is the firm's inventory turnover ratio? Assume that the firm’s cost of goods sold is 65% of sales. Do not round your intermediate calculations. a. 5.20 b. 4.68 c. 4.73 d. 5.51 e. 5.46 ANSWER: a 121. Refer to Exhibit 4.1. What is the firm's TIE? Do not round your intermediate calculations. a. 5.24 b. 6.12 c. 7.24 d. 5.88 e. 7.18 ANSWER: d 122. Refer to Exhibit 4.1. What is the firm's total debt to total capital ratio? Do not round your intermediate calculations. a. 49.29% b. 61.36% c. 53.82% d. 44.76% e. 50.30% ANSWER: e 123. Refer to Exhibit 4.1. What is the firm's ROA? Do not round your intermediate calculations. a. 6.23% b. 4.92% c. 5.23% d. 5.60% e. 7.35% ANSWER: a 124. Refer to Exhibit 4.1. What is the firm's ROE? Do not round your intermediate calculations. a. 20.90% b. 22.23% c. 23.34% d. 25.57% e. 24.68% ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements 125. Refer to Exhibit 4.1. What is the firm's BEP? Do not round your intermediate calculations. a. 10.40% b. 11.10% c. 10.00% d. 9.10% e. 11.60% ANSWER: c 126. Refer to Exhibit 4.1. What is the firm's profit margin? Do not round your intermediate calculations. a. 2.99% b. 3.49% c. 3.27% d. 3.11% e. 2.33% ANSWER: d 127. Refer to Exhibit 4.1. What is the firm's return on invested capital? a. 13.31% b. 14.51% c. 12.25% d. 12.38% e. 10.52% ANSWER: a 128. Refer to Exhibit 4.1. What is the firm's operating margin? Do not round your intermediate calculations. a. 4.05% b. 5.10% c. 5.35% d. 5.05% e. 5.00% ANSWER: e 129. Refer to Exhibit 4.1. What is the firm's P/E ratio? Do not round your intermediate calculations. a. 12.0 b. 12.6 c. 13.2 d. 13.9 e. 14.6 ANSWER: a 130. Refer to Exhibit 4.1. What is the firm's book value per share? Do not round your intermediate calculations. a. $30.58 b. $39.98 Copyright Cengage Learning. Powered by Cognero.

Page 27

Name:

Class:

Date:

Chapter 4 - Analysis of Financial Statements c. $34.94 d. $33.60 e. $41.66 ANSWER: d 131. Refer to Exhibit 4.1. What is the firm's market-to-book ratio? Do not round your intermediate calculations. a. 2.51 b. 3.04 c. 3.07 d. 2.69 e. 2.67 ANSWER: e 132. Refer to Exhibit 4.1. What is the firm's equity multiplier? Do not round your intermediate calculations. a. 3.57 b. 3.39 c. 3.75 d. 4.00 e. 4.32 ANSWER: a

Copyright Cengage Learning. Powered by Cognero.

Page 28

Name:

Class:

Date:

Chapter 5 - Time Value of Money Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in multiple-choice questions.

Multiple Choice: True/False 1. Starting to invest early for retirement increases the benefits of compound interest. a. True b. False ANSWER: True 2. Starting to invest early for retirement reduces the benefits of compound interest. a. True b. False ANSWER: False 3. A time line is meaningful even if all cash flows do not occur annually. a. True b. False ANSWER: True 4. A time line is not meaningful unless all cash flows occur annually. a. True b. False ANSWER: False 5. Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False ANSWER: True 6. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False ANSWER: False 7. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods. a. True b. False ANSWER: True 8. Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 5 - Time Value of Money 9. Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts. a. True b. False ANSWER: True 10. Some of the cash flows shown on a time line can be in the form of annuity payments but none can be uneven amounts. a. True b. False ANSWER: False 11. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series. a. True b. False ANSWER: False 12. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series. a. True b. False ANSWER: True 13. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value. a. True b. False ANSWER: True 14. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value. a. True b. False ANSWER: False 15. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate. a. True b. False ANSWER: False 16. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate. a. True b. False ANSWER: True 17. The greater the number of compounding periods within a year, (1) the greater the future value of a lump sum Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 5 - Time Value of Money investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date. a. True b. False ANSWER: False 18. The greater the number of compounding periods within a year, (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date. a. True b. False ANSWER: True 19. Suppose Sally Smith plans to invest $1,000. She can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be more than twice the compounded value of Security A. (Ignore the risk, and assume that compounding occurs annually.) a. True b. False ANSWER: True 20. Suppose Randy Jones plans to invest $1,000. He can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be somewhat less than twice the compounded value of Security A. (Ignore the risk, and assume that compounding occurs annually.) a. True b. False ANSWER: False 21. The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False ANSWER: True 22. The present value of a future sum increases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False ANSWER: False 23. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases. a. True b. False ANSWER: True 24. All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases. a. True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 5 - Time Value of Money b. False ANSWER: False 25. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by multiplying the periodic rate by the number of periods per year. a. True b. False ANSWER: True 26. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year. a. True b. False ANSWER: False 27. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or greater than the nominal rate on the deposit (or loan). a. True b. False ANSWER: True 28. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan). a. True b. False ANSWER: False 29. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years. a. True b. False ANSWER: False 30. When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years. a. True b. False ANSWER: True 31. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 5 - Time Value of Money 32. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal. a. True b. False ANSWER: False 33. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan. a. True b. False ANSWER: False 34. Midway through the life of an amortized loan, the percentage of the payment that represents interest could be equal to, less than, or greater than the percentage that represents repayment of principal. The proportions depend on the original life of the loan and the interest rate. a. True b. False ANSWER: True 35. The effective annual rate is also known as the nominal interest rate. a. True b. False ANSWER: False 36. The effective annual rate is also known as the equivalent annual rate. a. True b. False ANSWER: True Multiple Choice: Conceptual Please note that some of the answer choices, or answers that are very close, are used in different questions. This has caused us no difficulties, but please take this into account when you make up exams.

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

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 5 - Time Value of Money 38. Which of the following statements is CORRECT? a. A time line is not meaningful unless all cash flows occur annually. b. Time lines are not useful for visualizing complex problems prior to doing actual calculations. c. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods. e. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts.

ANSWER: d 39. Which of the following statements is CORRECT? a. A time line is not meaningful unless all cash flows occur annually. b. Time lines are not useful for visualizing complex problems prior to doing actual calculations. c. Time lines can be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities. e. Time lines cannot be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.

ANSWER: c 40. Which of the following statements is CORRECT? a. A time line is not meaningful unless all cash flows occur annually. b. Time lines are not useful for visualizing complex problems prior to doing actual calculations. c. Time lines cannot be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities. e. Time lines can be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.

ANSWER: e 41. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment? a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000. b. The discount rate increases. c. The riskiness of the investment's cash flows decreases. d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years, and less are received in the later years. e. The discount rate decreases.

ANSWER: b 42. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would increase the calculated value of the investment?

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 5 - Time Value of Money a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000. b. The discount rate decreases. c. The riskiness of the investment's cash flows increases. d. The total amount of cash flows remains the same, but more of the cash flows are received in the later years, and less are received in the earlier years. e. The discount rate increases.

ANSWER: b 43. Which of the following statements is CORRECT? a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. c. The cash flows for an annuity due must all occur at the ends of the periods. d. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. e. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity.

ANSWER: d 44. Which of the following statements is CORRECT? a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. c. The cash flows for an annuity due must all occur at the beginning of the periods. d. The cash flows for an annuity may vary from period to period, but they must occur at regular intervals, such as once a year or once a month. e. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity.

ANSWER: c 45. Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? a. The periodic rate of interest is 1.5%, and the effective rate of interest is 3%. b. The periodic rate of interest is 6%, and the effective rate of interest is greater than 6%. c. The periodic rate of interest is 1.5%, and the effective rate of interest is greater than 6%. d. The periodic rate of interest is 3%, and the effective rate of interest is 6%. e. The periodic rate of interest is 6%, and the effective rate of interest is also 6%.

ANSWER: c 46. Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? a. The periodic rate of interest is 2%, and the effective rate of interest is 4%. b. The periodic rate of interest is 8%, and the effective rate of interest is greater than 8%. c. The periodic rate of interest is 4%, and the effective rate of interest is less than 8%.

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 5 - Time Value of Money d. The periodic rate of interest is 2%, and the effective rate of interest is greater than 8%. e. The periodic rate of interest is 8%, and the effective rate of interest is also 8%.

ANSWER: d 47. A $50,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The annual payments would be larger if the interest rate were lower. b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 7-year amortization plan. c. The proportion of each payment that represents interest as opposed to repayment of principal would be lower if the interest rate were lower. d. The last payment would have a higher proportion of interest than the first payment. e. The proportion of interest versus principal repayment would be the same for each of the 7 payments.

ANSWER: c 48. A $150,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The annual payments would be larger if the interest rate were lower. b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 7-year amortization plan. c. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were lower. d. The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher. e. The proportion of interest versus principal repayment would be the same for each of the 7 payments.

ANSWER: d 49. Which of the following statements regarding a 15-year (180-month) $125,000 fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The remaining balance after three years will be $125,000 less one-third of the interest paid during the first three years. b. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. c. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. d. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. e. The outstanding balance declines at a slower rate in the later years of the loan's life.

ANSWER: b 50. Which of the following statements regarding a 15-year (180-month) $125,000 fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The remaining balance after three years will be $125,000 less one-third of the interest paid during the first three years. b. Because the outstanding balance declines over time, the monthly payments will also decline over time. c. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 5 - Time Value of Money remain constant. d. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. e. The outstanding balance declines at a faster rate in the later years of the loan's life.

ANSWER: e 51. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? a. The monthly payments will decline over time. b. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. c. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. d. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. e. Exactly 10% of the first monthly payment represents interest.

ANSWER: b 52. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? a. The monthly payments will increase over time. b. A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment. c. The total dollar amount of interest being paid off each month gets larger as the loan approaches maturity. d. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. e. Exactly 10% of the first monthly payment represents interest.

ANSWER: b 53. Which of the following investments would have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same and is greater than zero. a. Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments). b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (just one payment). e. Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).

ANSWER: a 54. Which of the following investments would have the lowest present value? Assume that the effective annual rate for all investments is the same and is greater than zero. a. Investment A pays $250 at the end of every year for the next 10 years (a total of 10 payments). b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (just one payment).

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 5 - Time Value of Money e. Investment E pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).

ANSWER: d 55. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? a. The periodic interest rate is greater than 3%. b. The periodic rate is less than 3%. c. The present value would be greater if the lump sum were discounted back for more periods. d. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually. e. The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity.

ANSWER: d 56. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? a. The periodic interest rate is greater than 3%. b. The periodic rate is less than 3%. c. The present value would be greater if the lump sum were discounted back for more periods. d. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually. e. The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity.

ANSWER: e 57. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. b. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. c. A bank loan's nominal interest rate will always be equal to or less than its effective annual rate. d. If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%. e. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly, and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

ANSWER: c 58. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. b. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. c. A bank loan's nominal interest rate will always be equal to or greater than its effective annual rate. d. If an investment pays 10% interest, compounded quarterly, its effective annual rate will be greater than 10%. e. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly, and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

ANSWER: d 59. Which of the following statements is CORRECT? a. The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 5 - Time Value of Money annuity. b. If a loan has a nominal annual rate of 8%, then the effective rate can never be greater than 8%. c. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. d. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. e. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

ANSWER: a 60. Which of the following statements is CORRECT? a. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. b. If a loan has a nominal annual rate of 8%, then the effective rate will never be less than 8%. c. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. d. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. e. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

ANSWER: b 61. You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? a. The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE. b. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. c. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. d. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. e. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant.

ANSWER: d 62. You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? a. A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ. b. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. c. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. d. The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD. e. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 5 - Time Value of Money the present value of DUE would remain constant.

ANSWER: a 63. Which of the following statements is CORRECT? a. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows will be more than the cash flow at Time 0. b. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. c. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is, essentially, a trial-and-error procedure that is easy with a computer or financial calculator but quite difficult otherwise. d. If you solve for I and get a negative number, then you must have made a mistake. e. If CF0 is positive and all the other CFs are negative, then you cannot solve for I. ANSWER: c 64. Which of the following statements is CORRECT? a. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows will be more than the cash flow at Time 0. b. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. c. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the FV of the negative CFs. It is impossible to find the value of I without a computer or financial calculator. d. If you solve for I and get a negative number, then you must have made a mistake. e. If CF0 is positive and all the other CFs are negative, then you can still solve for I. ANSWER: e 65. Which of the following bank accounts has the highest effective annual return? a. An account that pays 8% nominal interest with monthly compounding. b. An account that pays 8% nominal interest with annual compounding. c. An account that pays 7% nominal interest with daily (365-day) compounding. d. An account that pays 7% nominal interest with monthly compounding. e. An account that pays 8% nominal interest with daily (365-day) compounding.

ANSWER: e 66. Which of the following bank accounts has the lowest effective annual return? a. An account that pays 8% nominal interest with monthly compounding. b. An account that pays 8% nominal interest with annual compounding. c. An account that pays 7% nominal interest with daily (365-day) compounding. d. An account that pays 7% nominal interest with monthly compounding. e. An account that pays 8% nominal interest with daily (365-day) compounding.

ANSWER: d 67. You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest?

Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 5 - Time Value of Money a. Bank 1; 6.1% with annual compounding b. Bank 2; 6.0% with monthly compounding c. Bank 3; 6.0% with annual compounding d. Bank 4; 6.0% with quarterly compounding e. Bank 5; 6.0% with daily (365-day) compounding ANSWER: e 68. The interest rate charged on credit cards and student loans is known as the a. effective annual rate. b. equivalent annual rate. c. yield rate. d. annual percentage rate. e. compounded annual rate.

ANSWER: d 69. Which of the following statements is CORRECT regarding amortized loans? a. An amortized loan is paid back in one lump sum payment at the end of the borrowing period. b. An amortized loan is paid back in equal monthly, quarterly, or annual payments. c. An amortized loan is always more expensive than a lump sum loan. d. Each payment in an amortized loan consists of interest only. e. An amortized loan is paid back in uneven amounts, based on the terms of the loan.

ANSWER: b Multiple Choice: Problems

70. Sue now has $120. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? a. $230.47 b. $184.38 c. $271.96 d. $253.52 e. $262.74 ANSWER: a 71. Jose now has $500. How much would he have after 6 years if he leaves it invested at 5.7% with annual compounding? a. $864.65 b. $655.46 c. $787.95 d. $697.30 e. $662.44 ANSWER: d 72. Suppose you have $1,575 and plan to purchase a 5-year certificate of deposit (CD) that pays 3.5% interest, Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 5 - Time Value of Money compounded annually. How much will you have when the CD matures? a. $1,720.96 b. $1,870.61 c. $2,020.25 d. $2,038.96 e. $2,319.55 ANSWER: b 73. Suppose you have $2,000 and plan to purchase a 10-year certificate of deposit (CD) that pays 14.0% interest, compounded annually. How much will you have when the CD matures? a. $6,598.85 b. $7,414.44 c. $5,709.12 d. $8,378.32 e. $6,747.14 ANSWER: b 74. Last year Rocco Corporation's sales were $625 million. If sales grow at 6% per year, how large (in millions) will they be 5 years later? a. $1,045.49 b. $970.21 c. $986.94 d. $702.57 e. $836.39 ANSWER: e 75. Last year Dania Corporation's sales were $525 million. If sales grow at 11.7% per year, how large (in millions) will they be 8 years later? a. $1,412.24 b. $1,272.29 c. $1,157.78 d. $1,539.47 e. $1,081.44 ANSWER: b 76. How much would $1, growing at 12.7% per year, be worth after 75 years? a. $6,036.49 b. $7,839.60 c. $7,526.01 d. $9,721.10 e. $9,485.91 ANSWER: b 77. How much would $100, growing at 5% per year, be worth after 90 years?

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 5 - Time Value of Money a. $9,929.83 b. $6,216.24 c. $8,073.04 d. $6,942.81 e. $9,687.64 ANSWER: c 78. You deposit $1,025 today in a savings account that pays 6% interest, compounded annually. How much will your account be worth at the end of 25 years? a. $4,047.23 b. $4,355.18 c. $4,531.14 d. $4,399.17 e. $5,059.04 ANSWER: d 79. You deposit $500 today in a savings account that pays 6% interest, compounded annually. How much will your account be worth at the end of 20 years? a. $1,587.53 b. $1,924.28 c. $1,298.89 d. $1,635.64 e. $1,603.57 ANSWER: e 80. Suppose a State of New York bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.2%, how much is the bond worth today? a. $602.34 b. $493.92 c. $716.79 d. $505.97 e. $578.25 ANSWER: a 81. Suppose a State of California bond will pay $1,000 eight years from now. If the going interest rate on these 8-year bonds is 6.3%, how much is the bond worth today? a. $656.32 b. $601.12 c. $613.39 d. $594.98 e. $558.18 ANSWER: c 82. How much would $25,000 due in 50 years be worth today if the discount rate were 7.5%?

Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 5 - Time Value of Money a. $833.56 b. $806.67 c. $591.56 d. $672.23 e. $625.17 ANSWER: d 83. How much would $5,000 due in 25 years be worth today if the discount rate were 5.5%? a. $1,573.40 b. $1,311.17 c. $1,048.93 d. $1,416.06 e. $1,494.73 ANSWER: b 84. Suppose a U.S. treasury bond will pay $4,825 five years from now. If the going interest rate on 5-year treasury bonds is 4.25%, how much is the bond worth today? a. $3,918.47 b. $3,409.07 c. $3,761.74 d. $3,605.00 e. $2,938.86 ANSWER: a 85. Suppose an Evern Corporation bond will pay $4,500 ten years from now. If the going interest rate on safe 10-year bonds is 7.60%, how much is the bond worth today? a. $2,184.80 b. $2,163.17 c. $2,466.01 d. $1,708.90 e. $2,401.11 ANSWER: b 86. Suppose the U.S. Treasury offers to sell you a bond for $697.25. No payments will be made until the bond matures 5 years from now, at which time it will be redeemed for $1,000. What interest rate would you earn if you bought this bond at the offer price? a. 7.78% b. 6.28% c. 6.51% d. 7.25% e. 7.48% ANSWER: e 87. Suppose the U.S. Treasury offers to sell you a bond for $3,000. No payments will be made until the bond matures 10 Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 5 - Time Value of Money years from now, at which time it will be redeemed for $4,800. What interest rate would you earn if you bought this bond at the offer price? a. 5.49% b. 3.90% c. 4.81% d. 4.19% e. 5.15% ANSWER: c 88. Ten years ago, Lucas Inc. earned $0.50 per share. Its earnings this year were $2.00. What was the growth rate in earnings per share (EPS) over the 10-year period? a. 12.19% b. 11.60% c. 14.87% d. 12.64% e. 14.57% ANSWER: c 89. Five years ago, Weed Go Inc. earned $1.70 per share. Its earnings this year were $3.20. What was the growth rate in earnings per share (EPS) over the 5-year period? a. 13.49% b. 11.87% c. 13.62% d. 14.43% e. 14.02% ANSWER: a 90. Janice has $5,000 invested in a bank that pays 10.8% annually. How long will it take for her funds to triple? a. 9.86 years b. 10.71 years c. 10.07 years d. 9.75 years e. 10.93 years ANSWER: b 91. Bob has $2,500 invested in a bank that pays 5.0% annually. How long will it take for his funds to double? a. 11.22 years b. 16.20 years c. 14.21 years d. 10.94 years e. 12.79 years ANSWER: c 92. Last year Thomson Inc's earnings per share were $3.50, and its growth rate during the prior 5 years was 5.8% per year.

Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 5 - Time Value of Money If that growth rate were maintained, how many years would it take for Thomson's EPS to triple? (Note: EPS is calculated annually.) a. 19 years b. 18 years c. 20 years d. 15 years e. 24 years ANSWER: c 93. You plan to invest in securities that pay 10.0%, compounded annually. If you invest $5,000 today, how many years will it take for your investment to grow to $9,140.20? a. 7.47 years b. 6.27 years c. 5.57 years d. 6.77 years e. 6.33 years ANSWER: e 94. You plan to invest in bonds that pay 6.0%, compounded annually. If you invest $10,000 today, how many years will it take for your investment to grow to $25,000? a. 19 years b. 14 years c. 17 years d. 16 years e. 12 years ANSWER: d 95. You want to buy a new sports car 3 years from now, and you plan to save $4,200 per year, beginning one year from today. You will deposit your savings in an account that pays 5.2% interest. How much will you have just after you make the 3rd deposit, 3 years from now? a. $15,919.87 b. $13,664.55 c. $10,878.58 d. $13,266.56 e. $11,674.57 ANSWER: d 96. You want to buy a new ski boat 2 years from now, and you plan to save $3,600 per year, beginning one year from today. You will deposit your savings in an account that pays 6.2% interest. How much will you have just after you make the 2nd deposit, 2 years from now? a. $8,537 b. $7,423 c. $8,314 d. $5,939 e. $5,716 Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 5 - Time Value of Money ANSWER: b 97. You want to go to Europe 5 years from now, and you can save $4,700 per year, beginning one year from today. You plan to deposit the funds in a mutual fund that you think will return 8.5% per year. Under these conditions, how much would you have just after you make the 5th deposit, 5 years from now? a. $30,634.18 b. $30,912.67 c. $25,342.82 d. $27,570.76 e. $27,849.25 ANSWER: e 98. You want to quit your job and go back to school for a law degree 4 years from now, and you plan to save $9,100 per year, beginning immediately. You will make 4 deposits in an account that pays 5.7% interest. Under these assumptions, how much will you have 4 years from today? a. $49,012.68 b. $47,337.03 c. $43,147.92 d. $41,891.18 e. $45,242.48 ANSWER: d 99. You want to quit your job and return to school for an MBA degree 3 years from now, and you plan to save $9,600 per year, beginning immediately. You will make 3 deposits in an account that pays 5.2% interest. Under these assumptions, how much will you have 3 years from today? a. $31,900.38 b. $28,072.34 c. $25,839.31 d. $32,538.39 e. $38,599.46 ANSWER: a 100. What is the PV of an ordinary annuity with 10 payments of $6,600 if the appropriate interest rate is 5.5%? a. $55,718.13 b. $38,306.21 c. $62,185.41 d. $49,250.85 e. $49,748.33 ANSWER: e 101. What is the PV of an ordinary annuity with 5 payments of $5,400 if the appropriate interest rate is 4.5%? a. $26,313.52 b. $20,387.05 c. $26,550.58 d. $23,705.87 Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 5 - Time Value of Money e. $24,891.17 ANSWER: d 102. You have a chance to buy an annuity that pays $11,300 at the end of each year for 3 years. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $28,047.72 b. $27,742.85 c. $26,828.25 d. $32,620.71 e. $30,486.65 ANSWER: e 103. You just inherited some money, and a broker offers to sell you an annuity that pays $11,300 at the end of each year for 20 years. You could earn 5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $157,721.73 b. $142,231.21 c. $140,822.98 d. $143,639.44 e. $126,740.68 ANSWER: c 104. Your aunt is about to retire, and she wants to sell some of her stock and buy an annuity that will provide her with income of $39,000 per year for 30 years, beginning a year from today. The going rate on such annuities is 7.25%. How much would it cost her to buy such an annuity today? a. $590,053.56 b. $358,752.56 c. $429,558.99 d. $472,042.84 e. $405,956.85 ANSWER: d 105. What is the PV of an annuity due with 5 payments of $7,900 at an interest rate of 5.5%? a. $27,404.83 b. $32,387.52 c. $35,590.69 d. $28,828.46 e. $44,488.36 ANSWER: c 106. What's the present value of a perpetuity that pays $1,200 per year if the appropriate interest rate is 5%? a. $24,000.00 b. $28,560.00 c. $26,400.00 Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 5 - Time Value of Money d. $24,960.00 e. $29,760.00 ANSWER: a 107. What's the rate of return you would earn if you paid $1,080 for a perpetuity that pays $85 per year? a. 6.85% b. 9.29% c. 8.26% d. 6.06% e. 7.87% ANSWER: e 108. You have a chance to buy an annuity that pays $2,550 at the beginning of each year for 3 years. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $7,258.12 b. $8,637.16 c. $8,419.41 d. $8,782.32 e. $9,072.64 ANSWER: a 109. You have a chance to buy an annuity that pays $33,000 at the beginning of each year for 5 years. You could earn 4.5% on your money in other investments with equal risk. What is the most you should pay for the annuity? a. $151,388.35 b. $175,610.48 c. $149,874.46 d. $146,846.70 e. $119,596.79 ANSWER: a 110. Your uncle is about to retire, and he wants to buy an annuity that will provide him with $95,000 of income a year for 20 years, with the first payment coming immediately. The going rate on such annuities is 5.25%. How much would it cost him to buy the annuity today? a. $1,464,083.68 b. $1,390,879.49 c. $1,220,069.73 d. $1,098,062.76 e. $1,134,664.85 ANSWER: c 111. Your father is about to retire, and he wants to buy an annuity that will provide him with $57,000 of income a year for 25 years, with the first payment coming immediately. The going rate on such annuities is 5.15%. How much would it cost him to buy the annuity today? a. $624,129.65 b. $782,242.49 Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 5 - Time Value of Money c. $990,285.70 d. $832,172.86 e. $915,390.15 ANSWER: d 112. You inherited an oil well that will pay you $21,000 per year for 25 years, with the first payment being made today. If you think a fair return on the well is 7.5%, how much should you ask for it if you decide to sell it? a. $246,609.46 b. $231,510.92 c. $239,060.19 d. $251,642.30 e. $216,412.38 ANSWER: d 113. Sam was injured in an accident, and the insurance company has offered him the choice of $32,000 per year for 15 years, with the first payment being made today, or a lump sum. If a fair return is 7.5%, how large must the lump sum be to leave him as well off financially as with the annuity? a. $227,739.69 b. $245,958.86 c. $279,360.69 d. $330,981.68 e. $303,652.92 ANSWER: e 114. What's the present value of a 4-year ordinary annuity of $2,250 per year plus an additional $3,350 at the end of Year 4 if the interest rate is 5%? a. $11,593.20 b. $10,734.44 c. $9,231.62 d. $10,412.41 e. $10,949.13 ANSWER: b 115. Suppose you inherited $425,000 and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years? a. $45,418.48 b. $44,095.61 c. $46,741.35 d. $42,331.78 e. $51,150.91 ANSWER: b 116. Your uncle has $835,000 and wants to retire. He expects to live for another 25 years and to earn 7.5% on his invested funds. How much could he withdraw at the end of each of the next 25 years and end up with zero in the account? a. $85,395.59 Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 5 - Time Value of Money b. $62,923.07 c. $78,653.83 d. $74,908.41 e. $73,410.24 ANSWER: d 117. Your uncle has $600,000 and wants to retire. He expects to live for another 25 years, and he also expects to earn 7.5% on his invested funds. How much could he withdraw at the beginning of each of the next 25 years and end up with zero in the account? a. $50,071.07 b. $55,578.89 c. $38,054.02 d. $51,072.49 e. $52,574.63 ANSWER: a 118. Your grandmother just died and left you $75,000 in a trust fund that pays 6.5% interest. You must spend the money on your college education, and you must withdraw the money in 4 equal installments, beginning immediately. How much could you withdraw today and at the beginning of each of the next 3 years and end up with zero in the account? a. $25,695.66 b. $20,350.97 c. $22,612.18 d. $21,173.23 e. $20,556.53 ANSWER: e 119. Suppose you inherited $460,000 and invested it at 8.25% per year. How much could you withdraw at the beginning of each of the next 20 years? a. $48,498.58 b. $38,357.97 c. $47,616.79 d. $44,089.62 e. $45,853.20 ANSWER: d 120. Your father's employer was just acquired, and he was given a severance payment of $400,000, which he invested at a 7.5% annual rate. He now plans to retire, and he wants to withdraw $35,000 at the end of each year, starting at the end of this year. How many years will it take to exhaust his funds, i.e., run the account down to zero? a. 30.94 years b. 20.18 years c. 25.83 years d. 32.56 years e. 26.91 years ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 5 - Time Value of Money 121. Your uncle has $370,000 invested at 7.5%, and he now wants to retire. He wants to withdraw $35,000 at the end of each year, starting at the end of this year. He also wants to have $25,000 left to give you when he ceases to withdraw funds from the account. For how many years can he make the $35,000 withdrawals and still have $25,000 left in the end? a. 25 years b. 22 years c. 16 years d. 23 years e. 19 years ANSWER: b 122. Your Aunt Ruth has $550,000 invested at 6.5%, and she plans to retire. She wants to withdraw $40,000 at the beginning of each year, starting immediately. How many years will it take to exhaust her funds, i.e., run the account down to zero? a. 24 years b. 23 years c. 25 years d. 29 years e. 30 years ANSWER: e 123. Your aunt has $520,000 invested at 5.5%, and she now wants to retire. She wants to withdraw $45,000 at the beginning of each year, beginning immediately. She also wants to have $50,000 left to give you when she ceases to withdraw funds from the account. For how many years can she make the $45,000 withdrawals and still have $50,000 left in the end? a. 13 years b. 19 years c. 17 years d. 16 years e. 14 years ANSWER: c 124. Suppose you just won the state lottery, and you have a choice between receiving $2,100,000 today or a 20-year annuity of $250,000, with the first payment coming one year from today. What rate of return is built into the annuity?

Disregard taxes. a. 8.57% b. 10.20% c. 6.90% d. 9.60% e. 9.29% ANSWER: b 125. Your girlfriend just won the Florida lottery. She has the choice of $11,100,000 today or a 20-year annuity of $1,050,000, with the first payment coming one year from today. What rate of return is built into the annuity? Disregard taxes. a. 7.94% Copyright Cengage Learning. Powered by Cognero.

Page 24

Name:

Class:

Date:

Chapter 5 - Time Value of Money b. 6.89% c. 5.48% d. 7.03% e. 6.11% ANSWER: d 126. Assume that you own an annuity that will pay you $15,000 per year for 12 years, with the first payment being made today. You need money today to start a new business, and your uncle offers to give you $142,000 for the annuity. If you sell it, what rate of return would your uncle earn on his investment? a. 5.33% b. 4.59% c. 4.31% d. 4.64% e. 3.48% ANSWER: d 127. What annual payment must you receive in order to earn a 6.5% rate of return on a perpetuity that has a cost of $1,800? a. $90.09 b. $111.15 c. $133.38 d. $120.51 e. $117.00 ANSWER: e 128. What is the present value of the following cash flow stream at a rate of 8.00%?

Years: CFs:

0 $0

1 $75

2 $225

3 $0

4 $300

a. $439.40 b. $444.23 c. $482.85 d. $487.68 e. $564.94 ANSWER: c 129. What is the present value of the following cash flow stream at a rate of 20.0%?

Years: CFs:

0 $0

1 2 3 4 $1,500 $3,000 $4,500 $6,000

a. $8,654 b. $10,509 c. $10,597 Copyright Cengage Learning. Powered by Cognero.

Page 25

Name:

Class:

Date:

Chapter 5 - Time Value of Money d. $8,831 e. $6,712 ANSWER: d 130. What is the present value of the following cash flow stream at a rate of 12.5%?

Years: CFs:

0 1 2 3 $750 $2,450 $3,175 $4,400

a. $7,247.68 b. $6,565.54 c. $9,379.35 d. $7,929.81 e. $8,526.68 ANSWER: e 131. You sold a car and accepted a note with the following cash flow stream as your payment. What was the effective price you received for the car assuming an interest rate of 8.5%?

CFs:

0 $0

1 $1,000

2 $2,000

3 $2,000

4 $2,000

a. $5,742 b. $5,630 c. $6,924 d. $4,391 e. $4,335 ANSWER: b 132. At a rate of 5.5%, what is the future value of the following cash flow stream?

Years: CFs:

0 $0

1 $75

2 $225

3 $0

4 $300

a. $511 b. $485 c. $638 d. $696 e. $773 ANSWER: c 133. Your father paid $10,000 (CF at t = 0) for an investment that promises to pay $750 at the end of each of the next 5 years, then an additional lump sum payment of $15,750 at the end of the 5th year. What is the expected rate of return on this investment? a. 15.88% b. 11.11% Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 5 - Time Value of Money c. 18.03% d. 16.34% e. 16.78% ANSWER: a 134. You are offered a chance to buy an asset for $6,500 that is expected to produce cash flows of $750 at the end of Year 1, $1,000 at the end of Year 2, $850 at the end of Year 3, and $6,250 at the end of Year 4. What rate of return would you earn if you bought this asset? a. 8.61% b. 9.95% c. 10.81% d. 9.57% e. 7.27% ANSWER: d 135. What's the future value of $3,900 after 5 years if the appropriate interest rate is 6%, compounded semiannually? a. $5,503.34 b. $5,241.27 c. $5,031.62 d. $5,136.45 e. $5,765.40 ANSWER: b 136. What's the present value of $11,000 discounted back 5 years if the appropriate interest rate is 4.5%, compounded semiannually? a. $8,805.61 b. $8,981.72 c. $9,686.17 d. $6,868.38 e. $9,950.34 ANSWER: a 137. What's the future value of $1,375 after 5 years if the appropriate interest rate is 6%, compounded monthly? a. $1,595.02 b. $1,854.67 c. $1,483.74 d. $1,780.48 e. $1,910.31 ANSWER: b 138. What's the present value of $1,975 discounted back 5 years if the appropriate interest rate is 6%, compounded monthly? a. $1,522.78 b. $1,464.21 Copyright Cengage Learning. Powered by Cognero.

Page 27

Name:

Class:

Date:

Chapter 5 - Time Value of Money c. $1,669.20 d. $1,376.36 e. $1,303.15 ANSWER: b 139. Master Card and other credit card issuers must by law print the Annual Percentage Rate (APR) on their monthly statements. If the APR is stated to be 17.50%, with interest paid monthly, what is the card's EFF%? a. 18.97% b. 16.32% c. 17.27% d. 19.92% e. 21.63% ANSWER: a 140. Riverside Bank offers to lend you $50,000 at a nominal rate of 6.5%, compounded monthly. The loan (principal plus interest) must be repaid at the end of the year. Midwest Bank also offers to lend you the $50,000, but it will charge an annual rate of 7.5%, with no interest due until the end of the year. How much higher or lower is the effective annual rate charged by Midwest versus the rate charged by Riverside? a. 0.91% b. 0.62% c. 0.80% d. 1.00% e. 0.86% ANSWER: c 141. Suppose Community Bank offers to lend you $10,000 for one year at a nominal annual rate of 9.00%, but you must make interest payments at the end of each quarter and then pay off the $10,000 principal amount at the end of the year.

What is the effective annual rate on the loan? a. 9.49% b. 10.70% c. 9.87% d. 9.31% e. 7.91% ANSWER: d 142. Suppose a bank offers to lend you $10,000 for 1 year on a loan contract that calls for you to make interest payments of $240.00 at the end of each quarter and then pay off the principal amount at the end of the year. What is the effective annual rate on the loan? a. 9.95% b. 8.36% c. 11.74% d. 12.44% e. 9.85% ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 28

Name:

Class:

Date:

Chapter 5 - Time Value of Money 143. Charter Bank pays a 4.80% nominal rate on deposits, with monthly compounding. What effective annual rate (EFF%) does the bank pay? a. 4.91% b. 4.61% c. 3.88% d. 4.42% e. 3.73% ANSWER: a 144. Suppose your credit card issuer states that it charges a 19.50% nominal annual rate, but you must make monthly payments, which amounts to monthly compounding. What is the effective annual rate? a. 16.65% b. 17.29% c. 21.34% d. 23.05% e. 17.07% ANSWER: c 145. Pace Co. borrowed $14,000 at a rate of 7.25%, simple interest, with interest paid at the end of each month. The bank uses a 360-day year. How much interest would Pace have to pay in a 30-day month? a. $66.82 b. $96.42 c. $84.58 d. $86.27 e. $76.97 ANSWER: c 146. Suppose you deposited $40,000 in a bank account that pays 5.25% with daily compounding based on a 360-day year.

How much would be in the account after 8 months, assuming each month has 30 days? a. $36,039.47 b. $41,010.44 c. $41,424.68 d. $38,110.71 e. $35,625.23 ANSWER: c 147. Suppose you borrowed $26,000 at a rate of 9.0% and must repay it in 4 equal installments at the end of each of the next 4 years. How large would your payments be? a. $6,741.32 b. $8,025.39 c. $9,068.69 d. $6,099.29 e. $6,019.04 ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 29

Name:

Class:

Date:

Chapter 5 - Time Value of Money 148. Suppose you are buying your first condo for $130,000, and you will make a $15,000 down payment. You have arranged to finance the remainder with a 30-year, monthly payment, amortized mortgage at a 6.5% nominal interest rate, with the first payment due in one month. What will your monthly payments be? a. $661.46 b. $857.72 c. $646.92 d. $654.19 e. $726.88 ANSWER: e 149. Your uncle will sell you his bicycle shop for $235,000, with "seller financing," at a 6.0% nominal annual rate. The terms of the loan would require you to make 12 equal end-of-month payments per year for 4 years, and then make an additional final (balloon) payment of $50,000 at the end of the last month. What would your equal monthly payments be? a. $4,410.94 b. $4,594.73 c. $4,962.31 d. $5,467.73 e. $5,743.41 ANSWER: b 150. Suppose you borrowed $28,000 at a rate of 10.2% and must repay it in 5 equal installments at the end of each of the next 5 years. How much interest would you have to pay in the first year? a. $2,284.80 b. $2,598.96 c. $2,770.32 d. $2,856.00 e. $2,970.24 ANSWER: d 151. You plan to borrow $46,400 at a 7.5% annual interest rate. The terms require you to amortize the loan with 7 equal end-of-year payments. How much interest would you be paying in Year 2? a. $2,467.18 b. $2,775.58 c. $2,929.78 d. $3,083.97 e. $3,546.57 ANSWER: d 152. Your bank offers to lend you $117,100 at an 8.5% annual interest rate to start your new business. The terms require you to amortize the loan with 10 equal end-of-year payments. How much interest would you be paying in Year 2? a. $7,426.05 b. $8,354.30 c. $8,818.43 d. $9,282.56 e. $10,674.94 Copyright Cengage Learning. Powered by Cognero.

Page 30

Name:

Class:

Date:

Chapter 5 - Time Value of Money ANSWER: d 153. You are considering an investment in a Third World bank account that pays a nominal annual rate of 18%, compounded monthly. If you invest $5,000 at the beginning of each month, how many months would it take for your account to grow to $415,000? Round fractional months up. a. 58 b. 54 c. 62 d. 50 e. 52 ANSWER: b 154. You are considering investing in a bank account that pays a nominal annual rate of 7%, compounded monthly. If you invest $3,000 at the end of each month, how many months will it take for your account to grow to $370,000? a. 75 months b. 72 months c. 87 months d. 94 months e. 106 months ANSWER: d 155. Your child's orthodontist offers you two alternative payment plans. The first plan requires a $3,500 immediate upfront payment. The second plan requires you to make monthly payments of $137.41, payable at the end of each month for 3 years. What nominal annual interest rate is built into the monthly payment plan? a. 27.42% b. 24.53% c. 24.05% d. 21.41% e. 19.24% ANSWER: c 156. Your subscription to Investing Wisely Weekly is about to expire. You plan to subscribe to the magazine for the rest of your life, and you can renew it by paying $85 annually, beginning immediately, or you can get a lifetime subscription for $1,000, also payable immediately. Assuming that you can earn 6.0% on your funds and that the annual renewal rate will remain constant, how many years must you live to make the lifetime subscription the better buy? a. 15 years b. 16 years c. 19 years d. 22 years e. 17 years ANSWER: c 157. You agree to make 24 deposits of $500 at the beginning of each month into a bank account. At the end of the 24th month, you will have $12,900 in your account. If the bank compounds interest monthly, what nominal annual interest rate will you be earning?

Copyright Cengage Learning. Powered by Cognero.

Page 31

Name:

Class:

Date:

Chapter 5 - Time Value of Money a. 7.64% b. 6.13% c. 6.75% d. 5.30% e. 6.89% ANSWER: e 158. You just deposited $3,000 in a bank account that pays a 4.0% nominal interest rate, compounded quarterly. If you also add another $5,000 to the account one year (4 quarters) from now and another $7,500 to the account two years (8 quarters) from now, how much will be in the account three years (12 quarters) from now? a. $16,599.29 b. $13,113.44 c. $19,255.17 d. $19,753.15 e. $17,429.25 ANSWER: a 159. Farmers Bank offers to lend you $50,000 at a nominal rate of 5.0%, simple interest, with interest paid quarterly.

Merchants Bank offers to lend you the $50,000, but it will charge 6.0%, simple interest, with interest paid at the end of the year. What's the difference in the effective annual rates charged by the two banks? a. 1.03% b. 0.85% c. 0.98% d. 0.91% e. 0.87% ANSWER: d 160. Suppose you borrowed $60,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. By how much would you reduce the amount you owe in the first year? a. $10,125.95 b. $10,024.69 c. $9,012.09 d. $12,657.43 e. $9,113.35 ANSWER: a 161. Suppose you borrowed $45,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. How much would you still owe at the end of the first year, after you have made the first payment? a. $46,382.87 b. $46,008.82 c. $31,046.60 d. $37,405.54 e. $31,420.65 ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 32

Name:

Class:

Date:

Chapter 5 - Time Value of Money 162. Your company has just taken out a 1-year installment loan for $72,500 at a nominal rate of 14.5% but with equal end-of-month payments. What percentage of the 2nd monthly payment will go toward the repayment of principal? a. 71.85% b. 82.37% c. 65.72% d. 87.62% e. 79.74% ANSWER: d 163. Your brother's business obtained a 30-year amortized mortgage loan for $125,000 at a nominal annual rate of 7.0%, with 360 end-of-month payments. The firm can deduct the interest paid for tax purposes. What will the interest tax deduction be for Year 1? a. $6,706.53 b. $8,535.58 c. $8,709.78 d. $7,751.70 e. $8,622.68 ANSWER: c 164. Your sister turned 35 today, and she is planning to save $35,000 per year for retirement, with the first deposit to be made one year from today. She will invest in a mutual fund that's expected to provide a return of 7.5% per year. She plans to retire 30 years from today, when she turns 65, and she expects to live for 25 years after retirement, to age 90. Under these assumptions, how much can she spend each year after she retires? Her first withdrawal will be made at the end of her first retirement year. a. $292,194.94 b. $253,235.61 c. $282,455.11 d. $324,661.04 e. $275,961.89 ANSWER: d 165. Steve and Ed are cousins who were both born on the same day, and both turned 25 today. Their grandfather began putting $4,000 per year into a trust fund for Steve on his 20th birthday, and he just made a 6th payment into the fund. The grandfather (or his estate's trustee) will make 40 more $4,000 payments until a 46th and final payment is made on Steve's 65th birthday. The grandfather set things up this way because he wants Steve to work, not be a "trust fund baby," but he also wants to ensure that Steve is provided for in his old age.

Until now, the grandfather has been disappointed with Ed, hence has not given him anything. However, they recently reconciled, and the grandfather decided to make an equivalent provision for Ed. He will make the first payment to a trust for Ed today, and he has instructed his trustee to make 40 additional equal annual payments until Ed turns 65, when the 41st and final payment will be made. If both trusts earn an annual return of 8%, how much must the grandfather put into Ed's trust today and each subsequent year to enable him to have the same retirement nest egg as Steve after the last payment is made on their 65th birthday? Assume that all payments are made at the end of the year. a. $5,484 b. $4,530 c. $7,153 d. $5,961 Copyright Cengage Learning. Powered by Cognero.

Page 33

Name:

Class:

Date:

Chapter 5 - Time Value of Money e. $6,974 ANSWER: d 166. After graduation, you plan to work for Dynamo Corporation for 12 years and then start your own business. You expect to save and deposit $7,500 a year for the first 6 years (t = 1 through t = 6) and $15,000 annually for the following 6 years (t = 7 through t = 12). The first deposit will be made a year from today. In addition, your grandfather just gave you a $25,000 graduation gift which you will deposit immediately (t = 0). If the account earns 9% compounded annually, how much will you have when you start your business 12 years from now? a. $280,575 b. $230,572 c. $277,797 d. $266,685 e. $241,683 ANSWER: c 167. You are negotiating to make a 7-year loan of $27,500 to Breck Inc. To repay you, Breck will pay $2,500 at the end of Year 1, $5,000 at the end of Year 2, and $7,500 at the end of Year 3, plus a fixed but currently unspecified cash flow, X, at the end of each year from Year 4 through Year 7. Breck is essentially riskless, so you are confident the payments will be made. You regard 8% as an appropriate rate of return on a low risk but illiquid 7-year loan. What cash flow must the investment provide at the end of each of the final 4 years, that is, what is X? a. $5,683.99 b. $5,286.11 c. $5,570.31 d. $7,104.98 e. $5,513.47 ANSWER: a 168. John and Daphne are saving for their daughter Ellen's college education. Ellen just turned 10 (at t = 0), and she will be entering college 8 years from now (at t = 8). College tuition and expenses at State U. are currently $14,500 a year, but they are expected to increase at a rate of 3.5% a year. Ellen should graduate in 4 years—if she takes longer or wants to go to graduate school, she will be on her own. Tuition and other costs will be due at the beginning of each school year (at t = 8, 9, 10, and 11).

So far, John and Daphne have accumulated $10,000 in their college savings account (at t = 0). Their long-run financial plan is to add an additional $5,000 in each of the next 4 years (at t = 1, 2, 3, and 4). Then they plan to make 3 equal annual contributions in each of the following years, t = 5, 6, and 7. They expect their investment account to earn 9%. How large must the annual payments at t = 5, 6, and 7 be to cover Ellen's anticipated college costs? a. $6,033.18 b. $5,877.15 c. $5,201.02 d. $4,732.93 e. $3,952.77 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 34

Name:

Class:

Date:

Chapter 6 - Interest Rates The difficulty of these questions as seen by students will depend on (1) what was discussed in class and (2) how long students have to answer the questions. If time is not an issue, then many of the questions could be classified as EASY, but under exam conditions with time pressure, many might be regarded as being CHALLENGING. So, consider the amount of time students have when selecting questions for an exam.

Note that there is some overlap between the True/False and the multiple choice questions, as some T/F statements are used in the MC questions.

1. One of the four most fundamental factors that affect the cost of money as discussed in the text is the current state of the weather. If the weather is dark and stormy, the cost of money will be higher than if it is bright and sunny, other things held constant. a. True b. False ANSWER: False 2. One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant. a. True b. False ANSWER: False 3. One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the security's required return, other things held constant. a. True b. False ANSWER: True 4. One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption. The higher the time preference, the lower the cost of money, other things held constant. a. True b. False ANSWER: False 5. The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. a. True b. False ANSWER: True 6. The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions. a. True b. False ANSWER: False 7. The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 6 - Interest Rates for consumption, (3) risk, and (4) the skill level of the economy's labor force. a. True b. False ANSWER: False 8. If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase. a. True b. False ANSWER: True 9. During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining. a. True b. False ANSWER: True 10. If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*. a. True b. False ANSWER: True 11. If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. a. True b. False ANSWER: True 12. The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk." a. True b. False ANSWER: True 13. The risk that interest rates will decline, and that decline will lead to a decline in the income provided by a bond portfolio as interest and maturity payments are reinvested, is called "reinvestment rate risk." a. True b. False ANSWER: True 14. The "yield curve" shows the relationship between bonds' maturities and their yields. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 6 - Interest Rates 15. Because the maturity risk premium is normally positive, the yield curve is normally upward sloping. a. True b. False ANSWER: True 16. Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong. a. True b. False ANSWER: False 17. If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill. a. True b. False ANSWER: False 18. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. a. True b. False ANSWER: True 19. An upward-sloping yield curve is often called a "normal" yield curve, while a downward-sloping yield curve is called "abnormal." a. True b. False ANSWER: True 20. Since yield curves are based on a real risk-free rate plus the expected rate of inflation, at any given time there can be only one yield curve, and it applies to both corporate and Treasury securities. a. True b. False ANSWER: False 21. Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline. a. True b. False ANSWER: False 22. The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 6 - Interest Rates 23. One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant. a. True b. False ANSWER: True 24. The money supply in the United States is controlled by the Federal Reserve Board. a. True b. False ANSWER: True 25. Consistently predicting interest rates correctly is nearly impossible. a. True b. False ANSWER: True Multiple Choice: Conceptual 26. Assume that inflation is expected to decline steadily in the future but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant? a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping. b. If the pure expectations theory holds, the corporate yield curve must be downward sloping. c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping. d. If inflation is expected to decline, there can be no maturity risk premium. e. The expectations theory cannot hold if inflation is decreasing.

ANSWER: a 27. Which of the following factors would be most likely to lead to an increase in nominal interest rates? a. Households reduce their consumption and increase their savings. b. A new technology like the Internet has just been introduced, and it increases investment opportunities. c. There is a decrease in expected inflation. d. The economy falls into a recession. e. The Federal Reserve decides to try to stimulate the economy.

ANSWER: b 28. Which of the following statements is CORRECT, other things held constant? a. If companies have fewer good investment opportunities, interest rates are likely to increase. b. If individuals increase their savings rate, interest rates are likely to increase. c. If expected inflation increases, interest rates are likely to increase. d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 6 - Interest Rates ANSWER: c 29. Which of the following would be most likely to lead to a higher level of interest rates in the economy? a. Households start saving a larger percentage of their income. b. Corporations step up their expansion plans and thus increase their demand for capital. c. The level of inflation begins to decline. d. The economy moves from a boom to a recession. e. The Federal Reserve decides to try to stimulate the economy.

ANSWER: b 30. Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates? a. Prices and interest rates would both rise. b. Prices would rise and interest rates would decline. c. Prices and interest rates would both decline. d. Prices would decline and interest rates would rise. e. There is no reason to expect a change in either prices or interest rates.

ANSWER: d 31. Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72%

AAA = 8.72%

A = 9.64%

BBB = 10.18%

The differences in these rates were probably caused primarily by: a. tax effects. b. default and liquidity risk differences. c. maturity risk differences. d. inflation differences. e. real risk-free rate differences.

ANSWER: b 32. In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT? a. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury securities. b. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds. c. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds. d. The yield curve must be "humped." e. The yield curve must be upward sloping.

ANSWER: e 33. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a. The yield on a 10-year bond would be less than that on a 1-year bill. b. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 6 - Interest Rates premium. c. It is impossible to tell without knowing the coupon rates of the bonds. d. The yields on the two securities would be equal. e. It is impossible to tell without knowing the relative risks of the two securities.

ANSWER: a 34. Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information, which of the following statements is CORRECT? a. The yield curve for U.S. Treasury securities will be upward sloping. b. A 5-year corporate bond must have a lower yield than a 5-year Treasury security. c. A 5-year corporate bond must have a lower yield than a 7-year Treasury security. d. The real risk-free rate cannot be constant if inflation is not expected to remain constant. e. This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

ANSWER: e 35. Which of the following statements is CORRECT? a. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. b. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. c. If inflation is expected to increase in the future, and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. d. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. e. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

ANSWER: c 36. A bond trader observes the following information: The Treasury yield curve is downward sloping.

Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.

Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields.

On the basis of this information, which of the following statements is most CORRECT? a. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. b. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond. c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. d. The corporate yield curve must be flat. e. Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.

ANSWER: c 37. The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT? a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 6 - Interest Rates b. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond. c. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond. d. The conditions in the problem cannot all be true—they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

ANSWER: b 38. Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. e. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

ANSWER: b 39. Which of the following statements is CORRECT? a. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. b. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. c. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond. d. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond. e. The real risk-free rate should increase if people expect inflation to increase.

ANSWER: a 40. Which of the following statements is CORRECT? a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. c. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. e. The yield curve can never be downward sloping.

ANSWER: a 41. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that a. inflation is expected to decline in the future. b. the economy is not in a recession. c. long-term bonds are a better buy than short-term bonds. d. maturity risk premiums could help to explain the yield curve’s upward slope. e. long-term interest rates are more volatile than short-term rates.

ANSWER: d 42. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 6 - Interest Rates a. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. b. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. c. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. d. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. e. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

ANSWER: c 43. Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could be sure that a. long-term interest rates are more volatile than short-term rates. b. inflation is expected to decline in the future. c. the economy is not in a recession. d. long-term bonds are a better buy than short-term bonds. e. maturity risk premiums could help to explain the yield curve's upward slope.

ANSWER: e 44. Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT? a. In equilibrium, long-term rates must be equal to short-term rates. b. An upward-sloping yield curve implies that future short-term rates are expected to decline. c. The maturity risk premium is assumed to be zero. d. Inflation is expected to be zero. e. Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

ANSWER: c 45. Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. b. The interest rate today on a 2-year bond should be approximately 6%. c. The interest rate today on a 2-year bond should be approximately 7%. d. The interest rate today on a 3-year bond should be approximately 7%. e. The interest rate today on a 3-year bond should be approximately 8%.

ANSWER: d 46. The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT? a. Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond. b. Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 6 - Interest Rates c. Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds. d. The 10-year Treasury bond must have a higher yield than the 5-year corporate bond. e. The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

ANSWER: e 47. If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT? a. An upward-sloping yield curve would imply that interest rates are expected to be lower in the future. b. If a 1-year Treasury bill has a yield to maturity of 7%, and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now. c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond. d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds. e. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

ANSWER: d 48. Assuming the pure expectations theory is correct, which of the following statements is CORRECT? a. If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise. b. If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%. c. If 1-year rates are 6%, and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year. d. Reinvestment rate risk is higher on long-term bonds, and interest rate (price) risk is higher on short-term bonds. e. Interest rate (price) risk and reinvestment rate risk are relevant to investors in corporate bonds, but these concepts do not apply to Treasury bonds.

ANSWER: a 49. If the pure expectations theory holds, which of the following statements is CORRECT? a. The yield curve for both Treasury and corporate bonds should be flat. b. The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping. c. The yield curve for Treasury securities cannot be downward sloping. d. The maturity risk premium would be zero. e. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if they bought 2-year bonds.

ANSWER: d 50. Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. b. The real risk-free rate is higher for corporate than for Treasury bonds. c. Most evidence suggests that the maturity risk premium is zero. d. Liquidity premiums are higher for Treasury than for corporate bonds. e. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 6 - Interest Rates 51. Which of the following statements is CORRECT? a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. b. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. c. The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a longterm basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping. d. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. e. Liquidity premiums are generally higher on Treasury than on corporate bonds.

ANSWER: b 52. If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT? a. An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future. b. A 5-year T-bond would always yield less than a 10-year T-bond. c. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat. d. The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope. e. If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

ANSWER: c 53. Which of the following statements is CORRECT? a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. b. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. c. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. e. The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.

ANSWER: a 54. Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT? a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. b. The yield on any corporate bond must exceed the yields on all Treasury bonds. c. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds. d. The stated conditions cannot all be true–they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

ANSWER: a 55. Which of the following statements is CORRECT? a. Downward sloping yield curves are inconsistent with the expectations theory.

Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 6 - Interest Rates b. The actual shape of the yield curve depends only on expectations about future inflation. c. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. d. If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be zero. e. Yield curves must be either upward or downward sloping—they cannot first rise and then decline.

ANSWER: c 56. Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years.

Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT? a. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. b. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. c. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. d. If the Treasury yield curve is upward sloping, and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds. e. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.

ANSWER: d 57. Which of the following statements is CORRECT? a. It is impossible to accurately predict interest rates consistently. b. It is better for firms to finance short-term assets like inventory with long-term debt. c. Short-term debt should be avoided by businesses whenever possible. d. If the yield curve is upward sloping, short-term bonds have higher yields than long-term bonds. e. Businesses are more interested in looking at current interest rates rather than the yield curve when making important decisions.

ANSWER: a Multiple Choice: Problems Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math.

As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory.

We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 6 - Interest Rates the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use.

Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems.

The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero.

58. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.90% per year.

What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 3.13% b. 3.66% c. 3.47% d. 2.95% e. 3.10% ANSWER: e 59. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 5.90%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard crossproduct terms, i.e., if averaging is required, use the arithmetic average. a. 8.08% b. 9.49% c. 9.31% d. 9.40% e. 10.15% ANSWER: d 60. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 2.80%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard crossproduct terms, i.e., if averaging is required, use the arithmetic average. a. 5.30% b. 5.09% c. 5.99% d. 4.45% e. 6.36% ANSWER: a 61. The real risk-free rate is 3.05%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero.

Ignoring any cross-product terms, i.e., if averaging is required, use the arithmetic average, what is the equilibrium rate of return on a 1-year Treasury bond? a. 7.75% b. 6.20% Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 6 - Interest Rates c. 6.57% d. 5.02% e. 5.52% ANSWER: b 62. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.40%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid?

Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 6.00% b. 5.61% c. 4.29% d. 5.50% e. 6.66% ANSWER: d 63. Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 5.60%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 9.08% b. 10.20% c. 11.12% d. 10.00% e. 11.32% ANSWER: b 64. The real risk-free rate is 3.55%, inflation is expected to be 4.80% this year, and the maturity risk premium is zero.

Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? (Round your final answer to 3 decimal places.) a. 10.139% b. 9.543% c. 10.480% d. 8.520% e. 9.628% ANSWER: d 65. Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 1.80%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 2.80% b. 1.97% c. 2.35% d. 2.68% Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 6 - Interest Rates e. 1.83% ANSWER: c 66. Suppose the rate of return on a 10-year T-bond is 6.40%, the expected average rate of inflation over the next 10 years is 2.0%, the MRP on a 10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity premium is required on any Treasury security. Given this information, what should the yield be on a 10-year TIPS? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 3.01% b. 3.50% c. 2.70% d. 3.57% e. 3.82% ANSWER: b 67. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 7.15%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds? a. 1.33% b. 1.60% c. 1.82% d. 1.94% e. 1.78% ANSWER: b 68. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 11.3%, the maturity risk premium on all 10year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? a. 4.79% b. 4.70% c. 5.45% d. 4.94% e. 5.73% ANSWER: b 69. Koy Corporation's 5-year bonds yield 10.75%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds? a. 5.14% b. 4.85% c. 4.90% d. 5.43% e. 3.73% ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 6 - Interest Rates 70. Keys Corporation's 5-year bonds yield 5.80% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% versus zero for Tbonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds? a. 0.99% b. 0.90% c. 1.09% d. 1.02% e. 0.95% ANSWER: b 71. Kay Corporation's 5-year bonds yield 6.80% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds? a. 1.11% b. 0.86% c. 0.99% d. 1.10% e. 1.07% ANSWER: d 72. Niendorf Corporation's 5-year bonds yield 6.25%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf's bonds? a. 0.29% b. 0.27% c. 0.26% d. 0.25% e. 0.31% ANSWER: d 73. Kern Corporation's 5-year bonds yield 7.80% and 5-year T-bonds yield 4.60%. The real risk-free rate is r* = 2.5%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds? a. 1.70% b. 1.51% c. 1.56% d. 1.34% e. 2.11% ANSWER: a 74. Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.45%. The real risk-free rate is r* = Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 6 - Interest Rates 2.70%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What inflation premium (IP) is built into 5-year bond yields? a. 1.36% b. 1.27% c. 1.04% d. 1.20% e. 1.35% ANSWER: e 75. Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 5.30%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 1.8% versus zero on Tbonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds? a. 1.61% b. 1.30% c. 0.98% d. 1.17% e. 1.00% ANSWER: b 76. Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 5.20%. The default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP = 0.90% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*? a. 3.23% b. 3.40% c. 4.09% d. 3.93% e. 3.30% ANSWER: e 77. 5-year Treasury bonds yield 4.3%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*? a. 2.00% b. 1.72% c. 2.24% d. 2.46% e. 1.84% ANSWER: a 78. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 4.50% per year.

What is the real risk-free rate of return, r*? The cross-product term should be considered, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 2.15% Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 6 - Interest Rates b. 2.70% c. 2.39% d. 2.75% e. 2.89% ANSWER: c 79. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.10%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Include crossproduct terms, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 6.13% b. 5.67% c. 7.04% d. 6.07% e. 5.73% ANSWER: b 80. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 6.90%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the crossproduct term, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 11.84% b. 11.64% c. 10.21% d. 9.49% e. 8.88% ANSWER: c 81. Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 4.80%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places. a. 4.69% b. 4.60% c. 3.54% d. 4.51% e. 4.97% ANSWER: b 82. Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield 5.50%. Assuming the pure expectations theory is correct, and thus the maturity risk premium for T-bonds is zero, what is the yield on a 1-year T-bond expected to be one year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places. a. 7.02% b. 5.90% c. 8.78% d. 8.36% e. 7.09% Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 6 - Interest Rates ANSWER: a 83. Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.50% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 1.57% b. 1.69% c. 1.35% d. 1.22% e. 1.49% ANSWER: c 84. Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.30%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places. a. 6.26% b. 5.45% c. 5.85% d. 6.81% e. 6.74% ANSWER: d 85. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.20% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 1.70% applies to A-rated corporate bonds. What is the difference in the yields on a 5-year A-rated corporate bond and on a 10-year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 1.21% b. 1.20% c. 1.03% d. 1.25% e. 0.90% ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation True / False 1. If a firm raises capital by selling new bonds, it could be called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk. a. True b. False ANSWER: True 2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline. a. True b. False ANSWER: False 3. Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value. a. True b. False ANSWER: True 4. A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide compensation to investors in the form of capital appreciation. a. True b. False ANSWER: False 5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds. a. True b. False ANSWER: True 6. The market value of any real or financial asset, including stocks, bonds, or artwork purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present. a. True b. False ANSWER: True 7. The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 8. A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.) a. True b. False ANSWER: False 9. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond. a. True b. False ANSWER: False 10. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets, while debentures are unsecured. a. True b. False ANSWER: True 11. Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers and to provide financing to companies of questionable financial strength. a. True b. False ANSWER: True 12. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False ANSWER: True 13. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds. a. True b. False ANSWER: False 14. You are considering two bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investmentgrade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund, while Bond NSF does not.

Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 15. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floatingrate debt shifts price risk to companies, it offers no advantages to corporate issuers. a. True b. False ANSWER: False 16. A bond has a $1,000 par value, makes annual interest payments of $100, has five years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%. a. True b. False ANSWER: True 17. You have funds that you want to invest in bonds, and you just noticed on a financial website that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%. a. True b. False ANSWER: True 18. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.) a. True b. False ANSWER: True 19. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False ANSWER: True 20. Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. a. True b. False ANSWER: True 21. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 22. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond. a. True b. False ANSWER: False Multiple Choice 23. Which of the following statements is CORRECT? a. You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline. b. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. c. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline. d. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates, other things held constant. e. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.

ANSWER: a 24. Which of the following events would make it more likely that a company would call its outstanding callable bonds? a. The company’s bonds are downgraded. b. Market interest rates rise sharply. c. Market interest rates decline sharply. d. The company's financial situation deteriorates significantly. e. Inflation increases significantly.

ANSWER: c 25. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by: a. real risk-free rate differences. b. tax effects. c. default risk and liquidity differences. d. maturity risk differences. e. inflation differences.

ANSWER: c 26. Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation to be issued at par? a. Adding additional restrictive covenants that limit management's actions b. Adding a call provision c. The rating agencies change the bond's rating from BBB to AAA d. Making the bond a first mortgage bond rather than a debenture e. Adding a sinking fund ANSWER: b 27. Which of the following statements is CORRECT? a. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued. b. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. c. A sinking fund provision makes a bond more risky to investors at the time of issuance. d. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time. e. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price.

ANSWER: a 28. Amram Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. Alternatively, Amram could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Amram would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par? a. The coupon rate should be exactly equal to 6%. b. The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%. c. The rate should be slightly greater than 6%. d. The rate should be over 7%. e. The rate should be over 8%.

ANSWER: b 29. Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return? a. Because of the call premium, the required rate of return would decline. b. There is no reason to expect a change in the required rate of return. c. The required rate of return would decline because the bond would then be less risky to a bondholder. d. The required rate of return would increase because the bond would then be more risky to a bondholder. e. It is impossible to say without more information.

ANSWER: d 30. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. The bond’s expected capital gains yield is zero.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation b. The bond’s yield to maturity is above 9%. c. The bond’s current yield is above 9%. d. If the bond’s yield to maturity declines, the bond will sell at a discount. e. The bond’s current yield is less than its expected capital gains yield.

ANSWER: a 31. Which of the following statements is CORRECT? a. A zero coupon bond's current yield is equal to its yield to maturity. b. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par. c. All else equal, if a bond’s yield to maturity increases, its price will fall. d. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. e. All else equal, if a bond’s yield to maturity increases, its current yield will fall.

ANSWER: c 32. A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT? a. The bond’s coupon rate exceeds its current yield. b. The bond’s current yield exceeds its yield to maturity. c. The bond’s yield to maturity is greater than its coupon rate. d. The bond’s current yield is equal to its coupon rate. e. If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $850.

ANSWER: c 33. Which of the following statements is CORRECT? a. If a bond is selling at a discount, the yield to call is a better measure of return than is the yield to maturity. b. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss. c. On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest. d. If a coupon bond is selling at par, its current yield equals its yield to maturity and its expected capital gains yield is zero. e. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B. ANSWER: d 34. Three $1,000 face value, 10-year, noncallable bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT? a. Bond 8’s current yield will increase each year. b. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. c. Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next year. d. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year. e. Over the next year, Bond 8’s price is expected to decrease, Bond 10’s price is expected to stay the same, and Bond 12’s price is expected to increase.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation ANSWER: d 35. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT? a. The bond’s current yield is less than 8%. b. If the yield to maturity remains at 8%, then the bond’s price will decline over the next year. c. The bond’s coupon rate is less than 8%. d. If the yield to maturity increases, then the bond’s price will increase. e. If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year.

ANSWER: b 36. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? a. If market interest rates decline, the price of the bond will also decline. b. The bond is currently selling at a price below its par value. c. If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today. d. The bond should currently be selling at its par value. e. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.

ANSWER: c 37. A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT? a. The prices of both bonds will decrease by the same amount. b. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. c. The prices of both bonds would increase by the same amount. d. One bond's price would increase, while the other bond’s price would decrease. e. The prices of the two bonds would remain constant.

ANSWER: b 38. You are considering two bonds. Bond A has a 9% annual coupon, while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT? a. The price of Bond B will decrease over time, but the price of Bond A will increase over time. b. The prices of both bonds will remain unchanged. c. The price of Bond A will decrease over time, but the price of Bond B will increase over time. d. The prices of both bonds will increase by 7% per year. e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.

ANSWER: c 39. Which of the following bonds would have the greatest percentage increase in value if all interest rates in the economy fall by 1%? a. 10-year, zero coupon bond b. 20-year, 10% coupon bond c. 20-year, 5% coupon bond Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation d. 1-year, 10% coupon bond e. 20-year, zero coupon bond ANSWER: e 40. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price? a. An 8-year bond with a 9% coupon b. A 1-year bond with a 15% coupon c. A 3-year bond with a 10% coupon d. A 10-year zero coupon bond e. A 10-year bond with a 10% coupon ANSWER: d 41. Which of the following bonds has the greatest price risk? a. A 10-year $100 annuity b. A 10-year, $1,000 face value, zero coupon bond c. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments d. All 10-year bonds have the same price risk since they have the same maturity. e. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments ANSWER: b 42. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value? a. A 1-year, zero coupon bond b. A 1-year bond with an 8% coupon c. A 10-year bond with an 8% coupon d. A 10-year bond with a 12% coupon e. A 10-year, zero coupon bond ANSWER: e 43. Which of the following statements is CORRECT? a. All else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds. b. All else equal, long-term bonds have less price risk than short-term bonds. c. All else equal, low-coupon bonds have less price risk than high-coupon bonds. d. All else equal, short-term bonds have less reinvestment risk than long-term bonds. e. All else equal, long-term bonds have less reinvestment risk than short-term bonds.

ANSWER: e 44. Which of the following statements is CORRECT? a. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold. b. Long-term bonds have less price risk but more reinvestment risk than short-term bonds. c. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less price risk.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation d. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more price risk but less reinvestment risk. e. Long-term bonds have less price risk and also less reinvestment risk than short-term bonds.

ANSWER: d 45. Which of the following statements is CORRECT? a. All else equal, secured debt is more risky than unsecured debt. b. The expected return on a corporate bond must be greater than its promised return if the probability of default is greater than zero. c. All else equal, senior debt has more default risk than subordinated debt. d. A company’s bond rating is affected by its financial ratios but not by provisions in its indenture. e. Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Act. ANSWER: e 46. Which of the following statements is CORRECT? a. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. b. Liquidity premiums are generally higher on Treasury than corporate bonds. c. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. d. Default risk premiums are generally lower on corporate than on Treasury bonds. e. Reinvestment risk is lower, other things held constant, on long-term than on short-term bonds.

ANSWER: e 47. Which of the following statements is CORRECT? a. All else equal, senior debt generally has a lower yield to maturity than subordinated debt. b. An indenture is a bond that is less risky than a mortgage bond. c. The expected return on a corporate bond will generally exceed the bond's yield to maturity. d. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its yield to maturity. e. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

ANSWER: a 48. Which of the following statements is CORRECT? a. If a coupon bond is selling at par, its current yield equals its yield to maturity. b. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. c. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year, zero coupon bond. d. If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium. e. If a coupon bond is selling at a premium, its current yield equals its yield to maturity.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 49. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? a. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price. b. The bond is selling below its par value. c. The bond is selling at a discount. d. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price. e. The bond’s current yield is greater than 9%.

ANSWER: d 50. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT? a. The bond sells at a price below par. b. The bond has a current yield greater than 8%. c. The bond sells at a discount. d. The bond’s required rate of return is less than 7.5%. e. If the yield to maturity remains constant, the price of the bond will decline over time.

ANSWER: e 51. An investor is considering buying one of two 10-year, $1,000 face value, noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, and the YTM is expected to remain constant for the next 10 years. Which of the following statements is CORRECT? a. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. b. One year from now, Bond A’s price will be higher than it is today. c. Bond A’s current yield is greater than 8%. d. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. e. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.

ANSWER: b 52. Which of the following statements is CORRECT? a. If a bond is selling at a discount to par, its current yield will be greater than its yield to maturity. b. All else equal, bonds with longer maturities have less price risk than bonds with shorter maturities. c. If a bond is selling at its par value, its current yield equals its capital gains yield. d. If a bond is selling at a premium, its current yield will be less than its capital gains yield. e. All else equal, bonds with larger coupons have less price risk than bonds with smaller coupons.

ANSWER: e 53. Which of the following statements is CORRECT? a. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value. b. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. c. Other things held constant, including the coupon rate, a corporation would rather issue noncallable bonds than callable bonds. d. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond because it would have a shorter expected life. e. Bonds are exposed to both reinvestment risk and price risk. Longer-term low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment risk than price risk.

ANSWER: b 54. Which of the following statements is CORRECT? a. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. b. The total yield on a bond is derived from dividends plus changes in the price of the bond. c. Bonds are generally regarded as being riskier than common stocks, and therefore bonds have higher required returns. d. Bonds issued by larger companies always have lower yields to maturity (due to less risk) than bonds issued by smaller companies. e. The market price of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.

ANSWER: e 55. Which of the following statements is CORRECT? a. If a coupon bond is selling at par, its current yield equals its yield to maturity. b. If rates fall after its issue, a zero coupon bond could trade at a price above its maturity (or par) value. c. If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative. d. If a firm moves from a position of strength toward financial distress, its bonds’ yield to maturity would probably decline. e. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate.

ANSWER: a 56. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds is noncallable, has a maturity of 10 years, and has a yield to maturity of 10%. Which of the following statements is CORRECT? a. If the bonds' market interest rate remains at 10%, Bond Z’s price will be lower one year from now than it is today. b. Bond X has the greatest reinvestment risk. c. If market interest rates decline, the prices of all three bonds will increase, but Z's price will have the largest percentage increase. d. If market interest rates remain at 10%, Bond Z’s price will be 10% higher one year from today. e. If market interest rates increase, Bond X’s price will increase, Bond Z’s price will decline, and Bond Y’s price will remain the same.

ANSWER: a 57. Bonds A, B, and C all have a maturity of 10 years and a yield to maturity of 7%. Bond A’s price exceeds its par value, Bond B’s price equals its par value, and Bond C’s price is less than its par value. None of the bonds can be called. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation a. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price. b. Bond A has the most price risk. c. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year. d. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline. e. Bond C sells at a premium over its par value.

ANSWER: d 58. Which of the following statements is CORRECT? a. Ten-year, zero coupon bonds have more reinvestment risk than 10-year, 10% coupon bonds. b. A 10-year, 10% coupon bond has less reinvestment risk than a 10-year, 5% coupon bond (assuming all else equal). c. The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond's price at the beginning of the year. d. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond. e. A $1,000 bond with $100 annual interest payments that has five years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%.

ANSWER: c 59. Which of the following statements is CORRECT? a. The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield. b. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy. c. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices. d. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield. e. The expected capital gains yield on a bond will always be zero or positive because no investor would purchase a bond with an expected capital loss.

ANSWER: d 60. Which of the following statements is CORRECT? a. If a coupon bond is selling at a premium, then the bond's current yield is zero. b. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. c. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity. d. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 61. Which of the following statements is CORRECT? a. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of their coupon rates. b. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. c. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. d. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value. e. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.

ANSWER: d 62. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, an 8% yield to maturity, and are noncallable. Which of the following statements is CORRECT? a. Bond A’s capital gains yield is greater than Bond B’s capital gains yield. b. Bond A trades at a discount, whereas Bond B trades at a premium. c. If the yield to maturity for both bonds remains at 8%, Bond A’s price one year from now will be higher than it is today, but Bond B’s price one year from now will be lower than it is today. d. If the yield to maturity for both bonds immediately decreases to 6%, Bond A’s bond will have a larger percentage increase in value. e. Bond A’s current yield is greater than that of Bond B. ANSWER: e 63. Which of the following statements is CORRECT? a. Two bonds have the same maturity and the same coupon rate. However, one is callable, and the other is not.

The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate. b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used. d. Two bonds have the same maturity and the same coupon rate. However, one is callable, and the other is not.

The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.

ANSWER: a 64. Which of the following statements is CORRECT? a. Senior debt is debt that has been more recently issued, and in bankruptcy it is paid off after junior debt because the junior debt was issued first. b. A company's subordinated debt has less default risk than its senior debt. c. Convertible bonds generally have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. d. Junk bonds typically provide a lower yield to maturity than investment-grade bonds. e. A debenture is a secured bond that is backed by some or all of the firm's fixed assets.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 65. Which of the following statements is CORRECT? a. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the use of debt until the bonds mature. b. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. c. Once a firm declares bankruptcy, it must be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and legal fees. d. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds. e. A firm with a sinking fund that gives it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate.

ANSWER: d 66. Which of the following statements is CORRECT? a. The total return on a bond during a given year is based only on the coupon interest payments received. b. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%. c. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant. d. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. e. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized.

ANSWER: c 67. Which of the following statements is CORRECT? a. A bond is likely to be called if its coupon rate is below its YTM. b. A bond is likely to be called if its market price is below its par value. c. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called. d. A bond is likely to be called if its market price is equal to its par value. e. A bond is likely to be called if it sells at a discount below par.

ANSWER: c 68. Which of the following statements is CORRECT? a. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. b. A bond’s current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. c. If a bond sells at par, then its current yield will be less than its yield to maturity. d. If a bond sells for less than par, then its yield to maturity is less than its coupon rate. e. A discount bond’s price declines each year until it matures, when its value equals its par value.

ANSWER: b 69. Assume that a noncallable, 10-year T-bond has a 12% annual coupon, while a 15-year, noncallable T-bond has an 8% Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation annual coupon. Assume also that the yield curve is flat, and all Treasury securities have a 10% yield to maturity. Which of the following statements is CORRECT? a. If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price. b. If interest rates decline, the prices of both bonds would increase, but the 10-year bond would have a larger percentage increase in price. c. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium. d. The 10-year bond would sell at a premium, while the 15-year bond would sell at par. e. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase but the price of the 15-year bond would fall.

ANSWER: a 70. Which of the following statements is CORRECT? a. A zero coupon bond of any maturity will have more price risk than any coupon bond, even a perpetuity. b. If their maturities and other characteristics were the same, a 5% coupon bond would have more price risk than a 10% coupon bond. c. A 10-year coupon bond would have more reinvestment risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment risk. d. A 10-year coupon bond would have more price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of price risk. e. If their maturities and other characteristics were the same, a 5% coupon bond would have less price risk than a 10% coupon bond.

ANSWER: b 71. Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond?

1. Fixed assets are used as security for a bond.

2. A given bond is subordinated to other classes of debt.

3. The bond can be converted into the firm's common stock.

4. The bond has a sinking fund.

5. The bond has a call provision.

6. The indenture contains covenants that restrict the use of additional debt. a. 1, 3, 4, 6 b. 1, 4, 6 c. 1, 2, 3, 4, 6 d. 1, 2, 3, 4, 5, 6 e. 1, 3, 4, 5, 6 ANSWER: a 72. Suppose a new company decides to raise a total of $200 million, with $100 million as common equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT? a. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm’s total dollar interest charges will be. b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of debentures. c. In this situation, we cannot tell for sure how, or even whether, the firm’s total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each type of bond would increase as the percentage of mortgage bonds used was increased, but the average cost might well be such that the firm’s total interest charges would not be affected materially by the mix between the two. d. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures. e. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.

ANSWER: c 73. A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future. b. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. c. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate. d. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. e. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.

ANSWER: b 74. Assuming all else is constant, which of the following statements is CORRECT? a. Other things held constant, a 20-year, zero coupon bond has more reinvestment risk than a 20-year, coupon bond. b. Other things held constant, for any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate. c. From a corporate borrower’s point of view, interest paid on bonds is not tax-deductible. d. Other things held constant, price sensitivity as measured by the percentage change in price due to a given change in the required rate of return decreases as a bond’s maturity increases. e. For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.

ANSWER: e 75. Morin Company's bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 6.8% on these bonds. What is the bond's price? a. $981.95 b. $1,207.79 c. $932.85 Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation d. $893.57 e. $736.46 ANSWER: a 76. A zero-coupon bond is defined as a bond a. whose interest rate fluctuates with changes in interest rates. b. offered at a price below its par value. c. whose interest is fixed until its maturity. d. that is collateralized with a mortgage. e. that pays no annual interest but is sold at a discount below par.

ANSWER: e 77. Which of the following bond ratings would indicate investment-grade bonds? a. Double B rated bonds b. Triple A and double A rated bonds only c. A and triple B rated bonds and above d. C rated bonds e. Junk rated bonds ANSWER: c 78. Which of the following statements is CORRECT regarding the bond markets? a. Corporate bonds are traded primarily over the NYSE. b. Information about Treasury securities is only available on government websites. c. Junk bonds can only be purchased on corporate websites. d. Corporate bonds are mostly traded in the over-the-counter market. e. Pension funds are not allowed to purchase large blocks of bonds.

ANSWER: d 79. Ryngaert Inc. recently issued noncallable bonds that mature in 15 years. They have a par value of $1,000 and an annual coupon of 5.7%. If the current market interest rate is 6.2%, at what price should the bonds sell? a. $1,028.23 b. $1,152.00 c. $980.63 d. $1,009.19 e. $952.07 ANSWER: e 80. Adams Enterprises’ noncallable bonds currently sell for $1,180. They have a 15-year maturity, an annual coupon of $85, and a par value of $1,000. What is their yield to maturity? a. 5.33% b. 6.58% c. 5.92% d. 7.04% e. 7.69% Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation ANSWER: b 81. Dyl Inc.'s bonds currently sell for $910 and have a par value of $1,000. They pay a $65 annual coupon and have a 15year maturity, but they can be called in 5 years at $1,100. What is their yield to maturity (YTM)? a. 7.52% b. 9.10% c. 5.72% d. 6.54% e. 7.90% ANSWER: a 82. Radoski Corporation's bonds make an annual coupon interest payment of 7.35% every year. The bonds have a par value of $1,000, a current price of $1,380, and mature in 12 years. What is the yield to maturity on these bonds? a. 2.57% b. 4.15% c. 3.30% d. 3.12% e. 3.43% ANSWER: e 83. Sadik Inc.'s bonds currently sell for $1,140 and have a par value of $1,000. They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to call (YTC)? a. 8.36% b. 8.62% c. 7.67% d. 9.83% e. 6.72% ANSWER: b 84. Malko Enterprises’ bonds currently sell for $1,140. They have a 6-year maturity, an annual coupon of $75, and a par value of $1,000. What is their current yield? a. 8.09% b. 6.18% c. 7.43% d. 7.04% e. 6.58% ANSWER: e 85. Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require a 9.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $993.70 b. $1,087.84 c. $1,046.00 d. $1,244.74 Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation e. $805.42 ANSWER: c 86. Grossnickle Corporation issued 20-year, noncallable, 9.4% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity? a. $1,365.54 b. $1,351.01 c. $1,786.82 d. $1,452.70 e. $1,743.24 ANSWER: d 87. McCue Inc.'s bonds currently sell for $1,325. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM; it is possible to get a negative answer.) a. 2.66% b. 3.15% c. 3.56% d. 3.49% e. 4.16% ANSWER: d 88. Taussig Corp.'s bonds currently sell for $850. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels into the future. Under these conditions, what rate of return should an investor expect to earn if they purchase these bonds? a. 6.45% b. 7.86% c. 7.63% d. 7.08% e. 9.36% ANSWER: b 89. A 25-year, $1,000 par value bond has an 8.5% annual payment coupon. The bond currently sells for $775. If the yield to maturity remains at its current rate, what will the price be 5 years from now? a. $755.43 b. $621.66 c. $841.99 d. $786.91 e. $684.61 ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation 90. Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 7.70%, based on semiannual compounding. What is the bond’s price? a. $960.37 b. $787.51 c. $806.71 d. $729.88 e. $1,046.81 ANSWER: a 91. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures from historical book values to market values. KJM Corporation's balance sheet (book values) as of today is as follows: Long-term debt (bonds, at par) Preferred stock Common stock ($10 par) Retained earnings Total debt and equity

$23,500,000 2,000,000 10,000,000 4,000,000 $39,500,000

The bonds have an 8.1% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 11%, so the bonds now sell below par. What is the current market value of the firm's debt? a. $19,427,907 b. $16,319,442 c. $24,284,884 d. $15,542,326 e. $14,959,489 ANSWER: a 92. Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,175. What is the bond’s nominal yield to call? a. 8.76% b. 6.32% c. 5.46% d. 7.11% e. 7.18% ANSWER: e 93. O'Brien Ltd.'s outstanding bonds have a $1,000 par value, and they mature in 25 years. Their nominal annual, not semiannual, yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $700. What is the bond's nominal coupon interest rate? a. 4.80% b. 7.14% c. 6.15% d. 5.72% e. 7.44% Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 7 - Bonds and Their Valuation ANSWER: c 94. Kebt Corporation's Class Semi bonds have a 12-year maturity and a 9.75% coupon paid semiannually (4.875% each 6 months), and those bonds sell at their $1,000 par value. The firm's Class Ann bonds have the same risk, maturity, nominal interest rate, and par value, but these bonds pay interest annually. Neither bond is callable. At what price should the annual payment bond sell? a. $885.42 b. $983.80 c. $1,131.37 d. $905.09 e. $816.55 ANSWER: b 95. Moon Software Inc. is planning to issue two types of 25-year, noncallable bonds to raise a total of $6 million, $3 million from each type of bond. First, 3,000 bonds with a 10% semiannual coupon will be sold at their $1,000 par value to raise $3,000,000. These are called "par" bonds. Second, Original Issue Discount (OID) bonds, also with a 25-year maturity and a $1,000 par value, will be sold, but these bonds will have a semiannual coupon of only 3.50%. The OID bonds must be offered at below par in order to provide investors with the same effective yield as the par bonds. How many OID bonds must the firm issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds. a. 8,188 b. 6,787 c. 9,000 d. 8,631 e. 7,377 ANSWER: e

Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False ANSWER: False 2. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False ANSWER: True 3. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly. a. True b. False ANSWER: False 4. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse. a. True b. False ANSWER: True 5. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False ANSWER: True 6. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True b. False ANSWER: True 7. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data. a. True b. False ANSWER: True 8. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 9. Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. a. True b. False ANSWER: True 10. An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held. a. True b. False ANSWER: False 11. Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return. a. True b. False ANSWER: False 12. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM. a. True b. False ANSWER: True 13. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a welldiversified portfolio. a. True b. False ANSWER: True 14. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase. a. True b. False ANSWER: False 15. Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders. a. True b. False ANSWER: True 16. Variance is a measure of the variability of returns, and, since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, the standard deviation.

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. True b. False ANSWER: True 17. Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and, thus, allows investors to make better comparisons of investments' stand-alone risk. a. True b. False ANSWER: True 18. "Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. a. True b. False ANSWER: True 19. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the lower standard deviation. a. True b. False ANSWER: True 20. Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk. a. True b. False ANSWER: True 21. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False ANSWER: False 22. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False ANSWER: False 23. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: True 24. A stock with a beta equal to -1.0 has zero systematic (or market) risk. a. True b. False ANSWER: False 25. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative. a. True b. False ANSWER: True 26. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. True b. False ANSWER: True 27. Portfolio A has only one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will, by definition, be riskless. a. True b. False ANSWER: False 28. A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and, thus, reduce the riskiness of their portfolios. a. True b. False ANSWER: False 29. The distributions of rates of return for Companies AA and BB are given below: State of the Economy Boom Normal Recession

Probability of This State Occurring 0.2 0.6 0.2

AA BB 30% -10% 10% 5% -5% 50%

We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB. a. True b. False ANSWER: False 30. Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting two-asset portfolio will have less risk than either security held alone.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. True b. False ANSWER: False 31. Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away. a. True b. False ANSWER: True 32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio. a. True b. False ANSWER: False 33. We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False ANSWER: False 34. If an investor buys enough stocks, they can, through diversification, eliminate all of the market risk inherent in owning stocks, but, as a general rule, it will not be possible to eliminate all diversifiable risk. a. True b. False ANSWER: False 35. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True b. False ANSWER: False 36. Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return. a. True b. False ANSWER: False 37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 38. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. a. True b. False ANSWER: True 39. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False 40. The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML. a. True b. False ANSWER: True 41. If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False ANSWER: True 42. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future. a. True b. False ANSWER: False 43. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False ANSWER: True 44. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions. a. True b. False ANSWER: False 45. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. True b. False ANSWER: False 46. If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation. a. True b. False ANSWER: True 47. Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False ANSWER: True 48. Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0. a. True b. False ANSWER: True 49. The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False ANSWER: False 50. You have the following data on three stocks: Stock Standard Deviation Beta A 20% 0.59 B 10% 0.61 C 12% 1.29 If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; B Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: c 51. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Variance; correlation coefficient b. Standard deviation; correlation coefficient c. Beta; variance d. Coefficient of variation; beta e. Beta; beta ANSWER: d 52. A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio to form a four-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market.

Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to their portfolio, or does the choice not matter? a. Either A or B, i.e., the investor should be indifferent between the two. b. Stock A c. Stock B d. Neither A nor B, as neither has a return sufficient to compensate for risk. e. Add A, since its beta must be lower.

ANSWER: c 53. Which of the following statements is FALSE regarding a potential problem when estimating and using betas? a. The fact that a security or project may not have a past history that can be used as the basis for calculating beta b. Sometimes, during a period when the company is undergoing a change, such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. c. The beta of an "average stock," or "the market," can change over time, sometimes drastically. d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. e. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. This calculated historical beta may differ from the beta that exists in the future.

ANSWER: c 54. Which of the following statements is CORRECT? a. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. b. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would, by definition, have a riskless portfolio. c. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. e. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 55. Which of the following statements is CORRECT? a. Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak. b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last five years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that fiveyear period. c. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move. d. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks. e. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on lowbeta stocks will rise while those on high-beta stocks will decline.

ANSWER: b 56. Which of the following statements is CORRECT? a. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0. b. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. c. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. d. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. e. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

ANSWER: e 57. Stock A's beta is 1.5, and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct? a. Stock A would be a more desirable addition to a portfolio than Stock B. b. In equilibrium, the expected return on Stock B will be greater than that on Stock A. c. When held in isolation, Stock A has more risk than Stock B. d. Stock B would be a more desirable addition to a portfolio than A. e. In equilibrium, the expected return on Stock A will be greater than that on B. ANSWER: e 58. Stock X has a beta of 0.5, and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM? a. If you invest $50,000 in Stock X and $50,000 in Stock Y, your two-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return b. Stock Y's realized return during the coming year will be higher than Stock X's return. c. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount. d. Stock Y's return has a higher standard deviation than Stock X. e. If the market risk premium declines but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y. ANSWER: c 59. You have the following data on (1) the average annual returns of the market for the past five years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? Years Market 1 0.03 2 -0.05 3 0.01 4 -0.10 5 0.06 a. bA > 0; bB = 1 b. bA > +1; bB = 0 c. bA = 0; bB = -1 d. bA < 0; bB = 0 e. bA < -1; bB = 1 ANSWER: d

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

60. Which of the following statements is CORRECT? a. An investor can eliminate virtually all market risk if they hold a very large and well-diversified portfolio of stocks. b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. c. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. d. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. e. An investor can eliminate virtually all diversifiable risk if they hold a very large, well-diversified portfolio of stocks.

ANSWER: e 61. Which of the following statements is CORRECT? a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. b. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. c. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. d. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return portfolio, the portfolio can be made to be completely riskless. e. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

ANSWER: c 62. Inflation, recession, and high interest rates are economic events that are best characterized as being a. systematic risk factors that can be diversified away. b. company-specific risk factors that can be diversified away. c. among the factors that are responsible for market risk. d. risks that are beyond the control of investors and, thus, should not be considered by security analysts or portfolio managers. e. irrelevant except to governmental authorities like the Federal Reserve.

ANSWER: c 63. Which of the following statements is CORRECT? a. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. b. If an investor buys enough stocks, they can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. c. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. d. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. e. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

ANSWER: e 64. Which of the following statements is CORRECT? a. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected. b. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly diversified portfolios are subject to market (or systematic) risk. c. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a one-stock portfolio if that one stock has a beta less than 1.0. d. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

ANSWER: b 65. Which of the following statements is CORRECT? a. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. b. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return same standard deviations. c. A two-stock portfolio will always have a lower beta than a one-stock portfolio. d. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. e. A stock with an above-average standard deviation must also have an above-average beta.

ANSWER: b 66. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1.

Expected Standard Stock Return Deviation Beta A 10% 20% 1.0 B 10% 10% 1.0 C 12% 12% 1.4 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5% and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT? a. Portfolio AB has a standard deviation of 20%. b. Portfolio AB's coefficient of variation is greater than 2.0. c. Portfolio AB's required return is greater than the required return on Stock A. d. Portfolio ABC's expected return is 10.66667%. e. Portfolio ABC has a standard deviation of 20%.

ANSWER: d 67. Which of the following statements is CORRECT? a. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks. b. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable. c. If a stock has a negative beta, its expected return must be negative. d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5. e. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.

ANSWER: b 68. For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true? a. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. b. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. c. The beta of the portfolio is less than the weighted average of the betas of the individual stocks. d. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks. e. The beta of the portfolio is larger than the weighted average of the betas of the individual stocks.

ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 69. Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio? a. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk. b. Adding more such stocks will increase the portfolio's expected rate of return. c. Adding more such stocks will reduce the portfolio's beta coefficient and, thus, its systematic risk. d. Adding more such stocks will have no effect on the portfolio's risk. e. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.

ANSWER: a 70. Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%.

Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio? a. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. b. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. c. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. d. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. e. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%.

ANSWER: b 71. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your two-stock portfolio? a. Your portfolio has a standard deviation of 30%, and its expected return is 15%. b. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. c. Your portfolio has a beta equal to 1.6, and its expected return is 15%. d. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. e. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.

ANSWER: c 72. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of three average stocks? a. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change. b. The expected return of your portfolio is likely to decline. c. The diversifiable risk will remain the same, but the market risk will likely decline. d. Both the diversifiable risk and the market risk of your portfolio are likely to decline. e. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.

Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: a 73. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. b. The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. c. Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. e. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.

ANSWER: c 74. Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of +0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT? a. Portfolio P has a beta that is greater than 1.2. b. Portfolio P has a standard deviation that is greater than 25%. c. Portfolio P has an expected return that is less than 12%. d. Portfolio P has a standard deviation that is less than 25%. e. Portfolio P has a beta that is less than 1.2.

ANSWER: d 75. Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another, i.e., their correlation coefficient, r, equals 0. Stocks A and C have returns that are negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT? a. Portfolio AC has an expected return that is less than 10%. b. Portfolio AC has an expected return that is greater than 25%. c. Portfolio AB has a standard deviation that is greater than 25%. d. Portfolio AB has a standard deviation that is equal to 25%. e. Portfolio AC has a standard deviation that is less than 25%.

ANSWER: e 76. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is CORRECT? a. The portfolio's beta is less than 1.2. b. The portfolio's expected return is 15%. c. The portfolio's standard deviation is greater than 20%. d. The portfolio's beta is greater than 1.2. e. The portfolio's standard deviation is 20%.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 77. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has one-third of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Portfolio P's expected return is greater than the expected return on Stock B. b. Portfolio P's expected return is equal to the expected return on Stock A. c. Portfolio P's expected return is less than the expected return on Stock B. d. Portfolio P's expected return is equal to the expected return on Stock B. e. Portfolio P's expected return is greater than the expected return on Stock C. ANSWER: d 78. In a portfolio of three randomly selected stocks, which of the following statements is false? a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. c. The beta of the portfolio is lower than the lowest of the three betas. d. The beta of the portfolio is higher than the beta of one or two of the stocks in the portfolio. e. The beta of the portfolio is calculated as a weighted average of the individual stocks’ betas.

ANSWER: c 79. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. Stock B's required return is double that of Stock A's. b. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A. c. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. d. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B. e. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B. ANSWER: b 80. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10%, and its standard deviation is 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT? a. Portfolio AB's standard deviation is 17.5%. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. c. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. d. Portfolio AB's expected return is 11.0%. e. Portfolio AB's beta is less than 1.2.

ANSWER: b 81. Stock X has a beta of 0.7, and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. Portfolio P has a standard deviation of 20%. b. The required return on Portfolio P is equal to the market risk premium (rM – rRF). c. Portfolio P has a beta of 0.7. d. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. e. Portfolio P has the same required return as the market (rM).

ANSWER: e 82. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) a. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0 but it will decrease for stocks that have a beta less than 1.0. b. The effect of a change in the market risk premium depends on the slope of the yield curve. c. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. e. The effect of a change in the market risk premium depends on the level of the risk-free rate.

ANSWER: d 83. From 1928 to 2023, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last? a. Small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills b. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds d. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks e. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds ANSWER: a 84. During the coming year, the market risk premium (rM – rRF) is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0. b. The required return on all stocks will remain unchanged. c. The required return will fall for all stocks, but it will fall more for stocks with higher betas. d. The required return for all stocks will fall by the same amount. e. The required return will fall for all stocks, but it will fall less for stocks with higher betas.

ANSWER: c 85. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM – rRF, is positive. Which of the following statements is CORRECT? a. If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's. b. Stock B's required rate of return is twice that of Stock A. c. If Stock A's required return is 11%, then the market risk premium is 5%.

Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return d. If Stock B's required return is 11%, then the market risk premium is 5%. e. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.

ANSWER: c 86. Assume that in recent years both expected inflation and the market risk premium (rM – rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes? a. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. b. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. c. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. d. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. e. The required returns on all stocks have fallen by the same amount.

ANSWER: b 87. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? a. If a stock has a negative beta, its required return under the CAPM would be less than 5%. b. If a stock's beta doubled, its required return under the CAPM would also double. c. If a stock's beta doubled, its required return under the CAPM would more than double. d. If a stock's beta were 1.0, its required return under the CAPM would be 5%. e. If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%.

ANSWER: a 88. Stock HB has a beta of 1.5, and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If expected inflation remains constant but the market risk premium (rM – rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase. b. If both expected inflation and the market risk premium (rM – rRF) increase, the required return on Stock HB will increase by more than that on Stock LB. c. If both expected inflation and the market risk premium (rM – rRF) increase, the required returns of both stocks will increase by the same amount. d. Since the market is in equilibrium, the required returns of the two stocks should be the same. e. If expected inflation remains constant but the market risk premium (rM – rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase.

ANSWER: b 89. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT? a. The required return of all stocks will remain unchanged since there was no change in their betas. b. The required return on Stock A will increase by less than the increase in the market risk premium, while the Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return required return on Stock C will increase by more than the increase in the market risk premium. c. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease. d. The required returns on all three stocks will increase by the amount of the increase in the market risk premium. e. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.

ANSWER: b 90. Which of the following statements is CORRECT? a. If a company's beta doubles, then its required rate of return will also double. b. Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. c. If a company's beta were cut in half, then its required rate of return would also be halved. d. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline, while returns on stocks with betas above 1.0 will increase. e. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged but required returns on stocks with betas less than 1.0 will rise.

ANSWER: e 91. Assume that the risk-free rate is 6%, and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. An index fund with beta = 1.0 should have a required return of 11%. b. If a stock has a negative beta, its required return must also be negative. c. An index fund with beta = 1.0 should have a required return less than 11%. d. If a stock's beta doubles, its required return must also double. e. An index fund with beta = 1.0 should have a required return greater than 11%.

ANSWER: a 92. Which of the following statements is CORRECT? a. The slope of the security market line is equal to the market risk premium. b. Lower beta stocks have higher required returns. c. A stock's beta indicates its diversifiable risk. d. Diversifiable risk cannot be completely diversified away. e. Two securities with the same stand-alone risk must have the same betas.

ANSWER: a 93. Which of the following statements is CORRECT? a. Beta is measured by the slope of the security market line. b. If the risk-free rate rises, then the market risk premium must also rise. c. If a company's beta is halved, then its required return will also be halved. d. If a company's beta doubles, then its required return will also double. e. The slope of the security market line is equal to the market risk premium, (rM – rRF).

Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: e 94. Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%.

Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns. b. Stock B has a higher required rate of return than Stock A. c. Portfolio P has a standard deviation of 22.5%. d. More information is needed to determine the portfolio's beta. e. Portfolio P has a beta of 1.0.

ANSWER: e 95. Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium (rM – rRF) equals 4%. Which of the following statements is CORRECT? a. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks, but the increase will be larger for Nile since it has a higher beta. b. If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0. c. Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's. d. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. e. If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0.

ANSWER: d 96. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT? a. A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market. b. Stock Y must have a higher expected return and a higher standard deviation than Stock X. c. If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount. d. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y. e. If expected inflation declines but the market risk premium is unchanged, then the required return on both stocks will decrease, but the decrease will be greater for Stock Y. ANSWER: d 97. Stock A has a beta of 0.8, and Stock B has a beta of 1.2. Fifty percent of Portfolio P is invested in Stock A, and 50% is invested in Stock B. If the market risk premium (rM – rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur? a. The required return would increase for both stocks, but the increase would be greater for Stock B than for Stock A. b. The required return would decrease by the same amount for both Stock A and Stock B. Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return c. The required return would increase for Stock A but decrease for Stock B. d. The required return on Portfolio P would remain unchanged. e. The required return would increase for Stock B but decrease for Stock A. ANSWER: a 98. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant? a. The required return on Portfolio P would increase by 1%. b. The required return on both stocks would increase by 1%. c. The required return on Portfolio P would remain unchanged. d. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. e. The required return for Stock A would fall, but the required return for Stock B would increase.

ANSWER: a 99. Assume that the risk-free rate remains constant but the market risk premium declines. Which of the following is most likely to occur? a. The required return on a stock with beta = 1.0 will not change. b. The required return on a stock with beta > 1.0 will increase. c. The return on "the market" will remain constant. d. The return on "the market" will increase. e. The required return on a stock with a positive beta < 1.0 will decline.

ANSWER: e 100. Which of the following statements is CORRECT? a. The slope of the SML is determined by the value of beta. b. The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers. c. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed relationship to continue on into the future. d. If investors become less risk averse, the slope of the Security Market Line will increase. e. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock.

ANSWER: c 101. Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows: a. The y-axis intercept would decline, and the slope would increase. b. The x-axis intercept would decline, and the slope would increase. c. The y-axis intercept would increase, and the slope would decline. d. The SML would be affected only if betas changed.

Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return e. Both the y-axis intercept and the slope would increase, leading to higher required returns.

ANSWER: a 102. Assume that the risk-free rate, rRF, increases but the market risk premium (rM – rRF) declines with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT? a. The required return of all stocks will increase by the amount of the increase in the risk-free rate. b. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. c. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. e. The required return of all stocks will fall by the amount of the decline in the market risk premium.

ANSWER: d 103. Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium (rM – rRF). Under these conditions, with other things held constant, which of the following statements is most correct? a. The required return on all stocks would increase by the same amount. b. The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. c. Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. d. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. e. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

ANSWER: d 104. Which of the following statements is CORRECT? a. If a stock has a beta of 1.0, its required rate of return will be unaffected by changes in the market risk premium. b. The slope of the Security Market Line is beta. c. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. d. If a stock's beta doubles, its required rate of return must also double. e. If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.

ANSWER: e 105. Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. b. The required rate of return will decline for stocks whose betas are less than 1.0. c. The required rate of return on the market, rM, will not change as a result of these changes.

Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return d. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium. e. The required rate of return on a riskless bond will decline.

ANSWER: a 106. Which of the following statements is CORRECT? a. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis. b. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. c. If two "normal" or "typical" stocks were combined to form a two-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations. d. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks. e. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.

ANSWER: e 107. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels, a. the expected rate of return must be equal to the required rate of return; that is, = . b. the past realized rate of return must be equal to the expected future rate of return; that is, = . c. the required rate of return must equal the past realized rate of return; that is, = . d. all three of the above statements must hold for equilibrium to exist; that is = = . e. None of the above statements is correct.

ANSWER: a 108. Which of the following statements is CORRECT? a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. b. Portfolio diversification reduces the variability of returns on an individual stock. c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events. d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. e. A stock with a beta of -1.0 has zero market risk if held in a one-stock portfolio.

ANSWER: d 109. You observe the following information regarding Companies X and Y: —Company X has a higher expected return than Company Y. —Company X has a lower standard deviation of returns than Company Y. —Company X has a higher beta than Company Y. Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return Given this information, which of the following statements is CORRECT? a. Company X has more diversifiable risk than Company Y. b. Company X has a lower coefficient of variation than Company Y. c. Company X has less market risk than Company Y. d. Company X's returns will be negative when Y's returns are positive. e. Company X's stock is a better buy than Company Y's stock.

ANSWER: b 110. Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8, and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is +0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT? a. Portfolio P has a standard deviation of 25% and a beta of 1.0. b. Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. c. Portfolio P has more market risk than Stock A but less market risk than B. d. Stock A should have a higher expected return than Stock B as viewed by the marginal investor. e. Portfolio P has a coefficient of variation equal to 2.5.

ANSWER: c 111. The risk-free rate is 6%, and the market risk premium is 5%. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is CORRECT? a. If the stock market is efficient, your portfolio's expected return should equal the expected return on the market, which is 11%. b. The required return on the market is 10%. c. The portfolio's required return is less than 11%. d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio's required return will increase by more than 2%. e. If the market risk premium remains unchanged but expected inflation increases by 2%, your portfolio's required return will increase by more than 2%.

ANSWER: d 112. Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5%, and the market risk premium, rM – rRF, is 6%. Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT? a. Stock A's beta is 0.8333. b. Since the two stocks have zero correlation, Portfolio AB is riskless. c. Stock B's beta is 1.0000. d. Portfolio AB's required return is 11%. e. Portfolio AB's standard deviation is 25%.

ANSWER: a 113. Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%.

Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return Portfolio AB was created by investing in a combination of Stocks A and B. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT? a. Stock A has more market risk than Portfolio AB. b. Stock A has more market risk than Stock B but less stand-alone risk. c. Portfolio AB has more money invested in Stock A than in Stock B. d. Portfolio AB has the same amount of money invested in each of the two stocks. e. Portfolio AB has more money invested in Stock B than in Stock A. ANSWER: c 114. Which of the following statements is CORRECT? a. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds. b. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise, and the required return on low-beta stocks will decline, but the required return on an averagerisk stock will not change. c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the one-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. d. There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. e. Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF. ANSWER: e 115. A statistical measure of how far an actual stock return is likely to deviate from its expected return is called a. standard deviation. b. correlation. c. beta. d. risk-free rate of return. e. the Sharpe ratio.

ANSWER: a 116. A measure of stand-alone risk that compares the asset’s realized excess return to its standard deviation over a specified period of time is called a. systematic risk. b. the coefficient of variation. c. the Sharpe ratio. d. beta. e. risk-free rate.

ANSWER: c 117. Which of the following statements is correct regarding the security market line? a. The steeper the slope of the line, the more the average investor requires as compensation for bearing risk.

Copyright Cengage Learning. Powered by Cognero.

Page 24

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return b. The steeper the slope of the line, the less the average investor requires as compensation for bearing risk. c. If the slope of the line is flat, the average investor is content to ignore risk. d. If the slope of the line is flat, the more the average investor requires as compensation for bearing risk. e. The curvier the slope of the line, the less the average investor requires as compensation for bearing risk.

ANSWER: a 118. To reduce risk without reducing expected returns, investors should a. always use a certified financial planner to select stock in their portfolios. b. change all the stocks in their portfolio each year. c. purchase a large quantity of one company’s stock. d. diversify their portfolios. e. never buy common stock and only purchase long-term bonds.

ANSWER: d 119. Which of the following risks is the only one that should matter to a rational, diversified investor? a. Diversifiable risk b. Market risk c. Inflation risk d. Systematic risk e. Beta risk ANSWER: b 120. Taggart Inc.'s stock has a 50% chance of producing a 15% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return? Do not round your intermediate calculations. a. 5.59% b. 4.41% c. 4.90% d. 4.07% e. 4.75% ANSWER: c 121. Dothan Inc.'s stock has a 25% chance of producing a 33% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return? Do not round your intermediate calculations. a. 7.80% b. 9.75% c. 9.17% d. 11.12% e. 11.99% ANSWER: b 122. Cheng Inc. is considering a capital budgeting project that has an expected return of 42% and a standard deviation of 30%. What is the project's coefficient of variation? Do not round your intermediate calculations. Round the final answer to 2 decimal places.

Copyright Cengage Learning. Powered by Cognero.

Page 25

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. 0.54 b. 0.63 c. 0.66 d. 0.71 e. 0.74 ANSWER: d 123. Bae Inc. is considering an investment that has an expected return of 32% and a standard deviation of 10%. What is the investment's coefficient of variation? Do not round your intermediate calculations. Round the final answer to 2 decimal places. a. 0.31 b. 0.29 c. 0.26 d. 0.30 e. 0.32 ANSWER: a 124. Bill Dukes has $100,000 invested in a 2-stock portfolio. $20,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta? Do not round your intermediate calculations. Round the final answer to 2 decimal places. a. 0.69 b. 0.99 c. 0.82 d. 0.86 e. 0.60 ANSWER: d 125. Tom O'Brien has a 2-stock portfolio with a total value of $100,000. $35,000 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio's beta? Do not round your intermediate calculations. Round your final answer to 2 decimal places. a. 1.30 b. 1.19 c. 1.09 d. 1.00 e. 1.22 ANSWER: b 126. Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 15.5% and a beta of 1.60. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock? Do not round your intermediate calculations. a. 8.59%; 1.13 b. 13.74%; 1.17 c. 11.34%; 1.25 d. 11.45%; 1.24 Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return e. 8.93%; 1.26 ANSWER: d 127. Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 2.80, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Do not round your intermediate calculations. a. 19.32% b. 23.73% c. 20.58% d. 22.47% e. 21.00% ANSWER: e 128. Cooley Company's stock has a beta of 0.96, the risk-free rate is 2.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? Do not round your intermediate calculations. a. 7.53% b. 7.23% c. 7.98% d. 7.76% e. 6.70% ANSWER: a 129. Porter Inc's stock has an expected return of 12.75%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 2.00%, what is the market risk premium? Do not round your intermediate calculations. a. 9.98% b. 7.05% c. 9.55% d. 8.60% e. 7.31% ANSWER: d 130. Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? Do not round your intermediate calculations.

State of the Economy Boom Normal Recession

Probability Stock's of State Expected Occurring Return 0.31 25% 0.50 15% 0.19 5%

a. 0.4732 b. 0.3441 c. 0.4302 d. 0.4086 e. 0.3871 Copyright Cengage Learning. Powered by Cognero.

Page 27

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: c 131. Jim Angel holds a $200,000 portfolio consisting of the following stocks: Stock A B C D Total

Investment $50,000 $50,000 $50,000 $50,000 $200,000

Beta 1.15 0.80 1.00 1.20

What is the portfolio's beta? Do not round your intermediate calculations. a. 0.778 b. 1.214 c. 0.892 d. 0.903 e. 1.038 ANSWER: e 132. Jill Angel holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.88.

Stock A B C D Total

Investment $50,000 $50,000 $50,000 $50,000 $200,000

Beta 0.50 0.80 1.00 1.20

If Jill replaces Stock A with another stock, E, which has a beta of 1.70, what will the portfolio's new beta be? Do not round your intermediate calculations. a. 0.94 b. 1.00 c. 1.06 d. 0.82 e. 1.18 ANSWER: e 133. Mike Flannery holds the following portfolio: Stock A B C D Total

Investment $150,000 $45,000 $105,000 $75,000 $375,000

Beta 1.40 0.80 1.00 1.20

What is the portfolio's beta? Do not round your intermediate calculations.

Copyright Cengage Learning. Powered by Cognero.

Page 28

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return a. 1.18 b. 1.21 c. 0.98 d. 1.02 e. 1.19 ANSWER: a 134. Tom Noel holds the following portfolio: Stock A B C D Total

Investment $150,000 $50,000 $100,000 $75,000 $375,000

Beta 1.40 0.80 1.00 1.20

Tom plans to sell Stock A and replace it with Stock E, which has a beta of 0.61. By how much will the portfolio beta change? Do not round your intermediate calculations. a. –0.316 b. –0.278 c. –0.310 d. –0.237 e. –0.256 ANSWER: a 135. You hold a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each. The portfolio's beta is 1.12. You plan to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 2.25. What will the portfolio's new beta be? Do not round your intermediate calculations. a. 1.152 b. 0.914 c. 1.057 d. 1.188 e. 1.437 ANSWER: d 136. Mikkelson Corporation's stock had a required return of 12.00% last year, when the risk-free rate was 3% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%.

The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.) Do not round your intermediate calculations. a. 16.42% b. 15.79% c. 19.58% d. 14.84% e. 14.37% ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 29

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return 137. Company A has a beta of 0.70, while Company B's beta is 1.55. The required return on the stock market is 9.00%, and the risk-free rate is 2.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.) Do not round your intermediate calculations. a. 5.74% b. 5.62% c. 4.76% d. 6.77% e. 4.88% ANSWER: a 138. Stock A's stock has a beta of 1.30, and its required return is 11.50%. Stock B's beta is 0.80. If the risk-free rate is 2.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.) Do not round your intermediate calculations. a. 7.40% b. 8.13% c. 7.16% d. 8.62% e. 7.97% ANSWER: b 139. Kollo Enterprises has a beta of 0.90, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Kollo's required rate of return? Do not round your intermediate calculations. a. 9.51% b. 10.52% c. 10.61% d. 11.08% e. 9.23% ANSWER: e 140. Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 14.50%.

Based on the SML, what is the firm's required return? Do not round your intermediate calculations. a. 16.90% b. 13.01% c. 19.94% d. 20.28% e. 19.44% ANSWER: a 141. Nagel Equipment has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 14.50%. Using the SML, what is the firm's required rate of return? Do not round your intermediate calculations. a. 13.39% Copyright Cengage Learning. Powered by Cognero.

Page 30

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return b. 12.99% c. 15.40% d. 11.38% e. 10.44% ANSWER: a 142. Consider the following information and then calculate the required rate of return for the Global Investment Fund, which holds 4 stocks. The market's required rate of return is 9.00%, the risk-free rate is 3.00%, and the Fund's assets are as follows (Do not round your intermediate calculations.): Stock A B C D

Investment $ 200,000 300,000 500,000 $1,000,000

Beta 1.50 -0.50 1.25 0.75

a. 7.58% b. 7.80% c. 5.98% d. 6.67% e. 6.36% ANSWER: a 143. Data for Dana Industries is shown below. Now Dana acquires some risky assets that cause its beta to increase by 35.0%. In addition, expected inflation increases by 0.90%. What is the stock's new required rate of return? Do not round your intermediate calculations.

Initial beta Initial required return (rs) Market risk premium, RPM Percentage increase in beta Increase in inflation premium, IP

1.00 10.20% 6.00% 35.00% 0.90%

a. 13.20% b. 10.96% c. 10.16% d. 15.44% e. 13.86% ANSWER: a 144. Mulherin's stock has a beta of 1.23, its required return is 9.00%, and the risk-free rate is 2.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.) Do not round your intermediate calculations. a. 9.68% b. 6.89% c. 7.75% d. 9.06% Copyright Cengage Learning. Powered by Cognero.

Page 31

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return e. 8.99% ANSWER: c 145. Suppose you hold a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose you decided to sell one of your stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.50. What would the portfolio's new beta be? Do not round your intermediate calculations. a. 1.17 b. 1.31 c. 1.30 d. 1.56 e. 1.58 ANSWER: b 146. Returns for the Dayton Company over the last 3 years are shown below. What's the standard deviation of the firm's returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.) Do not round your intermediate calculations.

Year 2013 2012 2011

Return 21.00% 12.50% 20.00%

a. 18.87% b. 21.73% c. 18.11% d. 20.58% e. 19.06% ANSWER: e 147. Carson Inc.'s manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.) Do not round your intermediate calculations.

Economic Conditions Strong Normal Weak

Prob.

30% 40% 30%

Return 34.0% 10.0% -16.0%

a. 19.37% b. 19.76% c. 14.92% d. 18.02% e. 21.11% Copyright Cengage Learning. Powered by Cognero.

Page 32

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return ANSWER: a 148. Assume that your uncle holds just one stock, East Coast Bank (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified.

You obtain the following returns data for West Coast Bank (WCB). Both banks have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 55% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) Do not round your intermediate calculations.

Year 1

3

ECB 40.00% 10.00% 35.00%

4

-5.00%

5

15.00%

-5.00% 10.00% 35.00%

Average return = Standard deviation =

15.00% 22.64%

15.00% 22.64%

2

WCB 40.00% 15.00%

a. 4.45% b. 4.61% c. 4.01% d. 3.97% e. 4.17% ANSWER: d 149. Assume that you manage a $10.00 million mutual fund that has a beta of 1.05 and a 9.50% required return. The riskfree rate is 2.20%. You now receive another $12.50 million, which you invest in stocks with an average beta of 0.65.

Which of the following most closely approximates the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.) Do not round your intermediate calculations. a. 5.96% b. 6.92% c. 8.43% d. 6.84% e. 7.95% ANSWER: e 150. A mutual fund manager has a $40.00 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. The manager expects to receive an additional $24.50 million which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%.

What must the average beta of the new stocks be to achieve the target required rate of return? Do not round your intermediate calculations. a. 2.21 b. 1.65 c. 2.43 d. 2.76 Copyright Cengage Learning. Powered by Cognero.

Page 33

Name:

Class:

Date:

Chapter 8 - Risk and Rates of Return e. 1.88 ANSWER: a 151. Assume that you are the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 2.00%. What rate of return should investors expect (and require) on this fund? Do not round your intermediate calculations.

Stock A B C D

Amount $975,000 $675,000 $850,000 $500,000 $3,000,000

Beta 1.20 0.50 1.40 0.75

a. 11.22% b. 13.46% c. 13.35% d. 13.12% e. 12.11% ANSWER: a 152. CCC Corp has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 37.5% (not percentage points). Neither betas nor the risk-free rate change. What would CCC's new required return be? Do not round your intermediate calculations. a. 15.69% b. 14.45% c. 13.40% d. 17.63% e. 19.21% ANSWER: d

Copyright Cengage Learning. Powered by Cognero.

Page 34

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation True / False 1. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False ANSWER: True 2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False ANSWER: True 3. If a firm's stockholders are given the preemptive right, then they can call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders must seek a change in management through a proxy fight. a. True b. False ANSWER: False 4. Classified stock differentiates various classes of common stock, which is one way companies can meet special needs, such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control. a. True b. False ANSWER: True 5. Founders' shares, a type of classified stock owned by the firm's founders, generally have more votes per share than the other classes of common stock. a. True b. False ANSWER: True 6. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. a. True b. False ANSWER: False 7. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False ANSWER: True 8. According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation on the length of time they plan to hold the stock. a. True b. False ANSWER: False 9. When a new issue of stock is brought to market, the marginal investor determines the price at which the stock will trade. a. True b. False ANSWER: True 10. The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities. a. True b. False ANSWER: True 11. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False ANSWER: True 12. The corporate valuation model can be used only when a company doesn't pay dividends. a. True b. False ANSWER: False 13. The corporate valuation model cannot be used unless a company pays dividends. a. True b. False ANSWER: False 14. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the firm’s total corporate value. a. True b. False ANSWER: True 15. Preferred stock is a hybrid—a cross between a common stock and a bond—in the sense that it pays dividends that normally increase annually (like a stock), but its payments are contractually guaranteed (like interest on a bond). a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 16. From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but riskier than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the riskiest for the firm, preferred is next, and common is least risky. a. True b. False ANSWER: True 17. If a stock's expected return as seen by the marginal investor exceeds their required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return. a. True b. False ANSWER: True 18. If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value. a. True b. False ANSWER: True 19. For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor, and (2) the expected return as seen by the marginal investor must equal their required return. a. True b. False ANSWER: True 20. Two conditions are used to determine whether a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal their required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium. a. True b. False ANSWER: False Multiple Choice 21. Which of the following statements is CORRECT? a. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. b. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, then the stock’s dividend yield is also 5%. c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. d. The price of a stock is the present value of all expected future dividends discounted at the dividend growth rate. e. The constant growth model cannot be used for a zero growth stock, wherein the dividend is expected to remain Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation constant over time.

ANSWER: c 22. An increase in a firm’s expected growth rate would cause its required rate of return to a. increase. b. decrease. c. fluctuate less than before. d. fluctuate more than before. e. possibly increase, possibly decrease, or possibly remain constant.

ANSWER: e 23. If a given investor believes that a stock’s expected return exceeds its required return, then the investor most likely believes that a. the stock is experiencing supernormal growth. b. the stock should be sold. c. the stock is a good buy. d. management is probably not trying to maximize the price per share. e. dividends are not likely to be declared.

ANSWER: c 24. The preemptive right is important to shareholders because it a. allows managers to buy additional shares below the current market price. b. will result in higher dividends per share. c. is included in every corporate charter. d. protects the current shareholders against a dilution of their ownership interests. e. protects bondholders and thus enables the firm to issue debt with a relatively low interest rate.

ANSWER: d 25. If markets are in equilibrium, which of the following conditions will exist? a. Each stock's expected return should equal its realized return as seen by the marginal investor. b. Each stock's expected return should equal its required return as seen by the marginal investor. c. All stocks should have the same expected return as seen by the marginal investor. d. The expected and required returns on stocks and bonds should be equal. e. All stocks should have the same realized return during the coming year.

ANSWER: b 26. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks fall into one of three classes: A, B, and C. b. All common stocks, regardless of class, must have the same voting rights. c. All firms have several classes of common stock. d. All common stock, regardless of class, must pay the same dividend. e. Some class or classes of common stock are entitled to more votes per share than other classes.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 27. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Required return Market price Expected growth

A 10% $25 7%

B 12% $40 9%

a. These two stocks should have the same price. b. These two stocks must have the same dividend yield. c. These two stocks should have the same expected return. d. These two stocks must have the same expected capital gains yield. e. These two stocks must have the same expected year-end dividend.

ANSWER: b 28. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

a. The two stocks should have the same expected dividend. b. The two stocks could not be in equilibrium with the numbers given in the question. c. A's expected dividend is $0.50. d. B's expected dividend is $0.75. e. A's expected dividend is $0.75 and B's expected dividend is $1.20.

ANSWER: e 29. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. If Stock A has a lower dividend yield than Stock B, then its expected capital gains yield must be higher than Stock B’s. b. Stock B must have a higher dividend yield than Stock A. c. Stock A must have a higher dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, then its expected capital gains yield must be lower than Stock B’s. e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. ANSWER: a 30. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. The two stocks must have the same dividend per share. b. If one stock has a higher dividend yield, then it must also have a lower dividend growth rate. c. If one stock has a higher dividend yield, then it must also have a higher dividend growth rate.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation d. The two stocks must have the same dividend growth rate. e. The two stocks must have the same dividend yield.

ANSWER: b 31. Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. b. Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, then its expected dividend yield is 5% as well. c. A stock’s dividend yield can never exceed its expected growth rate. d. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceed its required rate of return. e. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.

ANSWER: a 32. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, then which of the following statements is CORRECT? a. The company’s current stock price is $20. b. The company’s dividend yield five years from now is expected to be 10%. c. The constant growth model cannot be used because the growth rate is negative. d. The company’s expected capital gains yield is 5%. e. The company’s expected stock price at the beginning of next year is $9.50.

ANSWER: e 33. Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rate must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12% and if its dividend is expected to grow at a constant rate of 5%, then the stock’s dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

ANSWER: a 34. If a stock’s dividend is expected to grow at a constant rate of 5% a year, then which of the following statements is CORRECT? The stock is in equilibrium. a. The expected return on the stock is 5% a year. b. The stock’s dividend yield is 5%. c. The price of the stock is expected to decline in the future. d. The stock’s required return must be equal to or less than 5%. e. The stock’s price one year from now is expected to be 5% above the current price.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 35. Stocks A and B have the following data. Assuming the stock market is efficient, and the stocks are in equilibrium, which of the following statements is CORRECT? A $25 10% 15%

Price Expected growth (constant) Required return

B $25 5% 15%

a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.

ANSWER: a 36. Stocks X and Y have the following data. Assuming the stock market is efficient, and the stocks are in equilibrium, which of the following statements is CORRECT? X $30 6% 12%

Price Expected growth (constant) Required return

Y $30 4% 10%

a. Stock X has a higher dividend yield than Stock Y. b. Stock Y has a higher dividend yield than Stock X. c. One year from now, Stock X’s price is expected to be higher than Stock Y’s price. d. Stock X has the higher expected year-end dividend. e. Stock Y has a higher capital gains yield.

ANSWER: c 37. Stock X has the following data. Assuming the stock market is efficient, and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 Current Price, P0 Expected constant growth rate

$3.00 $50 6.0%

a. The stock’s required return is 10%. b. The stock’s expected dividend yield and growth rate are equal. c. The stock’s expected dividend yield is 5%. d. The stock’s expected capital gains yield is 5%. e. The stock’s expected price 10 years from now is $100.00.

ANSWER: b 38. Stocks X and Y have the following data. Assuming the stock market is efficient, and the stocks are in equilibrium, which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation X $25 5% 12%

Price Expected dividend yield Required return

Y $25 3% 10%

a. Stock Y pays a higher dividend per share than Stock X. b. Stock X pays a higher dividend per share than Stock Y. c. One year from now, Stock X should have the higher price. d. Stock Y has a lower expected growth rate than Stock X. e. Stock Y has the higher expected capital gains yield.

ANSWER: b 39. The expected return on Natter Corporation’s stock is 14%. The stock’s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock’s dividend yield is 7%. b. The stock’s dividend yield is 8%. c. The current dividend per share is $4.00. d. The stock price is expected to be $54 a share one year from now. e. The stock price is expected to be $57 a share one year from now.

ANSWER: d 40. Stocks A and B have the following data. The market risk premium is 6.0%, and the risk-free rate is 6.4%. Assuming the stock market is efficient, and the stocks are in equilibrium, which of the following statements is CORRECT?

Beta Constant growth rate

A 1.10 7.00%

B 0.90 7.00%

a. Stock A must have a higher stock price than Stock B. b. Stock A must have a higher dividend yield than Stock B. c. Stock B’s dividend yield equals its expected dividend growth rate. d. Stock B must have the higher required return. e. Stock B could have the higher expected return.

ANSWER: b 41. Which of the following statements is CORRECT? a. The corporate valuation model cannot be used both for companies that pay dividends and those that do not pay dividends. b. The corporate valuation model discounts free cash flows by the required return on equity. c. The corporate valuation model cannot be used to find the value of a division. d. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. e. Free cash flows are assumed to stay constant beyond a specified date in order to find the horizon, or continuing, value.

ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 42. Which of the following statements is CORRECT? a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital. b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital. c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital. d. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital. e. The corporate valuation model requires the assumption of a constant growth rate in all years.

ANSWER: a 43. Which of the following statements is CORRECT? a. Preferred stockholders have a priority over bondholders to the income in the event of a bankruptcy but not to the proceeds in the event of a liquidation. b. The preferred stock of a given firm is generally less risky to investors than the same firm’s common stock. c. Corporations cannot buy the preferred stocks of other corporations. d. Preferred dividends are not generally cumulative. e. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation.

ANSWER: b 44. Which of the following statements is CORRECT? a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights. b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock. As a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. d. One of the disadvantages to a corporation of owning preferred stock is that 50% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds is tax free. e. One of the advantages to financing with preferred stock is that 50% of the dividends paid out are tax deductible to the issuer.

ANSWER: b 45. For a stock to be in equilibrium—that is, for there to be no long-term pressure for its price to change—the a. expected future return must be less than the most recent past realized return. b. past realized return must be equal to the expected return during the same period. c. required return must equal the realized return in all periods. d. expected return must be equal to both the required future return and the past realized return. e. expected future return must be equal to the required return.

ANSWER: e 46. Which of the following statements is CORRECT? a. If a company has two classes of common stock, Class A and Class B, then the stocks may pay different Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation dividends, but under all state charters the two classes must have the same voting rights. b. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. c. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. d. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms that have negative growth rates. e. The stock valuation model, P0 = D1/(rs - g), can be used only for firms whose growth rates exceed their required returns.

ANSWER: c 47. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? a. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate. b. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. c. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. d. The stocks must sell for the same price. e. Stock Y must have a higher dividend yield than Stock X. ANSWER: a 48. Which of the following statements is CORRECT regarding preferred stock? a. Preferred stock shareholders are paid dividends only after the common shareholders receive their dividends. b. Like common stock, all preferred stock is issued into perpetuity. c. A company can be forced into bankruptcy if they do not pay their dividends on preferred stock. d. Preferred dividends can be declared by the board of directors in variable amounts. e. Preferred stock is a hybrid, similar to both bonds and common stock in some ways.

ANSWER: e 49. Which of the following statements is CORRECT regarding types of common stock? a. Class A common stock is used exclusively to represent founders’ shares. b. Using dual classes of common stock allows founders to maintain control over a corporation. c. If a company uses dual classes of common stock, each class must have the same number of votes per share. d. Issuing a class of common stock with zero voting rights is not allowed. e. Most corporations have classified shares of common stock.

ANSWER: b 50. Which of the following statements is CORRECT regarding the intrinsic value of stock? a. The goal of most investors is to purchase stocks that are considered overvalued. b. Investors do not care about the intrinsic value of stock, whereas managers are very concerned about the intrinsic value of their company’s stock. c. An estimate of the intrinsic value of a company’s stock can help managers make better decisions. d. The corporate valuation model to estimate the intrinsic value of stock includes dividends and free cash flows.

Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation e. Managers should consider issuing new stock when it is undervalued.

ANSWER: c 51. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 3.5%. What is the stock's current price? a. $12.32 b. $9.75 c. $10.71 d. $10.07 e. $11.57 ANSWER: c 52. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 12.7%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $18.11 b. $19.19 c. $18.65 d. $13.81 e. $17.93 ANSWER: e 53. A share of common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investors' required rate of return is 14.6%, then what is the stock price? a. $13.52 b. $11.46 c. $13.63 d. $12.49 e. $8.59 ANSWER: b 54. If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $36.00, then what is the stock’s expected dividend yield for the coming year? a. 2.64% b. 4.31% c. 3.47% d. 2.67% e. 3.26% ANSWER: c 55. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $74, then what is the stock’s expected dividend yield for the coming year? a. 3.34% b. 2.74% Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation c. 2.42% d. 3.15% e. 2.71% ANSWER: d 56. If D1 = $1.50, g (which is constant) = 2.7%, and P0 = $56, then what is the stock’s expected capital gains yield for the coming year? a. 3.19% b. 2.13% c. 2.97% d. 2.70% e. 3.35% ANSWER: d 57. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $23, then what is the stock’s expected total return for the coming year? a. 12.47% b. 13.45% c. 8.97% d. 13.12% e. 10.93% ANSWER: e 58. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $35.00, then what is the stock’s expected total return for the coming year? a. 7.38% b. 8.78% c. 7.29% d. 10.80% e. 7.11% ANSWER: b 59. Gray Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $39.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 6.75% b. 6.24% c. 5.50% d. 7.85% e. 7.34% ANSWER: e 60. Reddick Enterprises' stock currently sells for $50.50 per share. The dividend is projected to increase at a constant rate Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? a. $57.52 b. $59.89 c. $59.30 d. $51.00 e. $74.12 ANSWER: c 61. Whited Inc.'s stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate of 1.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the stock's expected price 5 years from now? a. $38.44 b. $40.75 c. $29.60 d. $39.98 e. $34.22 ANSWER: a 62. Mooradian Corporation’s free cash flow during the just-ended year (t = 0) was $70 million, and its FCF is expected to grow at a constant rate of 5.0% in the future. Assume the firm has zero non-operating assets. If the weighted average cost of capital is 12.5%, what is the firm’s total corporate value, in millions? a. $980 b. $813 c. $1,029 d. $1,107 e. $755 ANSWER: a 63. Suppose Boyson Corporation’s projected free cash flow for next year is FCF1 = $530,000, and FCF is expected to grow at a constant rate of 6.5%. Assume the firm has zero non-operating assets. If the company’s weighted average cost of capital is 11.5%, then what is the firm’s total corporate value? a. $11,236,000 b. $12,614,000 c. $10,600,000 d. $8,374,000 e. $9,540,000 ANSWER: c 64. Molen Inc. has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, then at what price should the stock sell? a. $115.38 b. $123.46 c. $138.46 Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation d. $88.85 e. $102.69 ANSWER: a 65. The Francis Company is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.40, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company's current stock price? Do not round intermediate calculations. a. $24.12 b. $23.25 c. $21.93 d. $26.32 e. $23.46 ANSWER: c 66. The Isberg Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.30, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is the company's current stock price, P0? Do not round intermediate calculations. a. $17.25 b. $15.83 c. $16.62 d. $12.66 e. $13.93 ANSWER: b 67. Schnusenberg Corporation just paid a dividend of D0 = $0.75 per share, and that dividend is expected to grow at a constant rate of 6.50% per year in the future. The company's beta is 0.75, the required return on the market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price? Do not round intermediate calculations. a. $25.24 b. $26.20 c. $27.80 d. $31.95 e. $29.39 ANSWER: d 68. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for $59.00 per share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0? a. $2.01 b. $2.61 c. $2.23 d. $2.48 e. $2.38 ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 69. Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for $50.00 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1? a. $2.13 b. $1.59 c. $2.02 d. $2.66 e. $1.81 ANSWER: a 70. Sorenson Corp.’s expected year-end dividend is D1 = $0.80, its required return is rs = 11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the future. What is Sorenson's expected stock price in 7 years, i.e., what is

? Do not round intermediate calculations.

a. $14.07 b. $21.39 c. $21.76 d. $15.76 e. $18.76 ANSWER: e 71. Gupta Corporation is undergoing a restructuring, and its free cash flows are expected to vary considerably during the next few years. However, the FCF is expected to be $60.00 million in Year 5, and the FCF growth rate is expected to be a constant 6.5% beyond that point. The weighted average cost of capital is 12.0%. What is the horizon (or continuing) value (in millions) at t = 5? a. $1,336 b. $1,417 c. $1,348 d. $1,162 e. $1,022 ANSWER: d 72. Misra Inc. forecasts a free cash flow of $60 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5.5% thereafter. If the weighted average cost of capital (WACC) is 10.0% and the cost of equity is 15.0%, then what is the horizon, or continuing, value in millions at t = 3? a. $1,407 b. $1,294 c. $1,421 d. $1,463 e. $1,547 ANSWER: a 73. You must estimate the intrinsic value of Noe Technologies’ stock. The end-of-year free cash flow (FCF1) is expected to be $30.00 million, and it is expected to grow at a constant rate of 7.0% a year thereafter. The company’s WACC is 10.0%, it has $125.0 million of long-term debt plus preferred stock outstanding, and there are 15.0 million shares of common stock outstanding. Assume the firm has zero non-operating assets. What is the firm's estimated intrinsic value Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation per share of common stock? Do not round intermediate calculations. a. $50.17 b. $58.33 c. $51.92 d. $72.92 e. $64.17 ANSWER: b 74. You have been assigned the task of using the corporate, or free cash flow, model to estimate Petry Corporation's intrinsic value. The firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is expected to be $145.0 million, the FCFs are expected to grow at a constant rate of 5.00% a year in the future, the company has $200 million of long-term debt and preferred stock, and it has 30 million shares of common stock outstanding. Assume the firm has zero nonoperating assets. What is the firm's estimated intrinsic value per share of common stock? Do not round intermediate calculations. a. $95.40 b. $107.10 c. $110.70 d. $83.70 e. $90.00 ANSWER: e 75. Kedia Inc. forecasts a negative free cash flow for the coming year, FCF1 = -$10 million, but it expects positive numbers thereafter, with FCF2 = $24 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever.

Assume the firm has zero non-operating assets. If the weighted average cost of capital is 14.0%, what is the firm’s total corporate value, in millions? Do not round intermediate calculations. a. $233.56 b. $191.67 c. $222.43 d. $201.75 e. $211.84 ANSWER: d 76. Kale Inc. forecasts the free cash flows (in millions) shown below. Assume the firm has zero non-operating assets. If the weighted average cost of capital is 11.0% and FCF is expected to grow at a rate of 5.0% after Year 2, then what is the firm’s total corporate value (in millions)? Do not round intermediate calculations.

Year Free Cash flow

1 -$50

2 $125

a. $1,447 b. $1,667 c. $2,107 d. $1,942 e. $1,832 ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 77. Ryan Enterprises forecasts the free cash flows (in millions) shown below. Assume the firm has zero non-operating assets. The weighted average cost of capital is 13.0%, and the FCFs are expected to continue growing at a 5.0% rate after Year 3. What is the firm’s total corporate value (in millions)? Do not round intermediate calculations.

Year FCF

1 -$15.0

2 $10.0

3 $45.0

a. $535.14 b. $513.39 c. $456.83 d. $491.64 e. $435.08 ANSWER: e 78. Based on the corporate valuation model, Wang Inc.’s total corporate value is $775 million. Its balance sheet shows $100 million notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm’s value of equity (in millions)? a. $480 b. $475 c. $390 d. $366 e. $499 ANSWER: b 79. Based on the corporate valuation model, Gray Entertainment's total corporate value is $1,350 million. The company’s balance sheet shows $120 million of notes payable, $300 million of long-term debt, $50 million of preferred stock, $180 million of retained earnings, and $800 million of total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of its price per share? a. $24.64 b. $28.45 c. $29.33 d. $22.59 e. $22.88 ANSWER: c 80. Based on the corporate valuation model, the total corporate value of Chen Lin Inc. is $950 million. Its balance sheet shows $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of its stock price per share? a. $29.20 b. $22.48 c. $22.78 d. $35.04 e. $25.70 ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation 81. Based on the corporate valuation model, Morgan Inc.’s total corporate value is $225 million. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock’s price per share? a. $6.83 b. $5.72 c. $5.46 d. $6.50 e. $4.94 ANSWER: d 82. Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $75.00, what is its nominal (not effective) annual rate of return? a. 4.48% b. 6.51% c. 6.61% d. 6.24% e. 5.33% ANSWER: e 83. Rebello's preferred stock pays a dividend of $1.00 per quarter, and it sells for $72.50 per share. What is its effective annual (not nominal) rate of return? a. 4.90% b. 6.76% c. 5.29% d. 5.80% e. 5.63% ANSWER: e 84. Nachman Industries just paid a dividend of D0 = $2.25. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock’s current market value? Do not round intermediate calculations. a. $81.83 b. $66.54 c. $76.48 d. $78.77 e. $67.30 ANSWER: c 85. Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product.

Management expects earnings and dividends to grow at a rate of 38% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? Do not round intermediate calculations. a. $41.92 Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation b. $51.14 c. $46.11 d. $36.47 e. $42.76 ANSWER: a 86. The Ramirez Company's last dividend was $1.75. Its dividend growth rate is expected to be constant at 22% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price? Do not round intermediate calculations. a. $49.21 b. $44.73 c. $40.67 d. $34.16 e. $50.83 ANSWER: c 87. Ackert Company's last dividend was $2.50. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%. What is the best estimate of the current stock price? Do not round intermediate calculations. a. $66.93 b. $59.76 c. $54.98 d. $57.96 e. $44.82 ANSWER: b 88. Huang Company's last dividend was $1.25. The dividend growth rate is expected to be constant at 2.5% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price? Do not round intermediate calculations. a. $24.79 b. $25.03 c. $26.48 d. $24.07 e. $28.89 ANSWER: d 89. Agarwal Technologies was founded 10 years ago. It has been profitable for the last 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $0.25 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years, and then to increase it at a constant rate of 8.00% thereafter. Management's forecast of the future dividend stream, along with the forecasted growth rates, is shown below. Assuming a required return of 11.00%, what is your estimate of the stock's current value? Use the dividend values provided in the table below for your calculations. Do not round your intermediate calculations.

Year Growth rate

0 NA

1 NA

Copyright Cengage Learning. Powered by Cognero.

2 NA

3 NA

4 90.00%

5 45.00%

6 8.00% Page 19

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation Dividends

$0.000

$0.000

$0.000

$0.250

$0.475

$0.689

$0.744

a. $15.62 b. $14.84 c. $14.22 d. $16.09 e. $13.75 ANSWER: a 90. Savickas Petroleum’s stock has a required return of 12.00%, and the stock sells for $46.00 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30.00% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock’s expected constant growth rate after t = 4, i.e., what is X? Do not round your intermediate calculations. a. 7.15% b. 7.58% c. 5.36% d. 8.30% e. 7.87% ANSWER: a 91. Your boss, Sally Maloney, treasurer of Fred Clark Enterprises (FCE), asked you to help her estimate the intrinsic value of the company's stock. FCE just paid a dividend of $1.00, and the stock now sells for $19.00 per share. Sally asked a number of security analysts what they believe FCE's future dividends will be, based on their analysis of the company.

The consensus is that the dividend will be increased by 10% during Years 1 to 3, and it will be increased at a rate of 5% per year in Year 4 and thereafter. Sally asked you to use that information to estimate the required rate of return on the stock, rs, and she provided you with the following template for use in the analysis.

Estimated rs =

10.00%

(must be changed to force Calculated Price to equal the Actual Market Price)

Actual Market Price, P0: $19.00 Rapid growth 1 2 10% 10% $1.00 ? ?

Year Dividend growth rate (insert correct values) Calculated dividends (D0 has been paid) HV3 = D4/(rs - g4). Find using Estimated rs.

Total CFs PVs of CFs when discounted at Estimated rs

0

? ?

? ?

3 10% ? ? ? ?

Normal growth 4 5 5% 5% ? ?

A positive number will be here when dividends are estimated.

The Calculated Price will equal the Actual Market Price once the correct rs has been found.

Sally told you that the growth rates in the template were just put in as a trial, and that you must replace them with the analysts' forecasted rates to get the correct forecasted dividends and then the estimated HV. She also notes that the estimated value for rs, at the top of the template, is also just a guess, and you must replace it with a value that will cause the Calculated Price shown at the bottom to equal the Actual Market Price. She suggests that, after you have put in the correct dividends, you can manually calculate the price, using a series of guesses as to the Estimated rs. The value of rs that causes the calculated price to equal the actual price is the correct

Calculated Price = P0 = Sum of PVs =

Copyright Cengage Learning. Powered by Cognero.

$0.00

Page 20

Name:

Class:

Date:

Chapter 9 - Stocks and Their Valuation one. She notes, though, that this trial-and-error process is quite tedious, and that the correct rs could be found much faster with a simple Excel model, especially if you use Goal Seek. What is the value of rs?

a. 11.42% b. 8.82% c. 13.00% d. 10.85% e. 11.31% ANSWER: e 92. Wall Inc. forecasts that it will have the free cash flows (in millions) shown below. Assume the firm has zero nonoperating assets. If the weighted average cost of capital is 14% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the firm’s total corporate value, in millions? Do not round intermediate calculations.

Year Free cash flow

1 -$20.00

2 $48.00

3 $51.50

a. $738.24 b. $481.99 c. $726.03 d. $457.58 e. $610.11 ANSWER: e

Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 10 - The Cost of Capital 1. "Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False ANSWER: True 2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. a. True b. False ANSWER: True 3. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. a. True b. False ANSWER: False 4. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. a. True b. False ANSWER: True 5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False ANSWER: False 6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False ANSWER: False 7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False ANSWER: True 8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 10 - The Cost of Capital 9. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. a. True b. False ANSWER: True 10. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. a. True b. False ANSWER: True 11. For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm. a. True b. False ANSWER: False 12. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. a. True b. False ANSWER: False 13. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False ANSWER: False 14. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. a. True b. False ANSWER: False 15. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 10 - The Cost of Capital 16. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired. a. True b. False ANSWER: False 17. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. False ANSWER: False 18. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. a. True b. False ANSWER: True 19. The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. a. True b. False ANSWER: True 20. The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. a. True b. False ANSWER: False 21. The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate. a. True b. False ANSWER: False 22. The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 10 - The Cost of Capital a. True b. False ANSWER: True 23. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. a. True b. False ANSWER: True 24. When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs. a. True b. False ANSWER: True 25. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. a. True b. False ANSWER: True 26. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False ANSWER: True 27. The cost of external equity capital raised by issuing new common stock (re) is defined as follows: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)." a. True b. False ANSWER: False 28. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. a. True Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 10 - The Cost of Capital b. False ANSWER: True 29. Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC). a. True b. False ANSWER: False 30. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.

They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False ANSWER: True 31. The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T). a. True b. False ANSWER: True 32. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False ANSWER: False 33. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50). a. True b. False ANSWER: False 34. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.

Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True b. False ANSWER: False 35. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 10 - The Cost of Capital required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and, thus, limit the shift toward debt. a. True b. False ANSWER: True 36. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Long-term debt b. Accounts payable c. Retained earnings d. Common stock e. Preferred stock ANSWER: b 37. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the percentage of debt in the target capital structure. c. Increase the proposed capital budget. d. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure.

ANSWER: b 38. Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings.

This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company’s beta increases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase.

ANSWER: a 39. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes and assume that the firm operates at its target capital structure. a. rs > re > rd > WACC b. re > rs > WACC > rd c. WACC > re > rs > rd Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 10 - The Cost of Capital d. rd > re > rs > WACC e. WACC > rd > rs > re ANSWER: b 40. When working with the CAPM, which of the following factors can be determined with the most precision? a. The market risk premium (RPM) b. The beta coefficient, bi, of a relatively safe stock c. The most appropriate risk-free rate, rRF d. The expected rate of return on the market, rM e. The beta coefficient of “the market,” which is the same as the beta of an average stock ANSWER: e 41. Duval Inc. uses only equity capital, and it has two equally sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division B project with a 13% return b. A Division B project with a 12% return c. A Division A project with an 11% return d. A Division A project with a 9% return e. A Division B project with an 11% return ANSWER: c 42. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5% b. Project C, which is of above-average risk and has a return of 11% c. Project A, which is of average risk and has a return of 9% d. None of the projects should be accepted e. All of the projects should be accepted ANSWER: a 43. Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14% before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. b. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. d. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 10 - The Cost of Capital required return on a riskier-than-average project to 3% over rs, then it should reject the project. e. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

ANSWER: d 44. The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time? a. The company will take on too many high-risk projects and reject too many low-risk projects. b. The company will take on too many low-risk projects and reject too many high-risk projects. c. Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time. d. The company’s overall WACC should decrease over time because its stock price should be increasing. e. The CEO’s recommendation would maximize the firm’s intrinsic value.

ANSWER: a 45. If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become riskier over time, but its intrinsic value will be maximized. b. become less risky over time, and this will maximize its intrinsic value. c. accept too many low-risk projects and too few high-risk projects. d. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. e. continue as before because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

ANSWER: d 46. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

ANSWER: e 47. Which of the following statements is CORRECT? a. When calculating the cost of debt, a company needs to adjust for taxes because interest payments are deductible by the paying corporation. b. When calculating the cost of preferred stock, companies must adjust for taxes because dividends paid on preferred stock are deductible by the paying corporation.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 10 - The Cost of Capital c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. e. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company’s WACC. ANSWER: a 48. Which of the following statements is CORRECT? a. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. b. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company’s WACC for capital budgeting purposes. c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount. d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock. e. The component cost of preferred stock is expressed as rp(1 - T) because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

ANSWER: d 49. Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital. b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.” e. The WACC as used in capital budgeting would be simply the before-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

ANSWER: d 50. Which of the following statements is CORRECT? a. A change in a company’s target capital structure cannot affect its WACC. b. WACC calculations should be based on the before-tax costs of all the individual capital components. c. Flotation costs associated with issuing new common stock normally reduce the WACC. d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline. e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

ANSWER: d 51. Which of the following statements is CORRECT? a. The WACC is calculated using before-tax costs for all components. b. The after-tax cost of debt usually exceeds the after-tax cost of equity. c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. d. Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 10 - The Cost of Capital finance the firm’s capital budget during the coming year. e. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.

ANSWER: e 52. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of equity is always equal to or greater than the cost of debt. e. The cost of retained earnings typically exceeds the cost of new common stock.

ANSWER: d 53. Which of the following statements is CORRECT? a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and, thus, the after-tax cost of debt is always greater than the cost of equity. b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital.

ANSWER: c 54. Which of the following statements is CORRECT? a. The "break point" as discussed in the text refers to the point where the firm's tax rate increases. b. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. c. The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. d. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock. e. The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and, thus, must begin to finance with preferred stock.

ANSWER: d 55. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. They also believe that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, they estimate that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and they have assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 10 - The Cost of Capital a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time. d. The decision not to risk adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure, but it will not affect its intrinsic value.

ANSWER: c 56. Wickham Company and Risco Inc. are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Wickham having a WACC of 10% and Risco a WACC of 12%. Wickham is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Wickham project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.

Now assume that the two companies merge and form a new company, Wickham/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. After the merger, Wickham/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. d. Wickham/Risco’s WACC, as a result of the merger, would be 10%. e. After the merger, Wickham/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

ANSWER: a 57. Which of the following statements is CORRECT? a. The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested. c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them.

They are generated as cash flows by operating assets that were raised in the past, hence they are “free.” d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past five years. e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 10 - The Cost of Capital ANSWER: b 58. Which of the following statements is CORRECT? a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. b. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm’s outstanding debt. c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock.

In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value. d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital.

ANSWER: d 59. Which of the following statements is CORRECT? a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs—beta, the risk-free rate, and the market risk premium—can be estimated with little error. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures. d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

ANSWER: d 60. Which of the following statements is CORRECT? a. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. b. If the calculated beta underestimates the firm’s true investment risk—i.e., if the forward-looking beta that investors think exists exceeds the historical beta—then the CAPM method based on the historical beta will produce an estimate of rs and, thus, WACC that is too high. c. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well diversified. d. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 10 - The Cost of Capital that they are both "objective," as opposed to "subjective," hence little or no judgment is required. e. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-riskpremium approach.

ANSWER: c 61. Which of the following statements is CORRECT? a. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company’s own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal or is available online. b. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. c. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. d. The relevant WACC can change depending on the amount of funds a firm raises during a given year.

Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure. e. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well diversified.

ANSWER: d 62. Which of the following statements is CORRECT? a. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. b. Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should focus on before-tax cash flows when calculating the WACC. c. An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s bonds is not affected by the change in the tax rate. d. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. e. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the aftertax cost of debt.

ANSWER: e 63. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm has a beta that is less than 1.0, say 0.9, this suggests that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets. b. If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project’s expected future cash flows. c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. d. Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas. e. Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 10 - The Cost of Capital the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

ANSWER: e 64. Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. M should have the lower WACC because it is like most other companies, and investors like that fact. b. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. d. Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. e. Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. ANSWER: c 65. The market value of a company’s equity is equal to a. the number of common shares outstanding times the current price less the long-term debt of the company. b. the amount of retained earnings less the net amount of any long-term bonds issued. c. the amount of retained earnings plus the net income of the previous year. d. the number of common shares outstanding times the current stock price. e. the number of authorized shares of common stock times the current price.

ANSWER: d 66. The three major capital components are a. retained earnings, preferred stock, and bond indentures. b. cash, preferred stock, and common equity. c. debt, preferred stock, and common equity. d. debt, retained earnings, and preferred stock. e. cash, retained earnings, and common equity.

ANSWER: c 67. Which of the following items is tax deductible to corporations? a. Interest on debt b. Dividends paid to preferred stockholders c. Gains on retained earnings at each year end d. Dividends paid to common stockholders e. Common equity raised by issuing new stock ANSWER: a 68. Equity raised by selling common stock is more costly than equity from retained earnings because a. there is usually more than enough retained earnings that selling new stock is not necessary.

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 10 - The Cost of Capital b. retained earnings is a free source of equity, since the company already has it. c. companies incur debt when they issue common stock. d. dividends are required to be paid on common stock. e. the company must pay for flotation costs.

ANSWER: e 69. Which of the following statements is CORRECT regarding the use of the CAPM to determine the cost of common equity? a. The CAPM pricing model is the least used method for estimating the cost of common equity. b. The CAPM pricing model is often used because it is the most accurate method of determining the cost of common equity. c. Beta is an index of a stock’s risk. d. The five-year Treasury bond rate is primarily used to measure the risk-free rate. e. One advantage of the CAPM approach is how easy it is to estimate the proper market risk premium.

ANSWER: c 70. Which of the following factors that affect WACC are controllable by a firm? a. Interest rates in the economy b. General level of stock prices c. Tax rates d. Changing its capital budget decision rules e. Expectations from shareholders on the amount of dividends paid ANSWER: d 71. Which of the following statements is CORRECT regarding cost of capital estimates? a. Because there are multiple ways to estimate the cost of capital, it can be calculated accurately. b. Depreciation is a large source of capital for many firms. c. Establishing a company’s targeted capital structure is not difficult to determine. d. The determination of projects’ risk can be based on measures that are easy to use and accurate. e. Because private firms do not issue stock, it is impossible to estimate the cost of capital.

ANSWER: b 72. Bosio Inc.'s perpetual preferred stock sells for $132.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 7.02% b. 7.42% c. 5.75% d. 6.62% e. 6.68% ANSWER: e 73. A company’s perpetual preferred stock currently sells for $100.00 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 10 - The Cost of Capital a. 8.42% b. 8.84% c. 7.49% d. 7.16% e. 6.74% ANSWER: a 74. O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.50. What is the firm's cost of equity from retained earnings based on the CAPM? a. 13.86% b. 11.34% c. 12.32% d. 15.40% e. 14.00% ANSWER: e 75. Scanlon Inc.'s CFO hired you as a consultant to help them estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 0.85. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 7.62% b. 9.76% c. 10.45% d. 7.28% e. 8.56% ANSWER: e 76. Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $35.00; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach? a. 11.90% b. 9.91% c. 12.10% d. 11.60% e. 11.20% ANSWER: b 77. Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $36.00; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 12.95% b. 9.05% c. 8.53% d. 10.21% e. 10.53% Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 10 - The Cost of Capital ANSWER: e 78. A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 5.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings? a. 9.60% b. 9.02% c. 11.14% d. 8.16% e. 11.04% ANSWER: a 79. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 16.75%. The firm will not be issuing any new stock. What is its WACC? a. 11.06% b. 12.83% c. 9.85% d. 8.74% e. 9.51% ANSWER: a 80. To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $875, and has a par value of $1,000. If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations. a. 6.60% b. 7.77% c. 7.30% d. 6.47% e. 8.09% ANSWER: e 81. Several years ago, the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $875, and the company’s tax rate is 25%. What is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations. a. 4.92% b. 6.22% c. 5.92% d. 5.02% e. 4.33% ANSWER: b 82. Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $45.00; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 10 - The Cost of Capital retained earnings? Do not round your intermediate calculations. a. 7.13% b. 8.50% c. 10.05% d. 7.22% e. 9.14% ANSWER: e 83. Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $40.00; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? Do not round your intermediate calculations. a. 11.28% b. 8.13% c. 10.16% d. 10.57% e. 9.35% ANSWER: c 84. Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $25.00; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 10.42% b. 10.32% c. 8.36% d. 11.87% e. 11.66% ANSWER: b 85. You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $77.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a. 10.78% b. 10.22% c. 9.94% d. 9.38% e. 7.22% ANSWER: d 86. Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $60.00 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? Do not round your intermediate calculations. a. 9.99% b. 9.49% c. 8.69% Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 10 - The Cost of Capital d. 9.09% e. 8.19% ANSWER: a 87. Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $87.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 25%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings? Do not round your intermediate calculations. a. 5.69% b. 6.62% c. 7.35% d. 7.13% e. 5.10% ANSWER: d 88. You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 10.50%, and the tax rate is 25%. The firm will not be issuing any new stock. What is Quigley's WACC? Round final answer to two decimal places. Do not round your intermediate calculations. a. 9.37% b. 6.73% c. 6.11% d. 8.08% e. 6.97% ANSWER: d 89. Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 25.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? Do not round your intermediate calculations. a. 1.07% b. 0.89% c. 1.11% d. 1.29% e. 1.05% ANSWER: e 90. S. Bouchard and Company hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects? Do not round your intermediate calculations. a. –1.84% b. –2.17% c. –2.23% Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 10 - The Cost of Capital d. –1.68% e. –2.05% ANSWER: a 91. Sapp Trucking’s balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $24.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 25%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 2.62% b. 2.28% c. 1.87% d. 2.19% e. 3.11% ANSWER: b 92. The CFO of Lenard Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm’s bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 2.50. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference? a. 9.00% b. 6.84% c. 8.28% d. 8.82% e. 10.35% ANSWER: a 93. Eakins Inc.’s common stock currently sells for $17.50 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? Do not round your intermediate calculations. a. 0.67% b. 0.96% c. 0.86% d. 1.05% e. 1.15% ANSWER: b 94. Bolster Foods’ (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 25%. Calculate Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 10 - The Cost of Capital WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs. Do not round your intermediate calculations. a. 38.16% b. 31.08% c. 18.90% d. 12.68% e. 31.73% ANSWER: e 95. Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,000.00. (2) The company’s tax rate is 25%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations. a. 8.90% b. 10.32% c. 11.03% d. 6.76% e. 9.32% ANSWER: e 96. Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company’s outstanding bonds is 7.75%, its tax rate is 25%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $14.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget? a. 9.96% b. 7.98% c. 10.12% d. 8.75% e. 8.23% ANSWER: d 97. Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equalsized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 1.00. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be?

Project 1 2 3

Risk Risk factor Very low -2.00% Low -1.00% Average 0.00%

Expected return 7.60% 9.15% 10.10%

Copyright Cengage Learning. Powered by Cognero.

Cost (millions) $25 $25 $25 Page 21

Name:

Class:

Date:

Chapter 10 - The Cost of Capital 4 5 6 7

High Very high Very high Very high

1.00% 2.00% 2.00% 2.00%

10.40% 10.80% 10.90% 13.00%

$25 $25 $25 $25

a. $100 million b. $125 million c. $25 million d. $50 million e. $75 million ANSWER: e Exhibit 10.1 Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets Current assets Net plant, property, and equipment Total assets

$38,000,000 $101,000,000 $139,000,000

Liabilities and Equity Accounts payable $10,000,000 Accruals $9,000,000 Current liabilities $19,000,000 Long-term debt (40,000 bonds, $1,000 par value) $40,000,000 Total liabilities $59,000,000 Common stock (10,000,000 shares) $30,000,000 Retained earnings $50,000,000 Total shareholders' equity $80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000.00 par value, 20-year, 9.00% bonds with semiannual payments are selling for $930.41. The beta is 1.22, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

98. Refer to Exhibit 10.1. What is the best estimate of the after-tax cost of debt? a. 5.23% b. 5.59% c. 7.35% d. 6.17% e. 6.48% ANSWER: c 99. Refer to Exhibit 10.1. Based on the CAPM, what is the firm's cost of equity? a. 11.08% b. 11.98% c. 12.49% Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 10 - The Cost of Capital d. 12.88% e. 13.52% ANSWER: d 100. Refer to Exhibit 10.1. Which of the following is the best estimate for the weight of debt for use in calculating the WACC? Do not round your intermediate calculations. a. 14.07% b. 14.35% c. 14.78% d. 15.22% e. 15.53% ANSWER: a 101. Refer to Exhibit 10.1. What is the best estimate of the firm's WACC? Do not round your intermediate calculations. a. 10.43% b. 10.89% c. 11.46% d. 11.75% e. 12.39% ANSWER: d

Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 1. Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project. a. True b. False ANSWER: False 2. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False ANSWER: False 3. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV. a. True b. False ANSWER: True 4. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False ANSWER: False 5. The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. a. True b. False ANSWER: True 6. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False ANSWER: False 7. Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life. a. True b. False ANSWER: True 8. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting ANSWER: False 9. The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False ANSWER: True 10. The IRR method is based on the assumption that a project's cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False ANSWER: False 11. The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. a. True b. False ANSWER: True 12. For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False ANSWER: True 13. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated. a. True b. False ANSWER: False 14. One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk. a. True b. False ANSWER: True 15. When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 16. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant. a. True b. False ANSWER: False 17. The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and, thus, capital budgets if the projects' IRRs are greater than their costs of capital. a. True b. False ANSWER: False 18. The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and, thus, capital budgets if the cost of capital at which the projects' NPV profiles cross is greater than the crossover rate. a. True b. False ANSWER: False 19. A conflict will exist between the NPV and IRR methods when used to evaluate two equally risky but mutually exclusive projects if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross. a. True b. False ANSWER: True 20. Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S. a. True b. False ANSWER: True 21. The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. a. True b. False ANSWER: False 22. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 23. If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake. a. True b. False ANSWER: False 24. An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False ANSWER: False 25. The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X. a. True b. False ANSWER: False 26. Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV. a. True b. False ANSWER: False 27. If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0. a. True b. False ANSWER: False 28. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC. b. The lower the WACC used to calculate it, the lower the calculated NPV will be. c. If a project’s NPV is less than zero, then its IRR must be less than the WACC. d. If a project’s NPV is greater than zero, then its IRR must be less than zero. e. The NPV of a relatively low-risk project should be found using a relatively high WACC. ANSWER: c 29. Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life. b. One defect of the IRR method is that it does not take account of the time value of money.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting c. One defect of the IRR method is that it does not take account of the cost of capital. d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

ANSWER: e 30. Which of the following statements is CORRECT? a. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project’s full life. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. c. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. d. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.

ANSWER: e 31. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. b. A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. c. If a project’s IRR is greater than the WACC, then its NPV must be negative. d. To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs. e. To find a project’s IRR, we must find a discount rate that is equal to the WACC. ANSWER: d 32. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC. b. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR. c. If a project’s IRR is smaller than the WACC, then its NPV will be positive. d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost. e. If a project’s IRR is positive, then its NPV must also be positive.

ANSWER: d 33. Which of the following statements is CORRECT? a. If a project has “normal” cash flows, then its IRR must be positive. b. If a project has “normal” cash flows, then its MIRR must be positive. c. If a project has “normal” cash flows, then it will have exactly two real IRRs. Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting d. The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life. e. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR. ANSWER: e 34. Which of the following statements is CORRECT? a. Projects with “normal” cash flows can have only one real IRR. b. Projects with “normal” cash flows can have two or more real IRRs. c. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.” d. The “multiple IRR problem” can arise if a project’s cash flows are “normal.” e. Projects with “nonnormal” cash flows are almost never encountered in the real world.

ANSWER: a 35. Which of the following statements is CORRECT? a. The regular payback method recognizes all cash flows over a project’s life. b. The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money. c. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. d. The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. e. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

ANSWER: d 36. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of four years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

ANSWER: b 37. Which of the following statements is CORRECT? a. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting c. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

ANSWER: b 38. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project’s IRR increases as the WACC declines. b. A project’s NPV increases as the WACC declines. c. A project’s MIRR is unaffected by changes in the WACC. d. A project’s regular payback increases as the WACC declines. e. A project’s discounted payback increases as the WACC declines.

ANSWER: b 39. Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

ANSWER: d 40. Which of the following statements is CORRECT? a. An NPV profile graph shows how a project’s payback varies as the cost of capital changes. b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. c. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life. d. An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital. e. We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV. ANSWER: d 41. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project’s NPV is greater than zero, then its IRR must be less than the WACC. Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting d. If a project’s NPV is greater than zero, then its IRR must be less than zero. e. The NPVs of relatively risky projects should be found using relatively low WACCs. ANSWER: b 42. Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can occur only if the signs of the cash flows change more than once. e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

ANSWER: d 43. Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

ANSWER: a 44. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. d. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. e. If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive.

ANSWER: e 45. Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and, thus, your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L because, at the new WACC, it will have the higher NPV. d. You should recommend Project S because, at the new WACC, it will have the higher NPV. Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting e. You should recommend Project L because it will have the higher IRR at the new WACC. ANSWER: d 46. Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and, thus, your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L because, at the new WACC, it will have the higher NPV. d. You should recommend Project S because, at the new WACC, it will have the higher NPV. e. You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

ANSWER: c 47. Which of the following statements is CORRECT? a. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project’s profitability. b. If the cost of capital declines, this lowers a project’s NPV. c. The NPV method is regarded by most academics as being the best indicator of a project’s profitability, hence most academics recommend that firms use only this one method and disregard other methods. d. A project’s NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project’s life. e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

ANSWER: e 48. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years. The two NPV profiles are given below:

Which of the following statements is CORRECT? a. More of Project A's cash flows occur in the later years.

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting b. More of Project B's cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project's IRR. ANSWER: a 49. Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC? a. Project S b. Project L c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. e. The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs. ANSWER: b 50. Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? a. Project D probably has a higher IRR. b. Project D is probably larger in scale than Project C. c. Project C probably has a faster payback. d. Project C probably has a higher IRR. e. The crossover rate between the two projects is below 12%.

ANSWER: a 51. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a fouryear payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a four-year payback is too low. d. The firm will accept too few projects in all economic states because a four-year payback is too high. e. If the four-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

ANSWER: e 52. Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method? a. Lacks an objective, market-determined benchmark for making decisions b. Ignores cash flows beyond the payback period c. Does not directly account for the time value of money Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting d. Does not provide any indication regarding a project’s liquidity or risk e. Does not take account of differences in size among projects ANSWER: d 53. Which of the following statements is CORRECT? a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV. c. A project’s MIRR can never exceed its IRR. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. e. If the NPV is negative, the IRR must also be negative.

ANSWER: a 54. Which of the following statements is CORRECT? a. The MIRR and NPV decision criteria can never conflict. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. d. The higher the WACC, the shorter the discounted payback period. e. The MIRR method assumes that cash flows are reinvested at the crossover rate.

ANSWER: c 55. Which of the following statements is CORRECT? a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of three years or less) methods always lead to the same accept/reject decisions for independent projects. b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. d. If a firm uses the discounted payback method with a required payback of four years, then it will accept more projects than if it used a regular payback of four years. e. The percentage difference between the MIRR and the IRR is equal to the project’s WACC. ANSWER: c 56. Which of the following statements is CORRECT? a. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. b. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. c. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. e. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 57. Which of the following statements is CORRECT? a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life, whereas IRR does not. b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life, whereas MIRR does not. d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows, whereas the MIRR is based on undiscounted cash flows. e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

ANSWER: b 58. Which of the following statements is CORRECT? a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. b. The discounted payback method eliminates all of the problems associated with the payback method. c. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. d. To find the MIRR, we discount the TV at the IRR. e. A project’s NPV profile must intersect the X-axis at the project’s WACC. ANSWER: a 59. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT? a. If the WACC is 10%, both projects will have positive NPVs. b. If the WACC is 6%, Project S will have the higher NPV. c. If the WACC is 13%, Project S will have the lower NPV. d. If the WACC is 10%, both projects will have a negative NPV. e. Project S’s NPV is more sensitive to changes in WACC than Project L's.

ANSWER: a 60. Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? a. If the WACC is 13%, Project A’s NPV will be higher than Project B’s. b. If the WACC is 9%, Project A’s NPV will be higher than Project B’s. c. If the WACC is 6%, Project B’s NPV will be higher than Project A’s. d. If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s. e. If the WACC is 9%, Project B’s NPV will be higher than Project A’s.

ANSWER: e 61. You are considering two mutually exclusive, equally risky projects. Both have IRRs that exceed the WACC. Which of Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows. a. If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected. b. If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. One project will rank higher by both criteria. c. If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. One project will rank higher by both criteria. d. For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other. e. For a conflict to exist between NPV and IRR, one project must have an increasing stream of cash flows over time while the other has a decreasing stream. If both sets of cash flows are increasing or decreasing, then it would be impossible for a conflict to exist, even if one project is larger than the other.

ANSWER: b 62. Project X’s IRR is 19%, and Project Y’s IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is CORRECT? a. The crossover rate must be less than 10%. b. The crossover rate must be greater than 10%. c. If the WACC is 8%, Project X will have the higher NPV. d. If the WACC is 18%, Project Y will have the higher NPV. e. Project X is larger in the sense that it has the higher initial cost.

ANSWER: b 63. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527.01%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president? a. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC. b. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC. c. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that the firm’s value will increase if the project is accepted. d. You should recommend that the project be rejected because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted. e. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted.

ANSWER: c 64. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting with one cash outflow at t = 0 followed by a series of positive cash flows. a. A project’s MIRR is always greater than its regular IRR. b. A project’s MIRR is always less than its regular IRR. c. If a project’s IRR is greater than its WACC, then its MIRR will be greater than the IRR. d. To find a project’s MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost. e. To find a project’s MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.

ANSWER: e 65. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project’s MIRR is always greater than its regular IRR. b. A project’s MIRR is always less than its regular IRR. c. If a project’s IRR is greater than its WACC, then the MIRR will be less than the IRR. d. If a project’s IRR is greater than its WACC, then the MIRR will be greater than the IRR. e. To find a project’s MIRR, we compound cash inflows at the IRR and then discount the terminal value back to t = 0 at the WACC. ANSWER: c 66. Projects S and L both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT? a. Project S must have a higher NPV than Project L. b. If Project S has a positive NPV, Project L must also have a positive NPV. c. If the WACC falls, each project’s IRR will increase. d. If the WACC increases, each project’s IRR will decrease. e. If Projects S and L have the same NPV at the current WACC, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the WACC used to evaluate the projects declined.

ANSWER: e 67. Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky. a. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s NPV must be negative. b. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s IRR must be negative. c. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s NPV must be zero. d. There is no necessary relationship between a project’s IRR, its WACC, and its NPV. e. When evaluating mutually exclusive projects, those projects with relatively long lives will tend to have relatively high NPVs when the cost of capital is relatively high.

ANSWER: c 68. McCall Manufacturing has a WACC of 10%. The firm is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT? Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting a. Each project must have a negative NPV. b. Since the projects are mutually exclusive, the firm should always select Project B. c. If the crossover rate is 8%, Project B will have the higher NPV. d. Only one project has a positive NPV. e. If the crossover rate is 8%, Project A will have the higher NPV. ANSWER: c 69. A company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for five years, and an IRR of 15.24%. The smaller project has an initial cost of $51,600, annual cash flows of $16,000 for five years, and an IRR of 16.65%. The projects are equally risky. Which of the following statements is CORRECT? a. Since the smaller project has the higher IRR, the two projects’ NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of WACC. b. Since the smaller project has the higher IRR, the two projects’ NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of WACC. c. If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longerterm projects, regardless of how high or low the WACC is. d. Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects’ NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate. e. Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects’ NPV profiles will cross, and the smaller project will look better if the WACC is less than the crossover rate.

ANSWER: d 70. Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15%, and B's IRR is 20%. The company’s WACC is 12%, and at that rate, Project A has the higher NPV. Which of the following statements is CORRECT? a. The crossover rate for the two projects must be less than 12%. b. Assuming the timing pattern of the two projects’ cash flows is the same, Project B probably has a higher cost (and larger scale). c. Assuming the two projects have the same scale, Project B probably has a faster payback than Project A. d. The crossover rate for the two projects must be 12%. e. Since B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%.

ANSWER: c 71. Which of the following statements is considered a flaw in the payback method? a. Payback is a break-even calculation. b. The time value of money is ignored. c. The payback method provides information about liquidity and risk. d. The shorter the payback, the greater the project’s liquidity. e. The payback method is fairly simple to use.

ANSWER: b 72. Of the five capital budgeting decision criteria, the greatest weight should be given to a. IRR. Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting b. payback. c. NPV. d. MIRR. e. discounted payback.

ANSWER: c 73. Of the five capital budgeting methods, NPV is the single best criterion because it a. provides indications of liquidity and risk. b. incorporates a better reinvestment rate assumption. c. contains information concerning a project’s safety margin. d. measures profitability as a percentage rate of return. e. provides a direct measure of value the project adds to shareholder wealth.

ANSWER: e 74. The most challenging aspect of capital budgeting is a. deciding between long-term and short-term projects when both are profitable. b. choosing between independent and mutually exclusive projects. c. finding projects with a positive net present value. d. estimating the relevant cash flows. e. deciding which capital budgeting method is the best one to use.

ANSWER: d 75. Which capital budgeting method should be used when conflicts exist between mutually exclusive projects? a. Discounted payback b. NPV c. MIRR d. Payback e. IRR ANSWER: b 76. Which capital budgeting method is superior to IRR as an indicator of a project’s true rate of return? a. MIRR b. Payback c. Discounted payback d. Crossover rate e. NPV ANSWER: a 77. Anderson Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected.

WACC: Year Cash flows

8.25% 0 -$1,000

1 $500

Copyright Cengage Learning. Powered by Cognero.

2 $500

3 $500 Page 16

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting a. 313.86 b. 220.55 c. 243.17 d. 282.76 e. 257.31 ANSWER: d 78. Tuttle Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected.

WACC: 7.50% Year 0 Cash flows -$1,000 a. 184.32 b. 198.10 c. 161.93 d. 196.38 e. 172.26 ANSWER: e

1 $350

2 $350

3 $350

4 $350

79. Harry's Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected.

WACC: 12.75% Year 0 Cash flows -$1,000 a. 46.84 b. 66.57 c. 61.64 d. 53.62 e. 56.71 ANSWER: c

1 $300

2 $300

3 $300

4 $300

5 $300

80. Simms Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Year Cash flows a. 19.40% b. 20.57% c. 24.78% d. 22.44% e. 23.38% ANSWER: e

0 -$850

1 $425

2 $425

3 $425

81. Warr Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting project's projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Year Cash flows

0 -$1,410

1 $400

2 $400

3 $400

4 $400

a. 4.05% b. 4.62% c. 5.26% d. 5.36% e. 6.20% ANSWER: c 82. Thorley Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Year Cash flows

0 -$800

1 $325

2 $325

3 $325

4 $325

5 $325

a. 29.45% b. 30.04% c. 23.56% d. 36.22% e. 27.39% ANSWER: a 83. Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year 0 Cash flows -$1,350 a. 2.70 years b. 2.78 years c. 2.92 years d. 2.05 years e. 2.32 years ANSWER: a

1 $500

2 $500

3 $500

84. Resnick Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.08 years b. 2.23 years c. 1.63 years d. 2.18 years e. 1.88 years ANSWER: e

0 -$375

1 $200

Copyright Cengage Learning. Powered by Cognero.

2 $200

3 $200

Page 18

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 85. Susmel Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.25 years b. 2.70 years c. 1.91 years d. 2.79 years e. 2.43 years ANSWER: a

0 -$425

1 $150

2 $200

3 $300

86. Mansi Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.61 years b. 1.63 years c. 1.97 years d. 2.14 years e. 2.46 years ANSWER: d

0 -$675

1 $300

2 $325

3 $350

87. Cornell Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC: 10.00% Year 0 Cash flows -$1,275 a. -$128.65 b. -$132.63 c. -$164.46 d. -$156.50 e. -$120.69 ANSWER: b

1 $450

2 $460

3 $470

88. Warnock Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC: 10.00% Year 0 Cash flows -$1,075 a. -$72.86 b. -$65.13 c. -$62.55 d. -$76.73 e. -$64.48

1 $500

Copyright Cengage Learning. Powered by Cognero.

2 $400

3 $300

Page 19

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting ANSWER: e 89. Jazz World Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC: 13.00% Year 0 Cash flows -$1,200 a. $84.62 b. $90.02 c. $72.01 d. $67.51 e. $111.62 ANSWER: b

1 $400

2 $425

3 $450

4 $475

90. Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC: 9.75% Year 0 Cash flows -$1,100 a. $356.82 b. $367.52 c. $371.09 d. $378.23 e. $385.36 ANSWER: a

1 $400

2 $390

3 $380

4 $370

5 $360

91. Datta Computer Systems is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows

0 -$1,200

1 $450

2 $470

3 $490

a. 6.71% b. 7.13% c. 7.97% d. 9.31% e. 8.39% ANSWER: e 92. Simkins Renovations Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows

0 -$625

Copyright Cengage Learning. Powered by Cognero.

1 $300

2 $290

3 $280

4 $270 Page 20

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting a. 25.45% b. 35.33% c. 22.45% d. 30.54% e. 29.94% ANSWER: e 93. Maxwell Feed & Seed is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows a. 3.35% b. 3.84% c. 3.21% d. 3.49% e. 2.62% ANSWER: d

0 -$9,250

1 $2,000

2 $2,025

3 $2,050

4 $2,075

5 $2,100

94. Last month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected.

Old WACC: 10.00% Year 0 Cash flows -$1,000 a. -$63.73 b. -$79.67 c. -$57.36 d. -$59.27 e. -$54.81 ANSWER: a

New WACC: 13.75% 1 2 3 $410 $410 $410

95. Lasik Vision Inc. recently analyzed the project whose cash flows are shown below. However, before Lasik decided to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected.

Old WACC: 8.00% Year 0 Cash flows -$1,000 a. -$13.43 b. -$17.11 c. -$14.14 d. -$16.82

New WACC: 8.75% 1 2 3 $410 $410 $410

Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting e. -$11.88 ANSWER: c 96. Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 8.00% Year 0 Cash flows -$1,000 a. 13.47% b. 11.04% c. 12.26% d. 15.35% e. 13.06% ANSWER: a

1 $450

2 $450

3 $450

97. Ingram Electric Products is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 10.00% Year 0 Cash flows -$800 a. 12.35% b. 11.69% c. 13.14% d. 15.24% e. 10.64% ANSWER: c

1 $350

2 $350

3 $350

98. Malholtra Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 10.00% Year 0 Cash flows -$775 a. 15.60% b. 21.84% c. 22.75% d. 20.55% e. 18.35% ANSWER: e

1 $300

2 $320

3 $340

4 $360

99. Hindelang Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting WACC: 12.00% Year 0 Cash flows -$850 a. 12.68% b. 19.75% c. 16.46% d. 18.44% e. 16.63% ANSWER: c

1 $300

2 $320

3 $340

4 $360

100. Stern Associates is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.94 years b. 2.11 years c. 2.39 years d. 2.52 years e. 2.06 years ANSWER: d

0 -$775

1 $300

2 $310

3 $320

4 $330

5 $340

101. Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

WACC: 10.00% Year 0 Cash flows -$950 a. 2.44 years b. 2.15 years c. 2.71 years d. 2.22 years e. 1.95 years ANSWER: d

1 $500

2 $500

3 $500

102. Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

WACC: Year Cash flows a. 1.41 years b. 1.62 years c. 1.36 years d. 1.29 years e. 1.28 years ANSWER: b

10.00% 0 1 -$725 $525

Copyright Cengage Learning. Powered by Cognero.

2 $485

3 $445

4 $405

Page 23

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting 103. Tesar Chemicals is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost.

WACC:

8.25% 0 -$1,100 -$2,700

CFS CFL

1 $550 $650

2 $600 $725

3 $100 $800

4 $100 $1,400

a. $110.33 b. $117.16 c. $97.64 d. $108.38 e. $95.68 ANSWER: c 104. A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose?

WACC:

10.25% 0 -$1,025 -$2,150

CFS CFL

1 $380 $765

2 $380 $765

3 $380 $765

4 $380 $765

a. $69.28 b. $88.82 c. $111.03 d. $71.06 e. $79.05 ANSWER: b 105. Sexton Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used.

WACC:

8.50% 0 -$2,050 -$4,300

CFS CFL

1 $750 $1,500

2 $760 $1,518

3 $770 $1,536

4 $780 $1,554

a. $243.34 Copyright Cengage Learning. Powered by Cognero.

Page 24

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting b. $255.50 c. $228.74 d. $192.24 e. $194.67 ANSWER: a 106. Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist.

WACC:

10.50% 0 -$1,025 -$1,025

CFS CFL

1 $650 $100

2 $450 $300

3 $250 $500

4 $50 $700

a. $0.67 b. $0.68 c. $0.81 d. $0.53 e. $0.85 ANSWER: b 107. Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

WACC:

11.00% 0 -$1,050 -$1,050

CFS CFL

1 $675 $360

2 $650 $360

3

4

$360

$360

a. $0.00 b. $15.78 c. $17.09 d. $22.91 e. $16.34 ANSWER: a 108. Nast Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost.

WACC: CFS

11.50% 0 -$1,100

1 $375

Copyright Cengage Learning. Powered by Cognero.

2 $375

3 $375

4 $375 Page 25

Name:

Class:

Date:

Chapter 11 - The Basics of Capital Budgeting CFL

-$2,200

$725

$725

$725

$725

a. $24.87 b. $29.99 c. $0.00 d. $25.38 e. $29.74 ANSWER: c 109. Yonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost.

WACC: CFS CFL

10.00% 0 -$950 -$2,100

1 $500 $400

2 $800 $800

3 $0 $800

4 $0 $1,000

a. $41.43 b. $43.16 c. $51.36 d. $48.77 e. $33.66 ANSWER: b 110. Noe Drilling Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone, i.e., what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost.

WACC: CFS CFL

9.00% 0 -$1,100 -$2,750

1 $550 $725

2 $600 $725

3 $100 $800

4 $100 $1,400

a. $92.69 b. $62.57 c. $0.00 d. $95.01 e. $78.79 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 1. Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects. a. True b. False ANSWER: False 2. Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis. a. True b. False ANSWER: False 3. If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. a. True b. False ANSWER: True 4. Any cash flows that can be classified as incremental to a particular project—i.e., results directly from the decision to undertake the project—should be reflected in the capital budgeting analysis. a. True b. False ANSWER: True 5. We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis. a. True b. False ANSWER: False 6. In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows. a. True b. False ANSWER: True 7. Suppose a firm's CFO thinks that an externality is present in a project but that it cannot be quantified with any precision—estimates of its effect would really just be guesses. In this case, the externality should be ignored—i.e., not considered at all—because if it were considered, it would make the analysis appear more precise than it really is. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 8. Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. a. True b. False ANSWER: False 9. The primary advantage to immediately expensing depreciation rather than using straight-line depreciation is that with immediate expensing the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater. a. True b. False ANSWER: False 10. The primary advantage to immediately expensing depreciation rather than using straight-line depreciation is that with immediate expensing the present value of the tax savings provided by depreciation will be higher, other things held constant. a. True b. False ANSWER: True 11. Typically, a project will have a higher NPV if the firm immediately expenses depreciation rather than using straightline depreciation. This is because the total cash flows over the project's life will be higher if depreciation is immediately expensed, other things held constant. a. True b. False ANSWER: False 12. A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it immediately expenses depreciation than if it uses straight-line depreciation, other things being equal. a. True b. False ANSWER: True 13. Immediate expensing of depreciation has an advantage for profitable firms in that it moves cash flows forward, thus increasing their present value. On the other hand, in the year that depreciation is immediately expensed, the reported current year's profits are lower because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes. a. True b. False ANSWER: True 14. If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 15. Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions for capital budgeting projects. a. True b. False ANSWER: False 16. It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis. a. True b. False ANSWER: True 17. The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects. a. True b. False ANSWER: False 18. Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. a. True b. False ANSWER: True 19. Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and, as such, should not be considered in the analysis for the new book. a. True b. False ANSWER: False 20. The change in net operating working capital (NOWC) associated with new projects is always positive because new projects mean that more operating working capital will be required. a. True b. False ANSWER: False 21. Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the riskier the project, other things held constant. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis ANSWER: True 22. The relative risk of a proposed project is best accounted for by which of the following procedures? a. Adjusting the discount rate upward if the project is judged to have above-average risk b. Adjusting the discount rate upward if the project is judged to have below-average risk c. Reducing the NPV by 10% for risky projects d. Picking a risk factor equal to the average discount rate e. Ignoring risk because project risk cannot be measured accurately ANSWER: a 23. Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR = 9% b. Project B, which has below-average risk and an IRR = 8.5% c. Project C, which has above-average risk and an IRR = 11% d. Without information about the projects' NPVs, we cannot determine which one or ones should be accepted. e. All of these projects should be accepted as they will produce a positive NPV. ANSWER: b 24. Which of the following statements is CORRECT? a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project’s NPV. e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.

ANSWER: c 25. Which of the following statements is CORRECT? a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. c. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices. d. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. e. If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.

ANSWER: d

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 26. Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV. ANSWER: b 27. Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV. ANSWER: b 28. Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. d. If cannibalization is determined to exist, then this means that the calculated NPV, if cannibalization is considered, will be higher than the NPV if this effect is not recognized. e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

ANSWER: e 29. Which of the following statements is CORRECT? a. Using bonus depreciation rather than straight-line depreciation would normally have no effect on a project’s total projected cash flows, but it would affect the timing of the cash flows and, thus, the NPV. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are five years or longer. c. Corporations must use the same depreciation method (e.g., straight-line or accelerated) for stockholder reporting and tax purposes.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis d. Since depreciation is not a cash expense, it has no effect on cash flows and, thus, no effect on capital budgeting decisions. e. Under bonus depreciation, higher depreciation charges occur at t = 0, and this increases the initial investment outlay and, thus, lowers a project's projected NPV. ANSWER: a 30. Which of the following statements is CORRECT? a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are five years or longer. c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. d. Using bonus depreciation rather than straight-line depreciation normally has the effect of receiving depreciation cash flows immediately and, thus, increasing a project’s forecasted NPV. e. Using bonus depreciation rather than straight-line depreciation normally has the effect of delaying the receipt of depreciation cash flows and, thus, reducing a project’s forecasted NPV. ANSWER: d 31. Which of the following statements is CORRECT? a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are three years or longer. c. If firms use bonus depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result, projects’ forecasted NPVs would normally be lower than they would be if straight-line depreciation were required for tax purposes. d. If firms use bonus depreciation, they can write off assets faster than they could under straight-line depreciation, and as a result, projects’ forecasted NPVs would normally be lower than they would be if straight-line depreciation were required for tax purposes. e. If firms use bonus depreciation, they can write off assets faster than they could under straight-line depreciation, and as a result, projects’ forecasted NPVs would normally be higher than they would be if straight-line depreciation were required for tax purposes.

ANSWER: e 32. A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? a. All sunk costs that have been incurred relating to the project b. All interest expenses on debt used to help finance the project c. The additional investment in net operating working capital (NOWC) required to operate the project, even if that investment will be recovered at the end of the project’s life d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis ANSWER: c 33. Other things held constant, which of the following would increase the NPV of a project being considered? a. A shift from straight-line to bonus depreciation b. Making the initial investment in the first year rather than spreading it over the first three years c. An increase in the discount rate associated with the project d. An increase in required net operating working capital (NOWC) e. The project would decrease sales of another product line.

ANSWER: a 34. Which of the following factors should be included in the cash flows used to estimate a project’s NPV? a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted b. Interest on funds borrowed to help finance the project c. The end-of-project recovery of any additional net operating working capital required to operate the project d. Cannibalization effects but only if those effects increase the project’s projected cash flows e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes ANSWER: c 35. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. changes in net operating working capital attributable to the project. b. previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. c. the value of a building owned by the firm that will be used for this project. d. a decline in the sales of an existing product, provided that decline is directly attributable to this project. e. the salvage value of assets used for the project that will be recovered at the end of the project’s life.

ANSWER: b 36. Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear—there is no mortgage on it. Which of the following statements is CORRECT? a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project. b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. c. This is an example of an externality because the very existence of the building affects the cash flows for any new project that Rowell might consider. d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

ANSWER: b 37. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis a. The new project is expected to reduce sales of one of the company’s existing products by 5%. b. Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost. c. The company has spent and expensed $1 million on research and development costs associated with the new project. d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

ANSWER: a 38. Which of the following rules is CORRECT for capital budgeting analysis? a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows. b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects. c. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision. d. A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted. e. If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.

ANSWER: b 39. Which of the following statements is CORRECT? a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward bias in the NPV. b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward bias in the NPV. c. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality. d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration. e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

ANSWER: d 40. Which one of the following would result in incremental cash flows and, thus, should be included in the capital budgeting analysis for a new product? a. A firm realizes it had a previous project that was not profitable despite a careful analysis using net present value. b. A company paid $5,000 for a major study that would help them determine if an expansion project would be Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis profitable. c. A firm depreciated its old equipment under the straight-line method before considering buying new equipment for a project. d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.

ANSWER: e 41. A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? a. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it. b. Since depreciation is a non-cash expense, it has no impact on a project’s calculated NPV. c. When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.

ANSWER: a 42. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV $350,000 $350,000 $100,000 $150,000 Standard deviation ( NPV) Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows Cash flows are not correlated Cash flows are highly correlated with cash flows from currently with the cash flows from with the cash flows from existing projects. existing projects. existing projects.

Which of the following statements is CORRECT? a. Project X has more stand-alone risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has more market risk than Project Y. d. Project X has the same level of corporate risk as Project Y. e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.

ANSWER: c 43. Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis variation than an average company project. Also, the new project’s sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT? a. The proposed new project would have more stand-alone risk than the firm’s typical project. b. The proposed new project would increase the firm’s corporate risk. c. The proposed new project would increase the firm’s market risk. d. The proposed new project would not affect the firm’s risk at all. e. The proposed new project would have less stand-alone risk than the firm’s typical project.

ANSWER: a 44. A firm is considering a new project whose risk is greater than the risk of the firm’s average project based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated IRR of the project to reflect its greater risk b. Increase the estimated NPV of the project to reflect its greater risk c. Reject the project, because its acceptance would increase the firm’s risk d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk ANSWER: e 45. Which of the following statements is CORRECT? a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. c. Well-diversified stockholders do not need to consider market risk when determining required rates of return. d. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

ANSWER: e 46. Which of the following statements is CORRECT? a. Sensitivity analysis, as it is generally employed, is incomplete in that it fails to consider the probability of occurrence of the key input variables. b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV. c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. e. As computer technology advances, simulation analysis becomes increasingly obsolete and, thus, less likely to be used than sensitivity analysis.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 47. Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. b. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. c. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. d. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. e. The replacement chain (common life) approach and the equivalent annual annuity (EAA) approach must be used to evaluate independent projects with unequal lives; however, neither approach may be used to evaluate mutually exclusive projects with unequal lives.

ANSWER: a 48. Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis; the proper incremental cash flows are the reported accounting profits, and, thus, reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the project’s completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a project’s life. d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.

ANSWER: d 49. The issue of adjusting for unequal lives is only relevant to a. independent projects. b. projects that have significantly different lives, are mutually exclusive, and can be repeated. c. mutually exclusive projects that will not be repeated. d. independent projects that will be repeated. e. projects with significantly different lives.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis 50. Which of the following statements is CORRECT regarding risk analysis? a. It is fairly easy to measure projects’ within-firm and beta risks. b. Managers should never exhibit judgment related to risks on capital budgeting projects; rather they should focus only on quantitative analyses. c. Most projects’ returns are not correlated to returns on the stock market. d. The best approach to risk analysis in capital budgeting decisions should be to use computer analysis. e. Experienced managers bring judgment into capital budgeting decisions in addition to quantitative measures of risk analysis.

ANSWER: e 51. Which of the following is the most commonly used technique to measure stand-alone risk? a. Scenario analysis b. Best-case scenario c. Sensitivity analysis d. Monte Carlo simulation e. Base-case NPV ANSWER: c 52. Which of the following risks in capital budgeting refers to projects’ risks to a corporation rather than to its investors? a. Within-firm risk b. Stand-alone risk c. Cost of capital risk d. Beta risk e. Market risk ANSWER: a 53. Analysis of projects using various inputs, such as selling price, fixed costs, or salvage values, is called a. opportunity cost analysis. b. scenario analysis. c. net present value. d. sensitivity analysis. e. a Monte Carlo simulation.

ANSWER: d 54. Which of the following costs is not relevant to capital budgeting decisions? a. Operating costs b. Replacement costs c. Sunk costs d. Opportunity costs e. Depreciation of new equipment ANSWER: c 55. Which of the following risk analysis techniques is a sophisticated version of scenario analysis? a. Best-case scenario analysis Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis b. Sensitivity analysis c. Monte Carlo simulation d. Base-case scenario analysis e. Worst-case scenario analysis ANSWER: c 56. Your company, RMU Inc., is considering a new project whose data are shown below. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. What is the project's Year 1 cash flow?

Sales revenues Operating costs Tax rate a. $2,350 b. $4,345 c. $7,180 d. $11,063 e. $10,501 ANSWER: d

$26,750 $12,000 25.0%

57. As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data.

What is the Year 1 cash flow? Do not round the intermediate calculations, and round the final answer to the nearest whole number.

Sales revenues Operating costs Tax rate a. $4,425 b. $5,007 c. $5,519 d. $5,975 e. $4,324 ANSWER: a

$11,900 $6,000 35.0%

58. Clemson Software is considering a new project whose data are shown below. The required equipment has a three-year tax life, after which it will be worthless. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. Revenues and operating costs are expected to be constant over the project's three-year life. What is the project's Year 1 cash flow? Do not round the intermediate calculations, and round the final answer to the nearest whole number.

Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. depr.)

Tax rate a. $29,638 b. $39,858 c. $38,495 Copyright Cengage Learning. Powered by Cognero.

$100,000 $60,000 $25,000 25.0%

Page 13

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis d. $30,660 e. $26,250 ANSWER: e 59. As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. What is the Year 1 cash flow? Do not round the intermediate calculations, and round the final answer to the nearest whole number.

Sales revenues, each year Other operating costs Interest expense Tax rate a. $25,077 b. $18,860 c. $18,238 d. $21,375 e. $24,248 ANSWER: d

$45,500 $17,000 $4,000 25.0%

60. Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. Revenues and operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost Sales revenues, each year Operating costs (excl. depr.)

Tax rate a. $27,781 b. $23,772 c. $48,750 d. $32,650 e. $30,073 ANSWER: c

$55,000 $90,000 $25,000 25.0%

61. You work for Whittenerg Inc., which is considering a new project whose data are shown below. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0.

What is the project's Year 1 cash flow?

Sales revenues, each year Other operating costs Interest expense Tax rate a. $14,549 b. $12,489 c. $32,063

$67,750 $25,000 $8,000 25.0%

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis d. $16,094 e. $10,944 ANSWER: c 62. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life. Under the new law, the equipment used in the project is eligible for 100% bonus depreciation, so the equipment will be fully depreciated at t = 0. The equipment has no salvage value at the end of the project’s life, and the project does not require any additional operating working capital. Revenues and operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

Equipment cost Sales revenues, each year Operating costs Tax rate a. $13,932 b. $21,068 c. $10,125 d. $14,781 e. $17,160 ANSWER: c

$70,000 $38,500 $25,000 25.0%

63. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3year tax life. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. The equipment would have a zero salvage value at the end of the project’s life. No change in net operating working capital (NOWC) would be required. Revenues and operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number.

Risk-adjusted WACC Equipment cost Sales revenues, each year Annual operating costs Tax rate a. $10,236 b. $4,251 c. $4,490 d. $8,137 e. $5,302 ANSWER: d

10.0% $65,000 $55,500 $25,000 25.0%

64. Liberty Services is now at the end of the final year of a project. The equipment was purchased prior to the new tax law and originally cost $20,000, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 25%. What is the equipment’s after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale that will offset income from the company’s other projects. a. $5,750 b. $6,993 Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis c. $7,308 d. $6,426 e. $5,166 ANSWER: a 65. Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years. Under the new tax law, the machine is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. The firm expects to operate the machine for 4 years and then to sell it for $21,500. If the marginal tax rate is 25%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? a. $12,400 b. $9,100 c. $9,600 d. $16,125 e. $10,400 ANSWER: d 66. TexMex Food Company is considering a new salsa whose data are shown below. Under the new tax law, the equipment to be used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project’s life, the equipment would have zero salvage value, and no change in net operating working capital (NOWC) would be required for the project. Revenues and operating costs are expected to be constant over the project's 3year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC 10.0% Pre-tax cash flow reduction for other products (cannibalization) -$5,000 Equipment cost $80,000 Annual sales revenues Annual operating costs Tax rate

$55,000 -$25,000 25.0%

a. $12,386 b. $12,863 c. -$13,372 d. $9,409 e. $14,432 ANSWER: c 67. Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project’s life, the equipment would have no salvage value. No change in net operating working capital (NOWC) would be required for the project. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? Do not round the intermediate calculations and round the final answer to the nearest whole Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis number.

WACC Equipment cost Units sold Average price per unit, Year 1 Fixed op. cost excl. depr. (constant) Variable op. cost/unit, Year 1 Expected annual inflation rate Tax rate a. -$98,569 b. -$85,485 c. -$76,697 d. -$95,434 e. -$81,490 ANSWER: d

10.0% $200,000 56,000 $25.00 $150,000 $20.20 5.0% 25.0%

68. Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project’s life, the equipment would have zero salvage value. No change in net operating working capital (NOWC) would be required for the project. Revenues and operating costs would be constant over the project's 3year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC Opportunity cost (after taxes) Equipment cost) Annual sales revenues Annual operating costs Tax rate a. $20,978 b. $36,761 c. $18,450 d. $34,900 e. $12,543 ANSWER: a

10.0% $100,000 $65,000 $116,000 $25,000 25.0%

69. Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $9,200 at t = 0.

Project X has an expected life of 2 years with after-tax cash inflows of $7,000 and $7,800 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $5,000 at the end of each of the next 4 years. Each project has a WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project? Do not round the intermediate calculations and round the final answer to the nearest whole number. a. $7,371 b. $5,971 Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis c. $5,528 d. $7,592 e. $6,855 ANSWER: a 70. Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years. Under the new tax law, the equipment for the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project’s life, the equipment will have no salvage value. No change in net operating working capital (NOWC) would be required for the project. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made? Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC Equipment cost Units sold Average price per unit, Year 1 Fixed op. cost excl. depr. (constant) Variable op. cost/unit, Year 1 Expected annual inflation rate Tax rate a. $18,345 b. $7,944 c. $7,542 d. $8,346 e. $8,648 ANSWER: a

10.0% $200,000 54,000 $25.00 $150,000 $20.20 4.0% 25.0%

71. Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $9,900 at t = 0.

Project S has an expected life of 2 years with after-tax cash inflows of $6,700 and $7,500 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,110 at the end of each of the next 4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. The controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is selected over Project S, i.e., what is the value of NPVL - NPVS? a. -$1,320.80 b. -$1,166.92 c. -$1,282.33 d. -$1,307.98 e. -$1,025.87 ANSWER: c 72. Foley Systems is considering a new project whose data are shown below. Under the new tax law, the equipment for the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. After the project's 3-year life, the equipment would have zero salvage value. The project would require additional net operating working capital Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis (NOWC) that would be recovered at the end of the project's life. Revenues and operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows from operations are constant in Years 1 to 3.) Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC Equipment cost Required net operating working capital (NOWC)

10.0% $75,000

Annual sales revenues Annual operating costs Tax rate

$73,000 $25,000 25.0%

$15,000

a. $29,546 b. $13,388 c. $4,571 d. $13,562 e. $1,348 ANSWER: a 73. Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0.

The equipment would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down.

Also, additional net operating working capital (NOWC) would be required, but it would be recovered at the end of the project's life. Revenues and operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC Equipment cost Required net operating working capital (NOWC)

10.0% $70,000 $10,000

Annual sales revenues Annual operating costs Expected pre-tax salvage value Tax rate

$61,000 $30,000 $5,000 25.0%

a. $5,650 b. $20,958 c. $15,224 d. $8,521 e. $2,543 ANSWER: a 74. Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project's 3-year life, it would have zero salvage value. No change in net operating working capital (NOWC) would be required for the project. Revenues and operating costs will be constant over the project's life, and this Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 12 - Cash Flow Estimation and Risk Analysis is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) Do not round the intermediate calculations and round the final answer to the nearest whole number.

WACC Equipment cost Number of cars washed Average price per car Fixed op. cost Variable op. cost/unit (i.e., VC per car washed)

10.0% $60,000 2,960 $25.00 $10,000 $5.375

Tax rate

25.0%

a. -$43,339 b. -$33,164 c. -$38,441 d. -$31,280 e. -$36,933 ANSWER: a

Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting True / False 1. Real options exist whenever managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project's cash flows. a. True b. False ANSWER: True 2. Traditional discounted cash flow (DCF) analysis—where a project's cash flows are estimated and then discounted to obtain an expected NPV—has been the cornerstone of capital budgeting since the 1950s. However, in recent years, it has been demonstrated that DCF techniques do not always lead to proper capital budgeting decisions due to the existence of real options. a. True b. False ANSWER: True 3. Real options are options to buy real assets, especially stocks, rather than interest-bearing assets, like bonds. a. True b. False ANSWER: False 4. The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options, (3) timing options, and (4) abandonment options. a. True b. False ANSWER: True 5. The following are all examples of real options that are discussed in the text: (1) protection options, (2) flexibility options, (3) timing options, and (4) abandonment options. a. True b. False ANSWER: False 6. The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options. a. True b. False ANSWER: False 7. The option to abandon a project is a real option, but a call option on a stock is not a real option. a. True b. False ANSWER: True 8. The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option.

Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting a. True b. False ANSWER: True 9. It is not possible for abandonment options to decrease a project's risk as measured by the project's coefficient of variation. a. True b. False ANSWER: False 10. Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice—delay the decision until later, when more information will be available. a. True b. False ANSWER: True 11. For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC. a. True b. False ANSWER: True 12. The optimal capital budget is the size of the capital budget where the rate of return on the marginal project is equal to the marginal cost of capital. a. True b. False ANSWER: True 13. Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has. a. True b. False ANSWER: True 14. An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project's sponsors and explaining why any differences occurred. a. True b. False ANSWER: True 15. Real options are most valuable when the underlying source of risk—such as uncertainty about unit sales, or the sales price, or input costs—is very low. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting 16. Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no reason to consider real options separately from the NPV analysis. a. True b. False ANSWER: False 17. Real options can affect the size of a project's expected NPV but not a project's risk as measured by the standard deviation or coefficient of variation of the NPV. a. True b. False ANSWER: False 18. Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice—delay the decision until later, when more information will be available. Because the analysis extends out at least one additional year from the original analysis, it is unlikely that the firm would ever delay a project—particularly given the loss of the "first mover advantage." a. True b. False ANSWER: False 19. A firm's optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive projects that have the highest positive NPVs. a. True b. False ANSWER: True 20. If a firm practices capital rationing, this means that it is accepting fewer projects than would be theoretically optimal; hence, it is not maximizing its theoretical value. a. True b. False ANSWER: True Multiple Choice 21. Which one of the following is an example of a "flexibility" option? a. A company has an option to invest in a project today or to wait for a year before making the commitment. b. A company has an option to close down an operation if it turns out to be unprofitable. c. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change. d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date. e. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly a commercial airline.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting 22. Which one of the following is a real option? a. The option to expand production if the product is successful b. The option to buy shares of stock if its price is expected to increase c. The option to sell shares of stock to raise capital d. The option to buy bonds as an investment e. The option to issue bonds to shareholders ANSWER: a 23. Which one of the following statements best describes the most likely impact that a profitable abandonment option would have on a project's expected cash flow and risk? a. No impact on the PV of expected cash flows, but risk will increase. b. The PV of expected cash flows increases and risk decreases. c. The PV of expected cash flows increases and risk increases. d. The PV of expected cash flows decreases and risk decreases. e. The PV of expected cash flows decreases and risk increases.

ANSWER: b 24. Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following statements best describes the issues that the firm faces when considering this investment timing option? a. The investment timing option would not affect the cash flows and, therefore, would have no impact on the project's risk. b. The more uncertainty about the future cash flows, the more logical it is to go ahead with this project today. c. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if the firm chooses to wait a year. d. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV. e. Waiting would probably reduce the project's risk.

ANSWER: e 25. Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Project A B C D E

Risk High Average High Low Low

Expected Return 15% 12% 11% 9% 6%

Which set of projects would maximize shareholder wealth? a. A and B b. A, B, and C c. A, B, and D d. A, B, C, and D Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting e. A, B, C, D, and E ANSWER: c 26. Which one of the following will NOT increase the value of a real option? a. Lengthening the time during which a real option must be exercised b. An increase in the volatility of the underlying source of risk c. An increase in the risk-free rate d. An increase in the cost of obtaining the real option e. A decrease in the probability that a competitor will enter the market of the project in question ANSWER: d 27. Which one of the following statements is most CORRECT? a. Real options change the size, but not the risk, of projects' expected NPVs. b. Real options change the risk, but not the size, of projects' expected NPVs. c. Real options can reduce the cost of capital that should be used to discount a project's expected cash flows. d. Very few projects actually have real options. They are theoretically interesting but of little practical importance. e. Real options are more valuable when there is very little uncertainty about the true values of future sales and costs.

ANSWER: c 28. Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT? a. The abandonment option tends to reduce a project's NPV. b. The abandonment option tends to reduce a project's risk. c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project. d. A project can either have an abandonment option or an investment timing option, but never both. e. Investment timing options always increase the value of a project.

ANSWER: b 29. Which of the following statements is CORRECT? a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment. b. In general, the greater the strategic advantages of being the first competitor to enter a given market, the more attractive it probably is to wait before making an investment. c. In general, the higher the discount rate, the more attractive it probably is to wait before making an investment. d. In general, investment timing options are more valuable than abandonment options. e. In general, abandonment options are rarely seen in the real world.

ANSWER: a 30. Weisbach Electronics is considering investing in India. Which of the following factors would make the company less Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting likely to proceed with the investment? a. The company would have the option to withdraw from the investment after two years if it turns out to be unprofitable. b. The investment would increase the odds of the company being able to subsequently make a successful entry into China. c. The investment would preclude the company from being able to make a profitable investment in China. d. Competitors are considering similar investments in India, and the firm can discourage them from trying by entering now. e. The new plant could be easily retrofitted to manufacture many of the firm's other products.

ANSWER: c 31. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers any real options that might be associated with projects. Which of the following statements is most likely to describe its situation? a. Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account. b. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options. c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact the failure to consider real options has on the overall capital budget. d. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget. e. Real options should not have any effect on the size of the optimal capital budget.

ANSWER: a 32. Which of the following real options refers to a project that can be delayed until more information is known? a. Abandonment b. Output flexibility c. Investment timing d. Input flexibility e. Growth or expansion ANSWER: c 33. An investment timing option refers to a. when to begin a project. b. when to end a project. c. delaying a project until a particular time. d. ending a project at a particular time. e. merging two projects at a particular time.

ANSWER: a 34. When determining the optimal capital budget, the company treasurer would prepare the IRR schedule which ranks projects by Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting a. lowest NPV to highest NPV. b. lowest IRR to highest IRR. c. shortest project life to longest project life. d. highest IRR to lowest IRR. e. longest project life to shortest project life.

ANSWER: d 35. If a project is ended early due to an abandonment option, this could a. increase the risk of other projects. b. cause shareholders to sell their stock. c. lead to catastrophic losses. d. decrease expected profitability and increase risk. e. increase expected profitability and lower risk.

ANSWER: e 36. Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor's larger competitors, Online Professor (OP), is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $5.8 million and a 65% probability that it won't be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 11.5%, giving consideration to the potential future purchase? Do not round intermediate calculations.

WACC = Original project: Future Buys Doesn't buy a. $514.65 b. $561.44 c. $467.86 d. $584.83 e. $397.68 ANSWER: c

11.5% 0 −$2,900 Prob.

35% 65%

1 $600

2 $600

3 $600

4 $600

5 $600

$5,800 $0

37. Chrustuba Inc. is evaluating a new project that would cost $9.2 million at t = 0. There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $6.2 million during Years 1, 2, and 3. However, there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the project is highly successful, it would open the door for another investment of $11 million at the end of Year 2, and this new investment could be sold for $22 million at the end of Year 3. Assuming a WACC of 11.0%, what is the project's expected NPV (in thousands) after taking into account this growth option? Do not round intermediate calculations. a. $3,494 b. $3,177 Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting c. $3,335 d. $3,812 e. $3,653 ANSWER: b 38. Carlson Inc. is evaluating a project in India that would require a $6.3 million investment today (t = 0). The after-tax cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in which case the project will produce after-tax cash flows of $1,100,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,200,000 for 5 years. The project has a WACC of 10.6%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.10 million cash flow at t = 1 and would also sell the property for $4.65 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the value (in thousands) of this abandonment option? Do not round intermediate calculations. a. $366 b. $345 c. $406 d. $467 e. $305 ANSWER: c 39. High Roller Properties is considering building a new casino at a cost of $10.0 million at t = 0. The after-tax cash flows the casino generates will depend on whether the state imposes a new income tax, and there is a 50-50 chance the tax will pass. If it passes, after-tax cash flows will be $1.875 million per year for the next 5 years. If it doesn't pass, the after-tax cash flows will be $3.75 million per year for the next 5 years. The project's WACC is 9.2%. If the tax is passed, the firm will have the option to abandon the project 1 year from now, in which case the property could be sold to net $6.3 million after tax at t = 1. What is the value (in thousands) of this abandonment option? Do not round intermediate calculations. a. $92 b. $98 c. $139 d. $87 e. $115 ANSWER: e 40. Lindley Corp. is considering a new product that would require an investment of $10.5 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $4.7 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $2.6 million per year.

There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's WACC is 10.2%. What is the value (in thousands) of the project after considering the investment timing option? Do not round intermediate calculations. a. $599 b. $416 c. $468 d. $573 e. $520 Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting ANSWER: e 41. Winters Corp. is considering a new product that would require an investment of $21 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $10.5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $4 million per year.

There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak, but it would have to incur costs to obtain this timing option. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's WACC is 10.8%. What is the value (in thousands) of the option to delay the project? Do not round intermediate calculations. a. $1,929 b. $1,821 c. $2,679 d. $2,036 e. $2,143 ANSWER: e 42. Games Unlimited Inc. is considering a new game that would require an investment of $22.0 million. If the new game is well received, then the project would produce cash flows of $9.5 million a year for 3 years. However, if the market does not like the new game, then the cash flows would be only $5.2 million per year. There is a 50% probability of both good and bad market conditions. The firm could delay the project for a year while it conducts a test to determine if demand would be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. If the WACC is 9.8%, what is the value (in thousands) of the investment timing option? Do not round intermediate calculations. a. $778 b. $584 c. $895 d. $817 e. $661 ANSWER: a 43. Norris Production Company (NPC) is considering a project that has an up-front cost at t = 0 of $2,500. (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $750 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $50 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $2,500, the subsequent cash flows will remain at $750 per year if the competitor's product is rejected and $50 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7). In addition, once NPC knows the outcome of the FDA's decision, it will not take on the project if its NPV is negative.

This is a risky project, so a WACC of 13.8% is to be used. If NPC chooses to wait a year before proceeding, what is the Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting value (in thousand) of the timing option today? Do not round intermediate calculations. a. $313.58 b. $327.83 c. $242.31 d. $285.07 e. $228.06 ANSWER: d Multiple Part: The following two problems must be kept together. The first problem can be used alone, but use the second problem ONLY if the first problem is also used.

Exhibit 13.1 Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties, then selling the successful ones to major oil companies. It is now considering a new potential field, and its geologists have developed the following data, shown in thousands of dollars. * t = 0 A $500 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project. There is an 80% probability that the feasibility study would indicate that an exploratory well should be drilled. There is a 20% probability that no further work would be done. * t = 1 If the feasibility study indicates good potential, the firm would spend $800 at t = 1 to drill an exploratory well.

The best estimate is that there is a 60% probability that the exploratory well would indicate good potential and, thus, that further work would be done, and a 40% probability that the outlook would be poor and the project would be abandoned. * t = 2 If the exploratory well tests positive, the firm would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. * t = 3 If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving $23,000 cash inflow at t = 3, and a 50% probability of finding less oil and then receiving only a $10,000 inflow. * Since the project is considered to be quite risky, a 18.50% cost of capital is used.

44. Refer to Exhibit 13.1. What is the project's expected NPV, in thousands of dollars? a. $331.38 b. $286.19 c. $361.51 d. $301.26 e. $271.13 ANSWER: d 45. Refer to Exhibit 13.1 and to the previous problem. Calculate the project's coefficient of variation. (Hint: Use the expected NPV as found in previous problem.) a. 10.45 b. 12.44 c. 9.95 d. 10.94 e. 7.46 ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 13 - Real Options and Other Topics in Capital Budgeting

Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage 1. A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses. a. True b. False ANSWER: False 2. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt. a. True b. False ANSWER: True 3. If a firm borrows money, it is using financial leverage. a. True b. False ANSWER: True 4. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient. a. True b. False ANSWER: True 5. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant. a. True b. False ANSWER: False 6. Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT. a. True b. False ANSWER: False 7. The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing. a. True b. False ANSWER: True 8. Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage ANSWER: True 9. Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory. a. True b. False ANSWER: True 10. Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. a. True b. False ANSWER: True 11. Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital. a. True b. False ANSWER: False 12. It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B. a. True b. False ANSWER: True 13. As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components. a. True b. False ANSWER: False 14. If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk. a. True b. False ANSWER: False 15. In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value.

However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant. a. True b. False ANSWER: True 16. According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage a. True b. False ANSWER: False 17. According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing. a. True b. False ANSWER: True 18. According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value. a. True b. False ANSWER: True 19. Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt. a. True b. False ANSWER: True 20. Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%. a. True b. False ANSWER: True 21. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes. a. True b. False ANSWER: True 22. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes. a. True b. False ANSWER: False 23. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists. a. True b. False ANSWER: True 24. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio. a. True b. False ANSWER: False 25. Some people—including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)—have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms. a. True b. False ANSWER: True 26. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm's future prospects as its managers. That was called "symmetric information," and it is questionable. The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value. a. True b. False ANSWER: True 27. According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good. a. True b. False ANSWER: False 28. Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales. a. True b. False ANSWER: True 29. Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage whose assets are harder to sell (like those engaged in research and development). a. True b. False ANSWER: True 30. Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt. a. True b. False ANSWER: False 31. A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant. a. True b. False ANSWER: True 32. If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be. a. True b. False ANSWER: True 33. An increase in the debt ratio will generally have no effect on which of these items? a. Business risk b. Total risk c. Financial risk d. Market risk e. The firm's beta ANSWER: a 34. Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk? a. Demand variability b. Sales price variability c. The extent to which operating costs are fixed d. The extent to which interest rates on the firm's debt fluctuate e. Input price variability ANSWER: d 35. Which of the following statements is CORRECT? a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing.

However, this action still may raise the company's WACC. d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing.

However, this action still may lower the company's WACC. e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

ANSWER: d 36. Which of the following statements is CORRECT? a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the required return on equity also maximizes the stock price. d. The capital structure that minimizes the WACC also maximizes the price per share of common stock. e. The capital structure that gives the firm the best bond rating also maximizes the stock price.

ANSWER: d 37. Based on the information below, what is the firm's optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50 b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90 c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20 d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40 e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00 ANSWER: c 38. Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.

ANSWER: b 39. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? a. An increase in the corporate tax rate b. An increase in the personal tax rate c. An increase in the company's operating leverage d. The Federal Reserve tightens interest rates in an effort to fight inflation e. The company's stock price hits a new high ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage 40. Which of the following would tend to increase a firm's target debt ratio, other things held constant? a. The costs associated with filing for bankruptcy increase b. The corporate tax rate is increased c. The personal tax rate is increased d. The Federal Reserve tightens interest rates in an effort to fight inflation e. The company's stock price hits a new low ANSWER: b 41. Which of the following statements is CORRECT? a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC. ANSWER: e 42. The firm's target capital structure should do which of the following? a. Maximize the earnings per share (EPS) b. Minimize the cost of debt (rd) c. Obtain the highest possible bond rating d. Minimize the cost of equity (rs) e. Minimize the weighted average cost of capital (WACC) ANSWER: e 43. Which of the following statements is CORRECT? a. A firm's business risk is determined solely by the financial characteristics of its industry. b. The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control. c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy. d. A firm's financial risk can be minimized by diversification. e. The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

ANSWER: b 44. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this a. normally leads to an increase in its fixed assets turnover ratio. b. normally leads to a decrease in its business risk. c. normally leads to a decrease in the standard deviation of its expected EBIT. d. normally leads to a decrease in the variability of its expected EPS. Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage e. normally leads to a reduction in its fixed assets turnover ratio.

ANSWER: e 45. A firm's CFO is considering increasing the target debt ratio, which would also increase the company's interest expense. New bonds would be issued, and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases. b. If the plan reduces the WACC, the stock price is likely to decline. c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. d. If the plan does increase the EPS, the stock price will automatically increase at the same rate. e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

ANSWER: a 46. Which of the following statements is CORRECT? a. Increasing its use of financial leverage is one way to increase a firm's return on investors’ capital (ROIC). b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage. c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price. d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors’ capital (ROIC). (Assume that the repurchase has no impact on the company's operating income.) e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.

ANSWER: c 47. Your firm has $500 million of investor-supplied capital, its return on investors’ capital (ROIC) is 15%, and it currently has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would increase. b. The ROA would remain unchanged. c. The return on investors’ capital would decline. d. The return on investors’ capital would increase. e. The ROE would increase.

ANSWER: e 48. Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors’ capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 – T). However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? a. Company HD has a higher net income than Company LD. b. Company HD has a lower ROA than Company LD. c. Company HD has a lower ROE than Company LD. Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage d. The two companies have the same ROA. e. The two companies have the same ROE. ANSWER: b 49. Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors’ capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT? a. The two companies have the same times interest earned (TIE) ratio. b. Firm L has a lower ROA than Firm U. c. Firm L has a lower ROE than Firm U. d. Firm L has the higher times interest earned (TIE) ratio. e. Firm L has a higher EBIT than Firm U. ANSWER: b 50. Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock.

The recapitalization would not change the company's total investor-supplied capital, the size of the firm (i.e., total assets), and it would not affect the firm's return on investors’ capital (ROIC), which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? a. The company's net income would increase. b. The company's earnings per share would decline. c. The company's cost of equity would increase. d. The company's ROA would increase. e. The company's ROE would decline.

ANSWER: c 51. A major contribution of the Miller model is that it demonstrates, other things held constant, that a. personal taxes increase the value of using corporate debt. b. personal taxes lower the value of using corporate debt. c. personal taxes have no effect on the value of using corporate debt. d. financial distress and agency costs reduce the value of using corporate debt. e. debt costs increase with financial leverage.

ANSWER: b 52. Which of the following statements is CORRECT, holding other things constant? a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt. b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations. d. An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged. e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage structures.

ANSWER: e 53. Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure? a. Its sales are projected to become less stable in the future. b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. c. Management believes that the firm's stock is currently overvalued. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. The corporate tax rate is increased.

ANSWER: e 54. Which of the following statements is CORRECT? a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. b. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.

ANSWER: b 55. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rS). b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC. e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.

ANSWER: d 56. Which of the following statements is CORRECT? a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. b. There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.

Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. e. Suppose a firm has less than its optimal amount of debt, increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

ANSWER: a 57. Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors’ capital (ROIC) exceeds its after-tax cost of debt, rd(1 – T). Which of the following statements is CORRECT? a. Company HD has a higher return on assets (ROA) than Company LD. b. Company HD has a higher times interest earned (TIE) ratio than Company LD. c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's. d. The two companies have the same ROE. e. Company HD's ROE would be higher if it had no debt.

ANSWER: c 58. Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors’ capital (ROIC) exceed their after-tax costs of debt, rd(1 – T). Which of the following statements is CORRECT? a. HD should have a higher return on assets (ROA) than LD. b. HD should have a higher times interest earned (TIE) ratio than LD. c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. d. Given that ROIC > rd(1 – T), HD's stock price must exceed that of LD. e. Given that ROIC > rd(1 – T), LD's stock price must exceed that of HD. ANSWER: c 59. Which of the following statements is CORRECT? a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. b. A change in the personal tax rate should not affect firms' capital structure decisions. c. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.

ANSWER: a 60. Which of the following statements is CORRECT? a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.

Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios. d. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.

ANSWER: c 61. Which of the following statements is CORRECT? a. Generally, debt ratios do not vary much among different industries, although they do vary among firms within a given industry. b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. c. Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-toequity ratios. d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. e. Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms' weighted average costs of capital.

ANSWER: d 62. Which of the following statements is CORRECT? a. The optimal capital structure is a mix of debt, current liabilities, and preferred stock. b. The optimal capital structure is a mix of cash, debt, and retained earnings. c. The optimal capital structure is a mix of debt, common stock, and retained earnings. d. The optimal capital structure is a mix of debt, preferred stock, and common equity. e. The optimal capital structure is a mix of cash, debt, and common equity.

ANSWER: d 63. Because of the volatility in the financial markets, a. it is not possible to have a real target debt ratio. b. most firms set a single number as their target debt ratio. c. the target debt ratio is not attainable. d. a target debt ratio is based on those of similar firms in the same industry. e. most firms prefer a target debt ratio rather than a precise number.

ANSWER: e 64. The threat of bankruptcy will increase a. when a firm is paying back a lot of its old debt. b. the more debt a firm has in its capital structure. c. when a company buys back more of its outstanding shares of common stock. d. shareholders do not receive their dividends. e. the cost of capital is decreasing due to lower interest rates in the market.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage 65. Asymmetric information occurs when a. managers have different or better information than investors about a company’s prospects. b. shareholders have different or better information than management about a company’s prospects. c. the stock market is volatile, and various news comes out about a company’s financial health. d. management and shareholders are equally aware of information about a company’s prospects. e. shareholders demand better information from management about a company’s prospects.

ANSWER: a 66. Which of the following statements is CORRECT regarding capital structure decisions? a. Special-purpose assets are good collateral for debt financing. Faster growing companies rely more heavily on internal financing. b. Firms with low rates of return on investments use more debt. c. Because interest is deductible, interest expense is most valuable to firms with high tax rates. d. Faster growing companies rely less heavily on external capital. e. Most companies do not consider their cash holdings when determining their target capital structure.

ANSWER: c 67. Under the pecking order hypothesis, which of the following is the first source of raising capital? a. Accounts payable and accruals b. Existing balances of cash c. Retained earnings generated within the past year d. External debt e. Issuance of new common stock ANSWER: a 68. Industries that are cyclical and involved with research and development tend to a. raise capital with the issuance of bonds. b. sell large quantities of common stock. c. use relatively little debt. d. collateralize many of their fixed assets. e. be more concerned about potential bankruptcy.

ANSWER: c 69. Longstreet Inc. has fixed operating costs of $370,000, variable costs of $2.55 per unit produced, and its product sells for $3.75 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs? a. 308,333 b. 373,083 c. 277,500 d. 302,167 e. 262,083 ANSWER: a 70. Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage would be set at 1.60 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,270,000. What sales volume would be required to break even, i.e., to have EBIT = zero? a. 35,278 b. 26,529 c. 22,578 d. 21,449 e. 28,222 ANSWER: e 71. Southwest U's campus book store sells course packs for $17 each, the variable cost per pack is $7, fixed costs to produce the packs are $200,000, and expected annual sales are 45,000 packs. What are the pre-tax profits from sales of course packs? a. $297,500 b. $250,000 c. $307,500 d. $222,500 e. $260,000 ANSWER: b 72. Southwest U's campus book store sells course packs for $14 each. The variable cost per pack is $10, and at current annual sales of 35,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs? a. $70,200 b. $74,100 c. $68,900 d. $65,000 e. $68,250 ANSWER: d 73. Assume that you and your brother plan to open a business that will make and sell a new type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $24.50 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the break-even points for Machines A and B? Do not round your intermediate calculations. (Hint: Find BEB - BEA.) Price per pair (P) Fixed costs (F) Variable cost/unit (V)

Machine A Machine B $24.50 $24.50 $25,000 $100,000 $7.00 $4.00

a. 3,622 b. 3,863 c. 4,312 d. 2,967 e. 3,449 ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage 74. Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $26.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 80,000 units, how much higher or lower will the firm's expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with low fixed costs, i.e., what is EBITB - EBITA ?

Price per mouse (P) Fixed costs (F) Variable cost/unit (V) Exp. unit sales (Q)

Machine A Machine B $26.00 $26.00 $100,000 $400,000 $16.00 $7.00 80,000 80,000

a. $491,400 b. $378,000 c. $495,600 d. $516,600 e. $420,000 ANSWER: e 75. Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $260.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 23,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)

Price per phone (P) Fixed costs (F) Variable cost/unit (V) Expected unit sales (Q) Required equity investment

Machine A $260.00 $1,000,000 $210.00 23,000 $2,500,000

Machine B $260.00 $2,000,000 $160.00 23,000 $3,000,000

a. 3.00% b. 3.40% c. 4.64% d. 4.40% e. 4.00% ANSWER: e 76. You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $480,000. The company is small, so it is not subject to the interest deduction limitation. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? Do not round your intermediate calculations.

Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage

Oper. income (EBIT) Required investment % Debt $ of Debt $ of Common equity Interest rate Tax rate

0% Debt, U $480,000 $2,500,000 0.0% $0.00 $2,500,000 NA 25%

60% Debt, L $480,000 $2,500,000 60.0% $1,500,000 $1,000,000 10.00% 25%

a. 13.46% b. 10.35% c. 7.76% d. 8.28% e. 11.90% ANSWER: b 77. You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $490,000. Other data for the firm are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU?

Oper. income (EBIT) Required investment % Debt $ of Debt $ of Common equity Shares issued, $10/share Interest rate Tax rate

0% Debt, U $490,000 $2,500,000 0.0% $0.00 $2,500,000 250,000 NA 25%

60% Debt, L $490,000 $2,500,000 60.0% $1,500,000 $1,000,000 100,000 10.00% 25%

a. $1.03 b. $0.86 c. $1.24 d. $1.08 e. $1.40 ANSWER: d 78. Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE? Capital Debt/Capital, book value EBIT

$160,000 65% $25,000

Interest rate Tax rate

8% 25%

a. 18.09% b. 26.36% c. 23.90% Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage d. 22.34% e. 22.12% ANSWER: d 79. Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $15,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)? a. 22,400 b. 23,200 c. 20,000 d. 21,600 e. 24,800 ANSWER: c 80. A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $600,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal?

(Hint: Use the break-even formula, but include the required profit in the numerator.) a. 4,664 b. 4,400 c. 4,488 d. 4,532 e. 4,356 ANSWER: b 81. El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 25%, and its beta (leveraged) is 1.30. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU? a. 0.87 b. 0.81 c. 1.13 d. 1.02 e. 0.61 ANSWER: a 82. Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? Do not round your intermediate calculations. wd

65%

Copyright Cengage Learning. Powered by Cognero.

Orig cost of equity, rs

10.0% Page 17

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage wc Interest rate new = rd

35% 5.0%

New cost of equity = rs Tax rate

11.0% 25%

a. 3.86% b. 3.71% c. 3.94% d. 3.56% e. 4.34% ANSWER: b 83. As a consultant to First Responder Inc., you have obtained the following data (dollars in millions). The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 7.0%. What would the firm's total market value be if it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed, and then divide by (WACC - g). Do not round your intermediate calculations.

Oper. income (EBIT) New cost of equity (rs) Interest rate (rd)

$800 12.00% 7.00%

Tax rate New wd

25.0% 20.0%

a. $4,507 b. $3,425 c. $3,966 d. $4,597 e. $4,372 ANSWER: a 84. You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt-High uses more debt and thus must pay a higher interest rate. Both companies are small, so they are not subject to the interest deduction limitation. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh – EPSLow? Do not round your intermediate calculations.

Applicable to Both Firms Capital $3,000,000 EBIT $570,000 Tax rate 25%

Firm High's Data wd Shares Int. rate

70% 90,000 12%

Firm Low's Data 20% wd Shares 240,000 Int. rate 10%

a. $1.37 b. $1.16 c. $0.95 d. $0.79 e. $1.06 ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage 85. Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Both companies are small, so they are not subject to the interest deduction limitation. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD? Do not round your intermediate calculations.

Applicable to Both Firms Capital $3,000,000 wd EBIT $675,000 Int. rate Tax rate 25%

Firm HD's Data Firm LD's Data 70% wd 12% Int. rate

20% 10%

a. 16.83% b. 14.43% c. 13.63% d. 16.03% e. 18.44% ANSWER: d 86. Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Both companies are small, so they are not subject to the interest deduction limitation. Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA? Do not round your intermediate calculations.

Applicable to Both Firms Capital $230,000 EBIT $40,000 Tax rate 25%

Firm A's Data

Firm NA's Data 50% 12%

wd Int. rate

wd Int. rate

0% 10%

a. 4.77% b. 3.56% c. 4.04% d. 3.64% e. 3.19% ANSWER: c 87. Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (wc) = 1 – wd. Other things held constant, and based on the data below, if the firm increases the percentage of debt in its capital structure (wd) to 60.0%, by how much would the ROE change, i.e., what is ROENew - ROEOld? Do not round your intermediate calculations.

Operating Data

Other Data

Capital

$150,000

Old wd

5%

ROIC = EBIT (1 – T)/Capital

23.00%

Old interest rate

10%

New wd

60%

Tax rate

25%

Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage New interest rate

12%

a. 22.81% b. 22.20% c. 20.18% d. 17.16% e. 19.38% ANSWER: c 88. You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Both companies are small, so they are not subject to the interest deduction limitation. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROEHigher - ROELower debt? Do not round your intermediate calculations.

Operating Data Capital ROIC = EBIT(1 – T)/Capital Tax rate

Other Data $4,000 26.00% 25%

Higher wd Higher interest rate Lower wd Lower interest rate

60% 13% 10% 9%

a. 24.90% b. 22.24% c. 22.68% d. 23.13% e. 25.57% ANSWER: b 89. Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU? Do not round your intermediate calculations.

Expected unit sales Price per unit Fixed costs Variable cost/unit Required investment Shares issued at $10/share % Debt Debt, $ Equity, $ Interest rate

0% Debt, U 290,000 $10.00 $1,000,000 $3.50 $2,500,000 250,000 0.00% $0 $2,500,000 NA

Copyright Cengage Learning. Powered by Cognero.

60% Debt, L 290,000 $10.00 $1,000,000 $3.50 $2,500,000 100,000 60.00% $1,500,000 $1,000,000 10.00% Page 20

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage Tax rate

25.00%

25.00%

a. $2.86 b. $3.43 c. $3.00 d. $2.29 e. $2.00 ANSWER: a 90. Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $12.00, fixed costs for this operation are $300,000, and annual sales are 110,000 packs. The unit variable cost consists of a $3.00 royalty payment, VR , per pack to professors plus other variable costs of VO = $9.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant? Do not round your intermediate calculations. a. $1.77 b. $1.58 c. $1.45 d. $1.86 e. $2.16 ANSWER: a 91. Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 49.5% debt (wd) by issuing bonds and using the proceeds to repurchase and retire some common shares so the percentage of common equity in the capital structure (wc) = 1 – wd declines. Given the data shown below, by how much would this recapitalization change the firm's cost of equity, i.e., what is rL - rU? Do not round your intermediate calculations.

Risk-free rate, rRF Market risk prem, RPM Current beta, bU

5.00% 3.50% 1.15

Tax rate, T Current wd Target wd

25% 0% 49.5%

a. 3.40% b. 2.07% c. 2.81% d. 2.22% e. 2.96% ANSWER: e 92. Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%), but its new CFO is considering changing the capital structure so wd = 28.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity? Do not round your intermediate calculations. (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)

Risk-free rate, rRF

5.00% Tax rate, T

Copyright Cengage Learning. Powered by Cognero.

25% Page 21

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage Market risk prem, RPM Current beta, bL1

6.00% Current wd

20%

1.55 Target wd

28.0%

a. 1.15% b. 0.96% c. 1.23% d. 0.89% e. 1.21% ANSWER: a 93. Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per share (DPS), and its tax rate is 25%. The company is considering issuing $7,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 1.05. However, the CFO believes the beta would rise to 1.25 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.) a. $39.89 b. $44.33 c. $37.68 d. $55.41 e. $42.55 ANSWER: b 94. You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL ROEU? 0% Debt, U Expected unit sales (Q) Price per phone (P) Fixed costs (F) Variable cost/unit (V) Required investment % Debt Debt, $ Equity, $ Interest rate Tax rate

28,000 $250.00 $1,000,000 $200.00 $2,500,000 0.00% $0 $2,500,000 NA 25.00%

60% Debt, L 28,000 $250.00 $1,000,000 $200.00 $2,500,000 60.00% $1,500,000 $1,000,000 10.00% 25.00%

a. 6.28% b. 6.75% c. 8.03% d. 8.24% Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 14 - Capital Structure and Leverage e. 7.97% ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases 1. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price. a. True b. False ANSWER: True 2. Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be. a. True b. False ANSWER: False 3. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on either its cost of capital or its stock price. a. True b. False ANSWER: True 4. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on its cost of capital, but it does affect its stock price. a. True b. False ANSWER: False 5. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio. a. True b. False ANSWER: True 6. A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's stock price. a. True b. False ANSWER: True 7. A "reverse split" reduces the number of shares outstanding. a. True b. False ANSWER: True 8. The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock, other things held constant. a. True b. False ANSWER: False 9. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in dividend payout ratios. a. True b. False ANSWER: False 10. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, if the tax rate on dividends is high relative to that on capital gains, then individuals with low taxable incomes should favor stocks with low payouts, and high-income individuals should favor high-payout companies. a. True b. False ANSWER: False 11. It has been argued that investors prefer high-payout companies because dividends are more certain (less risky) than the capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that this argument is incorrect, and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most dividends are reinvested in stocks, hence are exposed to the same risks as reinvested earnings. a. True b. False ANSWER: True 12. Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk. a. True b. False ANSWER: True 13. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant. a. True b. False ANSWER: True 14. If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs. a. True b. False ANSWER: True 15. Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases ANSWER: True 16. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument. a. True b. False ANSWER: False 17. If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can have an important effect on its stock price and cost of equity. a. True b. False ANSWER: True 18. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm's investment opportunities, the lower its payout ratio will be, other things held constant. a. True b. False ANSWER: True 19. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm's debt ratio, the lower its payout ratio will be, other things held constant. a. True b. False ANSWER: False 20. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy. a. True b. False ANSWER: False 21. If on January 3 a company declares a dividend of $1.50 per share, payable on January 31 then the price of the stock should drop by approximately $1.50 on January 31. a. True b. False ANSWER: False 22. If on January 3 a company declares a dividend of $1.50 per share, payable on January 31 to holders of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is the ex-dividend date. a. True b. False ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases 23. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest. a. True b. False ANSWER: False 24. There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would have been paid as dividends to buy stock on the open market. Under the other type, the company issues new stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who choose to reinvest their dividends. a. True b. False ANSWER: True 25. If a firm pays out all of its earnings as dividends, and its stockholders then elect to have all of their dividends reinvested, the company should reconsider its dividend policy and possibly move to a lower dividend payout ratio. a. True b. False ANSWER: True 26. If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares. a. True b. False ANSWER: True 27. Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock prices decline. Your firm's earnings, investment opportunities, and capital structure do not change. If the firm follows the residual dividend model, then its dividend payout ratio would increase. a. True b. False ANSWER: True 28. Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its debt ratio on the horizontal axis. Then you plotted a similar curve for Firm V. The curve for Firm U resembled a shallow "U," while that for Firm V resembled a sharp "V." Both firms have debt ratios that cause their WACCs to be minimized. Other things held constant, it would be easier for Firm V than for Firm U to maintain a steady dividend in the face of varying investment opportunities and earnings from year to year. a. True b. False ANSWER: False 29. In the real world, dividends a. are usually more stable than earnings. b. fluctuate more widely than earnings.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases c. tend to be a lower percentage of earnings for mature firms. d. are usually changed every year to reflect earnings changes, and these changes are randomly higher to lower, depending on whether earnings increased or decreased. e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS would equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the dividend actually paid depends strictly on earnings.

ANSWER: a 30. You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The company is about to declare a 2-for-1 stock split. Which of the following best describes your likely position after the split? a. You will have 200 shares of stock, and the stock will trade at or near $120 a share. b. You will have 200 shares of stock, and the stock will trade at or near $60 a share. c. You will have 100 shares of stock, and the stock will trade at or near $60 a share. d. You will have 50 shares of stock, and the stock will trade at or near $120 a share. e. You will have 50 shares of stock, and the stock will trade at or near $600 a share.

ANSWER: b 31. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is lowered. Their argument is based on the assumption that a. investors are indifferent between dividends and capital gains. b. investors require that the dividend yield plus the capital gains yield equal a constant. c. capital gains are taxed at a higher rate than dividends. d. investors view dividends as being less risky than potential future capital gains. e. investors prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower tax rate on capital gains.

ANSWER: d 32. Your firm adheres strictly to the residual dividend model. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share? a. The firm's net income increases. b. The company increases the percentage of equity in its target capital structure. c. The number of profitable potential projects increases. d. Congress lowers the tax rate on capital gains, leaving the rest of the tax code unchanged. e. Earnings are unchanged, but the firm issues new shares of common stock.

ANSWER: a 33. If a firm adheres strictly to the residual dividend policy, and if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/assets ratio), then the firm should pay a. the same dividend as it paid the prior year. b. no dividends to common stockholders. c. dividends only out of funds raised by the sale of new common stock. d. dividends only out of funds raised by borrowing money (i.e., issuing debt). e. dividends only out of funds raised by selling off fixed assets.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases 34. If a firm adheres strictly to the residual dividend model, the issuance of new common stock would suggest that a. the dividend payout ratio has remained constant. b. the dividend payout ratio is increasing. c. no dividends will be paid during the year. d. the dividend payout ratio is decreasing. e. the dollar amount of capital investments had decreased.

ANSWER: c 35. Which of the following does NOT normally influence a firm's dividend policy decision? a. The firm's ability to accelerate or delay investment projects without adverse consequences b. A strong preference by most of its shareholders for current cash income versus potential future capital gains c. Constraints imposed by the firm's bond indenture d. The fact that much of the firm's equipment is leased rather than bought and owned e. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains ANSWER: d 36. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio? a. Its earnings become more stable. b. Its access to the capital markets increases. c. Its research and development efforts pay off, and it now has more high-return investment opportunities. d. Its accounts receivable decrease due to a change in its credit policy. e. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

ANSWER: c 37. Which of the following statements is CORRECT? a. When firms are deciding on the size of stock splits—say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used. b. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and reverse splits are illegal today. c. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them. So, today stock dividends are used far more often than stock splits. d. When a company declares a stock split, the price of the stock typically declines—for example, by about 50% after a 2-for-1 split—and this necessarily reduces the total market value of the firm's equity. e. If a firm's stock price is quite high relative to most stocks—say $500 per share—then it can declare a stock split of say 20-for-1 so as to bring the price down to something close to $25. Moreover, if the price is relatively low—say $2 per share—then it can declare a "reverse split" of say 1-for-10 so as to bring the price up to somewhere around $20 per share.

ANSWER: e 38. Which of the following statements about dividend policies is CORRECT? a. Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the-hand" effect.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases b. One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing stock is that dividends are normally taxed at a lower rate than gains on repurchased stock. c. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest. d. One key advantage of the residual dividend model is that it enables a company to follow a stable dividend policy. e. The clientele effect suggests that companies should follow a stable dividend policy.

ANSWER: e 39. Which of the following statements is CORRECT? a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their investment in the company. b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. c. Stock repurchases can be used by a firm that wants to increase its debt ratio. d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

ANSWER: c 40. Which of the following statements is CORRECT? a. Under the tax laws as they existed in 2017, a dollar received by an individual taxpayer as interest income is taxed at the same rate as a dollar received as dividends. b. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends. c. Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend. As a result, share prices fall when dividend increases are announced because investors interpret the increase as a signal that the firm expects fewer good investment opportunities in the future. d. If a company needs to raise new equity capital, a new-stock dividend reinvestment plan would make sense.

However, if the firm does not need new equity, then an open market purchase dividend reinvestment plan would probably make more sense. e. Dividend reinvestment plans have not caught on in most industries, and today over 99% of all DRIPs are offered by utilities.

ANSWER: d 41. Which of the following statements is CORRECT? a. Historically, the tax code has encouraged companies to pay dividends rather than retain earnings. b. If a company uses the residual dividend model to determine its dividend payments, dividend payout will tend to increase whenever its profitable investment opportunities increase relatively rapidly. c. The more a firm's management believes in the clientele effect, the more likely the firm is to adhere strictly to the residual dividend model. d. Large stock repurchases financed by debt tend to increase expected earnings per share, but they also tend to increase the firm's financial risk. e. A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out in dividends. Thus, both Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases companies and investors should be indifferent between distributing cash through dividends and stock repurchase programs.

ANSWER: d 42. Which of the following statements is CORRECT? a. If a company has a 2-for-1 stock split, its stock price should roughly double. b. Capital gains earned on shares repurchased are taxed less favorably than dividends, which is why companies typically pay dividends and avoid share repurchases. c. Very often, a company's stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen. d. Stock repurchases increase the number of outstanding shares. e. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.

ANSWER: c 43. Which of the following statements is CORRECT? a. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have aboveaverage dividend payout ratios. b. One advantage of the residual dividend model is that it leads to a stable dividend payout, which investors like. c. An increase in the stock price when a company cuts its dividend is consistent with signaling theory as postulated by MM. d. If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize its stock price. e. Stock repurchases make the most sense at times when a company believes its stock is undervalued.

ANSWER: e 44. Which of the following statements is CORRECT? a. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive. b. If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not adhere strictly to the residual dividend model. c. If a firm adheres strictly to the residual dividend model, then, holding all else constant, its dividend payout ratio will tend to rise whenever its investment opportunities improve. d. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios. e. Despite its drawbacks, following the residual dividend model will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees.

ANSWER: b 45. Firm M is a mature company in a mature industry. Its annual net income and cash flows are consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new company in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is CORRECT? a. Firm M probably has a lower target debt ratio than Firm N. b. Firm M probably has a higher target dividend payout ratio than Firm N. Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases c. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. d. The two firms are equally likely to pay high dividends. e. Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.

ANSWER: b 46. Which of the following statements is CORRECT? a. If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes. b. An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers. c. Stock repurchases tend to reduce financial leverage. d. If a company declares a 2-for-1 stock split, its stock price should roughly double. e. One advantage of adopting the residual dividend model is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory.

ANSWER: a 47. Which of the following actions will best enable a company to raise additional equity capital, other things held constant? a. Refund long-term debt with lower cost short-term debt b. Declare a stock split c. Begin an open-market purchase dividend reinvestment plan d. Initiate a stock repurchase program e. Begin a new-stock dividend reinvestment plan ANSWER: e 48. Which of the following statements is NOT CORRECT? a. Stock repurchases can be used by a firm as part of a plan to change its capital structure. b. After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will rise. c. Investors may interpret a stock repurchase program as a signal that the firm's managers believe the stock is undervalued, or, alternatively, as a signal that the firm does not have many good investment opportunities. d. A company can repurchase stock to distribute a large one-time cash inflow, say from the sale of a division, to stockholders without having to increase its regular dividend. e. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan.

ANSWER: e 49. Which of the following statements is CORRECT? a. If a firm follows the residual dividend model, then a sudden increase in the number of profitable projects would be likely to lead to a reduction of the firm's dividend payout ratio. b. The clientele effect explains why so many firms change their dividend policies so often. c. One advantage of adopting the residual dividend model is that this policy makes it easier for a corporation to attract a specific and well-identified dividend clientele. d. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the firm's total amount of book equity.

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases e. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received.

ANSWER: a 50. Which of the following statements is CORRECT? a. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument. b. Other things held constant, the higher a firm's target dividend payout ratio, the higher its expected growth rate should be. c. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings that a firm pays out in dividends has no effect on its cost of capital, but it does affect its stock price. d. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to a decrease in dividend payout ratios. e. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a high dividend payout ratio.

ANSWER: d 51. Which of the following statements CORRECTLY states a belief held by Modigliani and Miller? a. The value of a firm is based on how income is split between dividends and retained earnings. b. A firm’s dividend policy has no effect on their stock price or cost of capital. c. Investors and management have the same information on a firm’s future earnings. d. The value of a firm does not depend on the income produced by its assets. e. All investors prefer dividends over capital gains.

ANSWER: b 52. On which date of the dividend payment process does the company close its stock transfer book? a. Holder-of-record date b. Ex-dividend date c. Dividend payment date d. Quarterly dividend date e. Year-end date ANSWER: a 53. Stock splits have become less popular in recent years because a. shareholders prefer an increase in dividends instead of owning more shares. b. firms seek the prestige of having a highly priced stock. c. investors like owning highly priced stocks. d. investors have moved away from owning individual stocks towards mutual funds. e. it is too expensive for firms to issue stock splits.

ANSWER: d 54. Repurchased shares of a company’s own stock are called Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases a. buyback stock. b. company stock. c. undeclared stock. d. repurchased stock. e. treasury stock.

ANSWER: e 55. The target payout ratio is defined as the target percentage of a. stock paid out as cash dividends. b. stock dividends paid out to shareholders. c. net income paid out as cash dividends. d. retained earnings paid out as cash dividends. e. net equity paid out as cash dividends.

ANSWER: c 56. The impairment of capital rule refers to a. retained earnings cannot be used to pay dividends to shareholders. b. dividend payments cannot exceed the balance of retained earnings. c. dividend payments cannot exceed the amount of annual interest paid out to bondholders. d. dividend payments cannot be paid to common shareholders if preferred dividends are not paid. e. no more than fifty percent of retained earnings can be paid out as dividends each year.

ANSWER: b 57. Which of the following statements regarding dividend payments is CORRECT? a. Bondholders can force management to change their dividend policy if the cash balance is low. b. Shareholders prefer stock dividends over cash dividends. c. Cash dividends cannot be paid with borrowed money. d. Cash dividends can only be paid with cash. e. Firms can be charged a penalty for missing dividend payments to common shareholders.

ANSWER: d 58. Portland Plastics Inc. has the following data. If it follows the residual dividend model, what is its forecasted dividend payout ratio?

Capital budget % Debt Net income (NI)

$13,000 40% $8,950

a. 13.88% b. 14.01% c. 16.06% d. 12.85% e. 13.36% ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases 59. Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock sold for $105 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split? a. $49.88 b. $53.55 c. $52.50 d. $46.20 e. $64.05 ANSWER: c 60. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $50 per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's post-split price? a. $19.33 b. $17.17 c. $13.33 d. $19.50 e. $16.67 ANSWER: e 61. Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock sold for $80 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split? a. $26.51 b. $22.86 c. $26.29 d. $21.49 e. $18.29 ANSWER: b 62. Fauver Industries plans to have a capital budget of $550,000. It wants to maintain a target capital structure of 40% debt and 60% equity, and it also wants to pay a dividend of $400,000. If the company follows the residual dividend model, how much net income must it earn to meet its investment requirements, pay the dividend, and keep the capital structure in balance? a. $730,000 b. $839,500 c. $554,800 d. $824,900 e. $693,500 ANSWER: a 63. Ring Technology has a capital budget of $875,000, it wants to maintain a target capital structure of 35% debt and 65% equity, and it also wants to pay a dividend of $275,000. If the company follows the residual dividend model, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance? a. $894,375 b. $708,750 Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases c. $860,625 d. $843,750 e. $632,813 ANSWER: d 64. D. Paul Inc. forecasts a capital budget of $700,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and they also want to pay a dividend of $375,000. If the company follows the residual dividend model, how much income must it earn, and what will its dividend payout ratio be? a. $722,000; 51.94% b. $600,400; 62.46% c. $828,400; 45.27% d. $760,000; 49.34% e. $767,600; 48.85% ANSWER: d 65. Banerjee Inc. wants to maintain a target capital structure with 35% debt and 65% equity. Its forecasted net income is $100,000, and its board of directors has decreed that no new stock can be issued during the coming year. If the firm follows the residual dividend model, what is the maximum capital budget that is consistent with maintaining the target capital structure? a. $167,692 b. $143,077 c. $153,846 d. $118,462 e. $141,538 ANSWER: c 66. Dentaltech Inc. projects the following data for the coming year. If the firm follows the residual dividend model and also maintains its target capital structure, what will its dividend payout ratio be?

EBIT Interest rate Debt outstanding Shares outstanding

$2,500,000 Capital budget 10% % Debt $5,700,000 % Equity 5,000,000 Tax rate

$1,000,000 40% 60% 25%

a. 58.5% b. 61.5% c. 67.9% d. 53.9% e. 59.1% ANSWER: a 67. Mortal Inc. expects to have a capital budget of $450,000 next year. The company wants to maintain a target capital structure with 40% debt and 60% equity, and its forecasted net income is $550,000. If the company follows the residual dividend model, how much in dividends, if any, will it pay? a. $330,400 b. $243,600 Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases c. $212,800 d. $280,000 e. $344,400 ANSWER: d 68. Torrence Inc. has the following data. If it uses the residual dividend model, how much total dividends, if any, will it pay out?

Capital budget % Debt Net income (NI)

$1,100,000 60% $795,000

a. $284,000 b. $401,150 c. $433,100 d. $355,000 e. $358,550 ANSWER: d 69. NY Fashions has the following data. If it follows the residual dividend model, how much total dividends, if any, will it pay out?

Capital budget % Debt Net income (NI)

$1,500,000 65% $680,000

a. $179,800 b. $176,700 c. $167,400 d. $134,850 e. $155,000 ANSWER: e 70. Chicago Brewing has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?

Capital budget % Debt Net income (NI)

$6,000 35% $7,300

a. 45.18% b. 46.58% c. 50.77% d. 45.64% e. 36.33% ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases 71. LA Moving Company has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?

Capital budget % Debt Net income (NI)

$5,000 40% $7,250

a. 58.03% b. 72.10% c. 73.28% d. 51.00% e. 58.62% ANSWER: e 72. New Orleans Builders Inc. has the following data. If it follows the residual dividend model, what is its forecasted dividend payout ratio?

Capital budget % Debt Net income (NI)

$6,000 35% $12,500

a. 66.05% b. 77.06% c. 55.04% d. 56.42% e. 68.80% ANSWER: e 73. Ross-Jordan Financial has suffered losses in recent years, and its stock currently sells for only $0.80 per share.

Management wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $30 per share.

How many of the old shares must be given up for one new share to achieve the $30 price, assuming this transaction has no effect on total market value? a. 46.88 b. 29.25 c. 41.63 d. 37.50 e. 46.50 ANSWER: d 74. Keys Financial has done extremely well in recent years, and its stock now sells for $110 per share. Management wants to get the price down to a more typical level, which it thinks is $35.00 per share. What stock split would be required to get to this price, assuming the transaction has no effect on the total market value? Put another way, how many new shares should be given per one old share? a. 2.99 b. 3.46 c. 3.14 d. 3.61 Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases e. 2.20 ANSWER: c 75. Whited Products recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $195 per share. If the firm's total market value increased by 5% as a result of increased liquidity and favorable signaling effects, what was the stock price following the split? a. $66.20 b. $55.97 c. $74.39 d. $68.25 e. $77.81 ANSWER: d 76. Clark Farms Inc. has the following data, and it follows the residual dividend model. Currently, it finances with 15% debt. Some Clark family members would like for the dividends to be increased. If Clark increased its debt ratio, which the firm's treasurer thinks is feasible, by how much could the dividend be increased, holding other things constant?

Capital budget Net income (NI) % Debt now % Debt after change

$3,000,000 $3,500,000 15% 80%

a. $2,359,500 b. $1,794,000 c. $1,501,500 d. $1,950,000 e. $1,618,500 ANSWER: d 77. Purcell Farms Inc. has the following data, and it follows the residual dividend model. Currently, it finances with 10% debt. Some Purcell family members would like for the dividend payout ratio to be increased. If Purcell increased its debt ratio, which the firm's treasurer thinks is feasible, by how much could the dividend payout ratio be increased, holding other things constant?

Capital budget Net income (NI) % Debt now % Debt after change

$4,500,000 $5,000,000 10% 50%

a. 27.4% b. 32.4% c. 43.6% d. 37.1% e. 36.0% ANSWER: e 78. Whitman Antique Cars Inc. has the following data, and it follows the residual dividend model. Some Whitman family members would like more dividends, and they also think that the firm's capital budget includes too many projects whose Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases NPVs are close to zero. If Whitman reduced its capital budget to the indicated level, by how much could dividends be increased, holding other things constant?

Original capital budget New capital budget Net income % Debt

$3,000,000 $1,850,000 $3,500,000 32%

a. $813,280 b. $688,160 c. $954,040 d. $695,980 e. $782,000 ANSWER: e 79. Pavlin Corp.'s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity, and its forecasted net income is $1,600,000. If the company follows the residual dividend model, how much dividends will it pay or, alternatively, how much new stock must it issue? a. $400,000; $0 b. $416,000; $484,000 c. $428,000; $384,000 d. $476,000; $448,000 e. $388,000; $500,000 ANSWER: a 80. Grullon Co. is considering a 6-for-2 stock split. The current stock price is $67.50 per share, and the firm believes that its total market value would increase by 3% as a result of the improved liquidity that should follow the split. What is the stock's expected price following the split? a. $19.47 b. $17.84 c. $23.87 d. $23.18 e. $24.33 ANSWER: d 81. Walter Industries is a family owned concern. It has been using the residual dividend model, but family members who hold a majority of the stock want more cash dividends, even if that means a slower future growth rate. Neither the net income nor the capital structure will change during the coming year as a result of a dividend policy change to the indicated target payout ratio. By how much would the capital budget have to be cut to enable the firm to achieve the new target dividend payout ratio? Do not round intermediate calculations. % Debt % Equity = 1.0 – % Debt Capital budget under the residual dividend model Net income; it will not change this year even if dividends increase Equity to support the capital budget = % Equity × Capital budget Dividends paid = NI – Equity needed Currently projected dividend payout ratio Copyright Cengage Learning. Powered by Cognero.

35% 65% $5,000,000 $3,500,000 $3,250,000 $250,000 7.1% Page 17

Name:

Class:

Date:

Chapter 15 - Distributions to Shareholders: Dividends and Share Repurchases Target dividend payout ratio

46%

a. -$2,092,308 b. -$2,196,923 c. -$2,552,615 d. -$2,008,615 e. -$1,987,692 ANSWER: a 82. Sheehan Corp. is forecasting an EPS of $4.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at $975,000, and it is committed to maintaining a $3.00 dividend per share. It finances with debt and common equity, but it wants to avoid issuing any new common stock during the coming year. Given these constraints, what percentage of the capital budget must be financed with debt? a. 48.23% b. 46.28% c. 39.95% d. 58.46% e. 48.72% ANSWER: e 83. Del Grasso Fruit Company has more positive NPV projects than it can finance under its current policies without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. Your boss, the CFO, wants to know how the capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. You obtained the following data, which shows the firm's projected net income (NI), its current capital structure and dividend payout policies, and three possible new policies. Projected net income for the coming year will not be affected by a policy change. How much larger could the capital budget be if (1) the target debt ratio were raised to the indicated amount, other things held constant, (2) the target payout ratio were lowered to the indicated amount, other things held constant, or (3) the debt ratio and dividend payout were both changed by the indicated amounts?

Projected NI % Debt % Equity % Payout

Current policy $237.5 25.0% 75.0% 65.0%

Policy Changes Increase debt Lower payout Do both $237.5 $237.5 $237.5 75.0% 25.0% 75.0% 25.0% 75.0% 25.0% 65.0% 20.0% 20.0%

a. $221.7; $142.5; $649.2 b. $186.2; $165.3; $629.7 c. $237.2; $168.2; $545.3 d. $190.6; $132.5; $616.7 e. $266.0; $176.7; $532.3 ANSWER: a

Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 16 - Working Capital Management 1. Net operating working capital, defined as operating current assets minus the difference between current liabilities and notes payable, is equal to the current ratio minus the quick ratio. a. True b. False ANSWER: False 2. Net working capital is defined as current assets divided by current liabilities. a. True b. False ANSWER: False 3. An increase in any current asset must be accompanied by an equal increase in some current liability. a. True b. False ANSWER: False 4. The three alternative current asset investment policies discussed in the text differ regarding the size of current asset holdings. a. True b. False ANSWER: True 5. The concept of permanent current assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent current assets represent a minimum level of current assets that must be financed. a. True b. False ANSWER: True 6. A conservative financing approach to working capital will result in permanent current assets and some seasonal current assets being financed using long-term securities. a. True b. False ANSWER: True 7. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive current asset financing strategy because of the inherent risks of using short-term financing. a. True b. False ANSWER: True 8. If a firm takes actions that reduce its days sales outstanding (DSO), then, other things held constant, this will lengthen its cash conversion cycle (CCC) and cause a deterioration in its cash position. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 16 - Working Capital Management ANSWER: False 9. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC). a. True b. False ANSWER: False 10. Shorter-term cash budgets (such as a daily cash budget for the next month) are generally used for actual cash control, while longer-term cash budgets (such as a monthly cash budget for the next year) are generally used for planning purposes. a. True b. False ANSWER: True 11. Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers. a. True b. False ANSWER: True 12. Inventory management is largely self-contained in the sense that very little coordination among the sales, purchasing, and production personnel is required for successful inventory management. a. True b. False ANSWER: False 13. The average accounts receivables balance is a function of both the volume of credit sales and the days sales outstanding. a. True b. False ANSWER: True 14. The four primary elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy. a. True b. False ANSWER: True 15. Changes in a firm's collection policy can affect sales, working capital, and profits. a. True b. False ANSWER: True 16. Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances. a. True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 16 - Working Capital Management b. False ANSWER: True 17. If a firm buys on terms of 2/10, net 30, it should pay as early as possible during the discount period to lower its cost of trade credit. a. True b. False ANSWER: False 18. Trade credit can be separated into two components: free trade credit, which is credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken. a. True b. False ANSWER: False 19. As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources. a. True b. False ANSWER: True 20. If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease, other things held constant. a. True b. False ANSWER: True 21. When deciding whether or not to take a trade discount, the cost of borrowing from a bank or other source should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False ANSWER: True 22. The calculated cost of trade credit can be reduced by paying late. a. True b. False ANSWER: True 23. The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days. a. True b. False ANSWER: True 24. One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 16 - Working Capital Management a. True b. False ANSWER: True 25. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique, which is particularly useful when suppliers’ production plants are at full capacity. a. True b. False ANSWER: False 26. An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and, thus, is a more reliable source of funds for the borrower than the revolving credit agreement. a. True b. False ANSWER: False 27. The maturity of most bank loans is short term. Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature. However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan. a. True b. False ANSWER: True 28. A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower during some future period, assuming the borrower maintains its financial strength. a. True b. False ANSWER: True 29. If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit. a. True b. False ANSWER: True 30. Accruals arise automatically from a firm's operations and are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities. a. True b. False ANSWER: True 31. Accruals are "spontaneous" funds arising automatically from a firm's operations, but unfortunately, due to law and economic forces, firms have little control over the level of these accounts. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 16 - Working Capital Management ANSWER: True 32. The facts that (1) no explicit interest is paid on accruals and (2) the firm can vary the level of these accounts at will make them an attractive source of funding to meet the firm’s working capital needs. a. True b. False ANSWER: False 33. Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis. a. True b. False ANSWER: True 34. The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates.

When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs. a. True b. False ANSWER: False 35. A firm that follows an aggressive working capital financing approach uses primarily short-term credit and, thus, is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy. a. True b. False ANSWER: True 36. The relative profitability of a firm that employs an aggressive working capital financing policy will improve if the yield curve changes from upward sloping to downward sloping. a. True b. False ANSWER: False 37. If the yield curve is upward sloping, then short-term debt will be cheaper than long-term debt. Thus, if a firm's CFO expects the yield curve to continue to have an upward slope, this would tend to cause the current ratio to be relatively low, other things held constant. a. True b. False ANSWER: True 38. The risk to the firm of borrowing using short-term credit is usually greater than if it used long-term debt. Added risk stems from (1) the greater variability of interest costs on short-term than long-term debt and (2) the fact that even if its long-term prospects are good, the firm's lenders may not be willing to renew short-term loans if the firm is temporarily unable to repay those loans. a. True Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 16 - Working Capital Management b. False ANSWER: True 39. Long-term loan agreements always contain provisions, or covenants, that constrain the firm's future actions. Shortterm credit agreements are just as restrictive in order to protect the interest of the lender. a. True b. False ANSWER: False 40. A firm constructing a new manufacturing plant and financing it with short-term loans, which are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from its current liabilities associated with working capital when calculating net working capital. a. True b. False ANSWER: True 41. The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC. a. True b. False ANSWER: True 42. The cash conversion cycle (CCC) combines three factors: the inventory conversion period, the receivables collection period, and the payables deferral period, and its purpose is to show how long a firm must finance its working capital.

Other things held constant, the shorter the CCC, the more effective the firm's working capital management. a. True b. False ANSWER: True 43. The target cash balance is typically (and logically) set so that it does not need to be adjusted for either seasonal patterns or unanticipated random fluctuations. a. True b. False ANSWER: False 44. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month. a. True b. False ANSWER: False 45. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month, but in reality receipts are concentrated at the beginning of each month.

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 16 - Working Capital Management a. True b. False ANSWER: True 46. The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another. a. True b. False ANSWER: False 47. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget. a. True b. False ANSWER: False 48. Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability. a. True b. False ANSWER: True 49. On average, a firm collects checks totaling $250,000 per day. It takes the firm approximately four days from the day the checks were mailed until they result in usable cash for the firm. Assume that (1) a lockbox system could be employed which would reduce the cash conversion procedure to two and a half days, and (2) the firm could invest any additional cash generated at 6% after taxes. The lockbox system would be a good buy if it costs $25,000 annually. a. True b. False ANSWER: False 50. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. a. True b. False ANSWER: False 51. Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future. Dimon's accounts receivable balance will remain constant at the current level because the 10% cash sales can be used to support the 10% growth rate, other things held constant. a. True b. False ANSWER: False 52. For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently.

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 16 - Working Capital Management a. True b. False ANSWER: True 53. A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales. a. True b. False ANSWER: True 54. Because money has time value, a cash sale is always more profitable than a credit sale. a. True b. False ANSWER: False 55. If a firm sells on terms of 2/10, net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past due accounts. a. True b. False ANSWER: False 56. If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet. a. True b. False ANSWER: False 57. If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations. a. True b. False ANSWER: True 58. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance, but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance. a. True b. False ANSWER: False 59. The prime rate charged by big money center banks at any one time is likely to vary greatly (for example, as much as 2–4 percentage points) across banks due to banks' ability to differentiate themselves and because different banks operate in different parts of the country. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 16 - Working Capital Management 60. A revolving credit agreement is a formal line of credit. The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds. a. True b. False ANSWER: True 61. Other things held constant, which of the following will cause an increase in net working capital? a. Cash is used to buy marketable securities. b. A cash dividend is declared and paid. c. Merchandise is sold at a profit, but the sale is on credit. d. Long-term bonds are retired with the proceeds of a preferred stock issue. e. Missing inventory is written off against retained earnings.

ANSWER: c 62. Firms generally choose to finance temporary current assets with short-term debt because a. matching the maturities of assets and liabilities reduces risk under some circumstances and also because shortterm debt is often less expensive than long-term capital. b. short-term interest rates have traditionally been more stable than long-term interest rates. c. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term. d. the yield curve is normally downward sloping. e. short-term debt has a higher cost than equity capital.

ANSWER: a 63. Helena Furnishings wants to reduce its cash conversion cycle. Which of the following actions should it take? a. Increase average inventory without increasing sales b. Take steps to reduce the DSO c. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales d. Sell common stock to retire long-term bonds e. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock ANSWER: b 64. A lockbox plan is a. used to protect cash, i.e., to keep it from being stolen. b. used to identify inventory safety stocks. c. used to slow down the collection of checks our firm writes. d. used to speed up the collection of checks received. e. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks.

ANSWER: d 65. A lockbox plan is most beneficial to firms that a. have suppliers who operate in many different parts of the country. b. have widely dispersed manufacturing facilities.

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 16 - Working Capital Management c. have a large marketable securities portfolio and cash to protect. d. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks. e. have customers who operate in many different parts of the country.

ANSWER: e 66. Which of the following is NOT commonly regarded as being a credit policy variable? a. Credit period b. Collection policy c. Credit standards d. Cash discounts e. Payments deferral period ANSWER: e 67. Swim Suits Unlimited is in a highly seasonal business, and the following summary balance sheet data show its assets and liabilities at peak and off-peak seasons (in thousands of dollars): Cash Marketable securities Accounts receivable Inventories Net fixed assets Total assets

Peak $50 0 40 100 500 $690

Off-Peak $30 20 20 50 500 $620

Payables and accruals Short-term bank debt Long-term debt Common equity Total claims

$30 50 300 310 $690

$10 0 300 310 $620

From this data we may conclude that a. Swim Suits' current asset financing policy calls for exactly matching asset and liability maturities. b. Swim Suits' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. c. Swim Suits follows a relatively conservative approach to current asset financing; that is, some of its short-term needs are met by permanent capital. d. without income statement data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. e. without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy.

ANSWER: c 68. Which of the following statements is CORRECT? a. Net working capital is defined as operating current assets minus the difference between current liabilities and notes payable, and any increase in the current ratio automatically indicates that net working capital has increased. b. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of shortterm debt is considered to be an aggressive strategy because of the inherent risks associated with using shortCopyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 16 - Working Capital Management term financing. c. If a company follows a policy of “matching maturities,” this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt. d. Net working capital is defined as operating current assets minus the difference between current liabilities and notes payable, and any decrease in the current ratio automatically indicates that net working capital has decreased. e. If a company follows a policy of “matching maturities,” this means that it matches its use of short-term debt with its use of long-term debt.

ANSWER: b 69. Other things held constant, which of the following would tend to reduce the cash conversion cycle? a. Carry a constant amount of receivables as sales decline b. Place larger orders for raw materials to take advantage of price breaks c. Take all discounts that are offered d. Continue to take all discounts that are offered and pay on the net date e. Offer longer payment terms to customers ANSWER: d 70. Which of the following actions would be likely to shorten the cash conversion cycle? a. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days. b. Change the credit terms offered to customers from 3/10, net 30 to 1/10, net 50. c. Begin to take discounts on inventory purchases; we buy on terms of 2/10, net 30. d. Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days. e. Change the credit terms offered to customers from 2/10, net 30 to 1/10, net 60.

ANSWER: a 71. Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket? a. Payment lags b. Payment for plant construction c. Cumulative cash d. Repurchases of common stock e. Writing off bad debts ANSWER: e 72. Which of the following statements concerning the cash budget is CORRECT? a. Depreciation expense is not explicitly included, but depreciation's effects are reflected in the estimated tax payments. b. Cash budgets do not include financial items such as interest and dividend payments. c. Cash budgets do not include cash inflows from long-term sources such as the issuance of bonds. d. Changes that affect the DSO do not affect the cash budget. e. Capital budgeting decisions have no effect on the cash budget until projects go into operation and start producing revenues.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 16 - Working Capital Management 73. Which of the following items should a company report directly in its monthly cash budget? a. Its monthly depreciation expense b. Cash proceeds from selling one of its divisions c. Accrued interest on zero coupon bonds that it issued d. New shares issued in a stock split e. New shares issued in a stock dividend ANSWER: b 74. Which of the following statements is CORRECT? a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control. b. The cash budget and the capital budget are developed separately, and although they are both important to the firm, one does not affect the other. c. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. d. The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations. e. The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash.

These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts.

ANSWER: e 75. Which of the following is NOT a situation that might lead a firm to increase its holdings of short-term marketable securities? a. The firm must make a known future payment, such as paying for a new plant that is under construction. b. The firm is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline. c. The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases. d. The firm has just sold long-term securities and has not yet invested the proceeds in operating assets. e. The firm just won a product liability suit one of its customers had brought against it.

ANSWER: c 76. Which of the following statement completions is CORRECT? If the yield curve is upward sloping, then the marketable securities held in a firm's portfolio, assumed to be held for emergencies, should a. consist mainly of long-term securities because they pay higher rates. b. consist mainly of short-term securities because they pay higher rates. c. consist mainly of U.S. Treasury securities to minimize interest rate risk. d. consist mainly of short-term securities to minimize interest rate risk. e. be balanced between long- and short-term securities to minimize the adverse effects of either an upward or a downward trend in interest rates.

ANSWER: d 77. Which of the following statements is most consistent with efficient inventory management? The firm has a a. below-average inventory turnover ratio.

Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 16 - Working Capital Management b. low incidence of production schedule disruptions. c. below-average total assets turnover ratio. d. relatively high current ratio. e. relatively low DSO. ANSWER: b 78. Which of the following statements is CORRECT? a. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant rate of 10% annually.

Such a firm will be able to keep its accounts receivable at the current level, since the 10% cash sales can be used to finance the 10% growth rate. b. In managing a firm's accounts receivable, it is possible to increase credit sales per day yet still keep accounts receivable fairly steady, provided the firm can shorten the length of its collection period (its DSO) sufficiently. c. Because of the costs of granting credit, it is not possible for credit sales to be more profitable than cash sales. d. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. e. Other things held constant, if a firm can shorten its DSO, this will lead to a higher current ratio.

ANSWER: b 79. Which of the following statements is CORRECT? a. Other things held constant, the higher a firm's days sales outstanding (DSO), the better its credit department. b. If a firm that sells on terms of net 30 changes its policy to 2/10, net 30, and if no change in sales volume occurs, then the firm's DSO will probably increase. c. If a firm sells on terms of 2/10, net 30, and its DSO is 30 days, then the firm probably has some past due accounts. d. If a firm sells on terms of net 60 and if its sales are highly seasonal, with a sharp peak in December, then its DSO as it is typically calculated (with sales per day = sales for past 12 months/365) would probably be lower in January than in July. e. If a firm changed the credit terms offered to its customers from 2/10, net 30 to 2/10, net 60, then its sales should increase, and this should lead to an increase in sales per day, and that should lead to a decrease in the DSO. ANSWER: c 80. Which of the following statements is CORRECT? a. Trade credit is provided only to relatively large, strong firms. b. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies. c. Short-term debt is favored by firms because, while it is generally more expensive than long-term debt, it exposes the borrowing firm to less risk than long-term debt. d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. e. Commercial paper is typically offered at a long-term maturity of at least five years.

ANSWER: b 81. Which of the following statements is NOT CORRECT? a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. b. Accruals are “free” in the sense that no explicit interest is paid on these funds.

Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 16 - Working Capital Management c. A conservative approach to working capital management will result in most if not all permanent assets being financed with long-term capital. d. The risk to a firm that borrows with short-term credit is usually greater than if it borrowed using long-term debt. This added risk stems from the greater variability of interest costs on short-term debt and possible difficulties with rolling over short-term debt. e. Bank loans generally carry a higher interest rate than commercial paper.

ANSWER: a 82. Which of the following statements is CORRECT? a. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk. b. Conservative firms generally use no short-term debt and, thus, have zero current liabilities. c. A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt. d. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. e. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance, but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance.

ANSWER: a 83. Which of the following statements is NOT CORRECT? a. A company may hold a relatively large amount of cash and marketable securities if it is uncertain about its volume of sales, profits, and cash flows during the coming year. b. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected. c. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans. d. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10, net 30 to net 60. e. Managing working capital is important because it influences financing decisions and the firm's profitability.

ANSWER: d 84. Which of the following statements is CORRECT? a. Depreciation is included in the estimate of free cash flows (FCF = EBIT(1 – T) + Depreciation – [Capital expenditures + ΔNOWC]); hence, depreciation is set forth on a separate line in the cash budget. b. If cash inflows from collections occur in equal daily amounts but most payments must be made on the 10th of each month, then a regular monthly cash budget will be misleading. The problem can be corrected by using a daily cash budget. c. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. d. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10, net 30 to net 60. e. If a firm sells on terms of net 90 and if its sales are highly seasonal, with 80% of its sales in September, then its DSO as it is typically calculated (with sales per day = sales for past 12 months/365) would probably be lower in October than in August.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 16 - Working Capital Management 85. Which of the following statements is CORRECT? a. Accruals are an expensive but commonly used way to finance working capital. b. A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds. c. If a company receives trade credit under terms of 2/10, net 30, this implies that the company has 10 days of free trade credit. d. One cannot tell if a firm has a conservative, aggressive, or moderate current asset financing policy without an examination of its cash budget. e. If a firm has a relatively aggressive current asset financing policy vis-à-vis other firms in its industry, then its current ratio will probably be relatively high.

ANSWER: c 86. Net operating working capital is the working capital that is used for a. reducing the cash conversion cycle. b. repayment of long-term debt. c. operating purposes. d. financing purposes. e. distribution of cash dividends.

ANSWER: c 87. Which of the following statements is CORRECT regarding a relaxed investment policy? a. It would result in a high level of receivables. b. Holdings of cash and marketable securities would be constrained. c. Smaller amounts of cash and inventories are carried. d. Holdings of current assets are minimized. e. There is a high total assets turnover ratio.

ANSWER: a 88. The inventory conversion period refers to the time required to a. produce finished goods from raw materials. b. sell the inventory to customers and receive payment from them. c. purchase raw materials and get them into the production cycle. d. convert raw materials into finished goods and sell them. e. replace the raw materials inventory during the production cycle.

ANSWER: d 89. The target cash balance refers to the a. cash needed to pay all current liabilities when they are due. b. cash needed to pay quarterly dividends. c. amount of cash desired to add to retained earnings each year. d. compensating cash balance needed by the company’s bank. e. desired cash balance a firm plans to maintain to conduct business.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 16 - Working Capital Management 90. Which of the following forms is needed when a company secures a loan with property held on their premises? a. Commercial paper b. UCC-1 c. 10-K d. Security collateralization form e. Promissory note ANSWER: b 91. Halka Company is a no-growth firm. Its sales fluctuate seasonally, causing total assets to vary from $380,000 to $410,000, but fixed assets remain constant at $260,000. If the firm follows a maturity matching (or moderate) working capital financing policy, what is the most likely total of long-term debt plus equity capital? a. $380,000 b. $345,800 c. $307,800 d. $300,200 e. $410,400 ANSWER: a 92. Cass & Company has the following data. What is the firm's cash conversion cycle?

Inventory Conversion Period = Receivables Collection Period = Payables Deferral Period =

45 days 17 days 25 days

a. 45 days b. 28 days c. 33 days d. 37 days e. 31 days ANSWER: d 93. Romano Inc. has the following data. What is the firm's cash conversion cycle?

Inventory Conversion Period = Receivables Collection Period = Payables Deferral Period =

38 days 19 days 34 days

a. 22 days b. 20 days c. 23 days d. 27 days e. 29 days ANSWER: c 94. Whittington Inc. has the following data. What is the firm's cash conversion cycle?

Inventory Conversion Period =

41 days

Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 16 - Working Capital Management Receivables Collection Period = Payables Deferral Period =

23 days 38 days

a. 26 days b. 27 days c. 32 days d. 22 days e. 28 days ANSWER: a 95. Inmoo Company’s average age of accounts receivable is 52 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle? a. 91 days b. 92 days c. 81 days d. 84 days e. 87 days ANSWER: c 96. Singal Inc. is preparing its cash budget. It expects to have sales of $30,000 in January, $35,000 in February, and $42,500 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March? a. $31,050 b. $32,085 c. $34,500 d. $40,365 e. $35,535 ANSWER: c 97. Dyl Pickle Inc. had credit sales of $3,700,000 last year, and its days sales outstanding was DSO = 35 days. What was its average receivables balance, based on a 365-day year? a. $266,096 b. $436,397 c. $276,740 d. $344,151 e. $354,795 ANSWER: e 98. Edwards Enterprises follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy. The firm’s annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $42,000; the interest rate on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? Do not round intermediate calculations. a. 6.99% b. 6.17% Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 16 - Working Capital Management c. 6.30% d. 5.99% e. 6.43% ANSWER: c 99. Data on Shick Inc. for last year are shown below, along with the days sales outstanding of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its receivables enough to reduce its DSO to the benchmarks' average. If this were done, by how much would receivables decline? Use a 365-day year. Do not round your intermediate calculations.

Sales Accounts receivable Days Sales Outstanding (DSO) Benchmarks' Days Sales Outstanding (DSO)

$104,000 $16,000 56.154 20.000

a. $9,786 b. $12,877 c. $8,550 d. $10,301 e. $7,829 ANSWER: d 100. Your firm's cost of goods sold (COGS) average $2,000,000 per month, and it keeps inventory equal to 40% of its monthly COGS on hand at all times. Using a 365-day year, what is its inventory conversion period? a. 12.2 days b. 14.1 days c. 9.9 days d. 12.2 days e. 11.7 days ANSWER: a 101. Data on Shin Inc. for last year are shown below, along with the inventory conversion period (ICP) of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its inventory enough to reduce its ICP to the benchmarks' average. If this were done, by how much would inventories decline? Use a 365-day year. Do not round your intermediate calculations.

Cost of goods sold = Inventory = Inventory Conversion Period (ICP) = Benchmark Inventory Conversion Period (ICP) =

$83,000 $20,000 87.95 38.00

a. $11,359 b. $9,996 c. $9,655 d. $14,085 e. $12,949 ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 16 - Working Capital Management 102. Data on Wentz Inc. for last year are shown below, along with the payables deferral period (PDP) for the firms against which it benchmarks. The firm's new CFO believes that the company could delay payments enough to increase its PDP to the benchmarks' average. If this were done, by how much would payables increase? Use a 365-day year. Do not round your intermediate calculations.

Cost of goods sold = Payables = Payables Deferral Period (PDP) = Benchmark Payables Deferral Period =

$84,000 $5,000 21.726 30.000

a. $1,847 b. $1,771 c. $1,447 d. $1,923 e. $1,904 ANSWER: e 103. Your consulting firm was recently hired to improve the performance of Shin-Soenen Inc., which is highly profitable but has been experiencing cash shortages due to its high growth rate. As one part of your analysis, you want to determine the firm’s cash conversion cycle. Using the following information and a 365-day year, what is the firm’s present cash conversion cycle? Do not round intermediate calculations.

Average inventory = Annual sales = Annual cost of goods sold = Average accounts receivable = Average accounts payable =

$75,000 $725,000 $435,000 $160,000 $25,000

a. 95.6 days b. 104.1 days c. 106.6 days d. 122.5 days e. 138.4 days ANSWER: d 104. Dewey Corporation has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle? Do not round intermediate calculations. Round your answer to the nearest day.

Annual sales = Annual cost of goods sold = Inventory = Accounts receivable = Accounts payable =

$46,000 $32,200 $4,000 $2,000 $2,400

a. 31 days b. 27 days c. 34 days d. 41 days Copyright Cengage Learning. Powered by Cognero.

Page 19

Name:

Class:

Date:

Chapter 16 - Working Capital Management e. 36 days ANSWER: c 105. Zervos Inc. had the following data for last year (in millions). The new CFO believes (1) that an improved inventory management system could lower the average inventory by $4,000, (2) that improvements in the credit department could reduce receivables by $2,000, and (3) that the purchasing department could negotiate better credit terms and thereby increase accounts payable by $2,000. Furthermore, they think that these changes would not affect either sales or the costs of goods sold. If these changes were made, by how many days would the cash conversion cycle be lowered? Do not round your intermediate calculations.

Original $114,000 $80,000 $20,000 $16,000 $10,000 365

Annual sales: unchanged Cost of goods sold: unchanged Average inventory: lowered by $4,000 Average receivables: lowered by $2,000 Average payables: increased by $2,000 Days in year

Revised $114,000 $80,000 $16,000 $14,000 $12,000 365

a. 35.47 days b. 29.73 days c. 41.21 days d. 33.78 days e. 37.49 days ANSWER: d 106. Desai Inc. has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle?

Do not round intermediate calculations. Round to the nearest whole day.

Annual sales = Annual cost of goods sold = Inventory = Accounts receivable = Accounts payable =

$45,000 $22,500 $4,500 $1,800 $2,500

a. 47 days b. 57 days c. 38 days d. 46 days e. 37 days ANSWER: a 107. Edison Inc. has annual sales of $37,595,000, or $103,000 a day on a 365-day basis. The firm's cost of goods sold is 75% of sales. On average, the company has $9,000,000 in inventory and $8,000,000 in accounts receivable. The firm is looking for ways to shorten its cash conversion cycle. Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable. She also anticipates that these policies would reduce sales by 10%, while the payables deferral period would remain unchanged at 35 days. What effect would these policies have on the company's cash conversion cycle? Do not round intermediate calculations. Round to the nearest whole day. a. –20 days Copyright Cengage Learning. Powered by Cognero.

Page 20

Name:

Class:

Date:

Chapter 16 - Working Capital Management b. –25 days c. –17 days d. –22 days e. –24 days ANSWER: d 108. Van Den Borsh Corp. has annual sales of $64,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level, but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year? Do not round intermediate calculations. Round to the nearest whole day. a. –33 days b. –35 days c. –42 days d. –31 days e. –34 days ANSWER: e 109. Nogueiras Corp’s budgeted monthly sales are $12,000, and they are constant from month to month. 40% of its customers pay in the first month and take the 2% discount, while the remaining 60% pay in the month following the sale and do not receive a discount. The firm has no bad debts. Purchases for next month’s sales are constant at 50% of projected sales for the next month. "Other payments," which include wages, rent, and taxes, are 25% of sales for the current month. Construct a cash budget for a typical month and calculate the average cash gain or loss during the month. Do not round intermediate calculations. a. $2,178 b. $3,020 c. $3,078 d. $2,904 e. $3,485 ANSWER: d 110. Whitmer Inc. sells to customers all over the U.S., and all receipts come in to its headquarters in New York City. The firm's average accounts receivable balance is $2.5 million, and they are financed by a bank loan at an 5.25% annual interest rate. The firm is considering setting up a regional lockbox system to speed up collections, and it believes this would reduce receivables by 20%. If the annual cost of the system is $15,000, what pre-tax net annual savings would be realized? a. $10,350 b. $11,588 c. $11,250 d. $8,775 e. $13,050 ANSWER: c 111. A firm buys on terms of 3/15, net 45. It does not take the discount, and it generally pays after 100 days. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year?

Copyright Cengage Learning. Powered by Cognero.

Page 21

Name:

Class:

Date:

Chapter 16 - Working Capital Management a. 10.76% b. 13.55% c. 12.62% d. 13.28% e. 15.41% ANSWER: d 112. Atlanta Cement, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 55 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 17.13% b. 18.62% c. 20.48% d. 22.16% e. 14.53% ANSWER: b 113. Your company has been offered credit terms of 4/30, net 90 days. What will be the nominal annual percentage cost of its non-free trade credit if it pays 150 days after the purchase? (Assume a 365-day year.) a. 12.29% b. 13.43% c. 12.67% d. 11.15% e. 15.72% ANSWER: c 114. Bumpas Enterprises purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 60. If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its non-free trade credit? (Assume a 365-day year.) a. 16.03% b. 17.81% c. 14.96% d. 14.24% e. 17.45% ANSWER: b 115. A firm buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays after 86 days. What is the effective annual percentage cost of its non-free trade credit? (Use a 365-day year.) a. 9.92% b. 10.11% c. 10.91% d. 12.29% e. 12.00% ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 22

Name:

Class:

Date:

Chapter 16 - Working Capital Management 116. Buskirk Construction buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $225,000 per year. On average, how much “free” trade credit does the firm receive during the year? (Assume a 365-day year, and note that purchases are net of discounts.) a. $11,281 b. $9,524 c. $10,079 d. $9,247 e. $10,171 ANSWER: d 117. Ingram Office Supplies, Inc., buys on terms of 2/15, net 50 days. It does not take discounts, and it typically pays on time, 50 days after the invoice date. Net purchases amount to $200,000 per year. On average, what is the dollar amount of costly trade credit (total credit – free credit) the firm receives during the year? (Assume a 365-day year, and note that purchases are net of discounts.) Do not round intermediate calculations. a. $17,068 b. $19,178 c. $17,644 d. $22,822 e. $23,205 ANSWER: b 118. Roton Inc. purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $750,000 per year. What is the maximum dollar amount of costly trade credit the firm could get, assuming it abides by the supplier’s credit terms? (Assume a 365-day year.) Do not round intermediate calculations. a. $62,425 b. $53,866 c. $55,377 d. $52,356 e. $50,342 ANSWER: e 119. Kirk Development buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $325,000 per year. On average, what is the dollar amount of total trade credit (costly + free) the firm receives during the year, i.e., what are its average accounts payable? (Assume a 365day year, and note that purchases are net of discounts.) a. $53,425 b. $56,630 c. $64,110 d. $59,301 e. $52,356 ANSWER: a 120. Affleck Inc.'s business is booming, and it needs to raise more capital. The company purchases supplies on terms of 1/10, net 20, and it currently takes the discount. One way of acquiring the needed funds would be to forgo the discount, and the firm's owner believes she could delay payment to 30 days without adverse effects. What would be the effective annual percentage cost of funds raised by this action? (Assume a 365-day year.)

Copyright Cengage Learning. Powered by Cognero.

Page 23

Name:

Class:

Date:

Chapter 16 - Working Capital Management a. 21.14% b. 15.30% c. 20.13% d. 18.92% e. 24.56% ANSWER: c 121. Weiss Inc. arranged an $8,000,000 revolving credit agreement with a group of banks. The firm paid an annual commitment fee of 0.5% on the unused balance of the loan commitment. On the used portion of the revolver, it paid 1.5% above prime for the funds actually borrowed on a simple interest basis. The prime rate was 9% during the year. If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar annual cost of the revolver? Do not round intermediate calculations. a. $755,200 b. $761,600 c. $640,000 d. $492,800 e. $678,400 ANSWER: c 122. Soenen Inc. had the following data for last year (in millions). The new CFO believes that the company could improve its working capital management sufficiently to bring its net working capital and cash conversion cycle up to the benchmark companies' level without affecting either sales or the costs of goods sold. Soenen finances its net working capital with a bank loan at an 8% annual interest rate, and it uses a 365-day year. If these changes had been made, by how much would the firm's pre-tax income have increased? Do not round your intermediate calculations.

Sales Cost of goods sold Inventory (ICP) Receivables (DSO) Payables (PDP)

Original Data $92,000 $80,000 $20,000 $16,000 $5,000

Related CCC

Benchmarks' CCC

91.25 63.48 22.81 131.92

38.00 20.00 30.00 28.00

a. $1,549 b. $1,936 c. $2,401 d. $1,510 e. $1,472 ANSWER: b 123. Margetis Inc. carries an average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold are 75% of annual sales, and its receivables collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. Its new CFO wants to decrease the cash conversion cycle by 8 days, based on a 365-day year. He believes he can reduce the average inventory to $640,650 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of its cash conversion cycle? a. $73,378 Copyright Cengage Learning. Powered by Cognero.

Page 24

Name:

Class:

Date:

Chapter 16 - Working Capital Management b. $60,904 c. $79,982 d. $90,989 e. $82,917 ANSWER: a 124. Suppose the credit terms offered to your firm by its suppliers are 2/10, net 30 days. Your firm is not taking discounts but is paying after 15 days instead of Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%. But since your firm is neither taking discounts nor paying on the due date, what is the effective annual percentage cost (not the nominal cost) of its costly trade credit, using a 365-day year? a. 377.5% b. 306.7% c. 313.4% d. 340.4% e. 337.0% ANSWER: e 125. Aggarwal Inc. buys on terms of 2/10, net 30, and it always pays on the 30th day. The CFO calculates that the average amount of costly trade credit carried is $250,000. What is the firm's average accounts payable balance? Assume a 365-day year. a. $431,250 b. $461,250 c. $375,000 d. $390,000 e. $337,500 ANSWER: c 126. Gonzales Company currently uses maximum trade credit by not taking discounts on its purchases. The standard industry credit terms offered by all its suppliers are 2/10, net 44 days, and the firm pays on time. The new CFO is considering borrowing from its bank, using short-term notes payable, and then taking discounts. The firm wants to determine the effect of this policy change on its net income. Its net purchases are $11,760 per day, using a 365-day year.

The interest rate on the notes payable is 10%, and the tax rate is 40%. If the firm implements the plan, what is the expected change in net income? Do not round intermediate calculations. a. $28,570 b. $26,855 c. $30,284 d. $29,141 e. $34,855 ANSWER: a 127. Zarruk Construction’s DSO is 50 days (on a 365-day basis), accounts receivable are $100 million, and its balance sheet shows inventory of $200 million. The firm's cost of goods sold is 70% of sales. What is the inventory turnover ratio? a. 3.39 b. 4.53 c. 2.56 Copyright Cengage Learning. Powered by Cognero.

Page 25

Name:

Class:

Date:

Chapter 16 - Working Capital Management d. 3.69 e. .43 ANSWER: c 128. Madura Inc. wants to increase its free cash flow by $180 million during the coming year, which should result in a higher EVA and stock price. The CFO has made these projections for the upcoming year: · EBIT is projected to equal $800 million.

Gross capital expenditures are expected to total to $360 million versus depreciation of $120 million, so its net · capital expenditures should total $240 million. · The tax rate is 40%.

There will be no changes in cash or marketable securities, nor will there be any changes in notes payable or · accruals.

What increase in net operating working capital (in millions of dollars) would enable the firm to meet its target increase in FCF? a. $66 b. $60 c. $74 d. $56 e. $49 ANSWER: b Exhibit 16.1 Zorn Corporation is deciding whether to pursue a restricted or relaxed working capital investment policy. The firm's annual sales are expected to total $4,000,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

129. Refer to Exhibit 16.1. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy? Do not round intermediate calculations. a. $11,018 b. $13,309 c. $10,909 d. $13,418 e. $11,673 ANSWER: c 130. Refer to Exhibit 16.1. What's the difference in the projected ROEs under the restricted and relaxed policies? Do not round intermediate calculations. a. 1.647% b. 1.242% c. 1.350% d. 1.202% e. 1.121% Copyright Cengage Learning. Powered by Cognero.

Page 26

Name:

Class:

Date:

Chapter 16 - Working Capital Management ANSWER: c 131. Refer to Exhibit 16.1. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same.

In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies? Do not round intermediate calculations. a. 2.01% b. 1.57% c. 1.67% d. 2.07% e. 1.85% ANSWER: a

Copyright Cengage Learning. Powered by Cognero.

Page 27

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting 1. The first, and most critical, step in constructing a set of forecasted financial statements is the sales forecast. a. True b. False ANSWER: True 2. A typical sales forecast, though concerned with future events, will usually be based on recent historical trends and events as well as on forecasts of economic prospects. a. True b. False ANSWER: True 3. Errors in the sales forecast can be offset by similar errors in costs and income forecasts. Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm. a. True b. False ANSWER: False 4. As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneously generated funds arise from transactions brought on by sales increases. a. True b. False ANSWER: True 5. The term "spontaneously generated funds" generally refers to increases in the cash account that result from growth in sales, assuming the firm is operating with a positive profit margin. a. True b. False ANSWER: False 6. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset. a. True b. False ANSWER: True 7. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding. a. True b. False ANSWER: False 8. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds. a. True Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting b. False ANSWER: False 9. When developing forecasted financial statements, there are some inputs that management controls such as the growth rate and operating costs/sales ratio, while other inputs such as the tax rate and interest rate are not under its control. a. True b. False ANSWER: True 10. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. a. True b. False ANSWER: True 11. A firm's profit margin is 5%, its debt ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing. a. True b. False ANSWER: False 12. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant. a. True b. False ANSWER: True 13. If a firm's capital intensity ratio (A */S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant. a. True b. False ANSWER: False 14. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis. a. True b. False ANSWER: False 15. When we use the AFN equation to forecast the additional funds needed (AFN), we are implicitly assuming that all financial ratios are constant. If financial ratios are not constant, regression techniques can be used to improve the financial forecast. a. True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting b. False ANSWER: True 16. Which of the following is NOT a key element in strategic planning as it is described in the text? a. The mission statement b. The statement of the corporate scope c. The statement of cash flows d. The statement of corporate objectives e. The operating plan ANSWER: c 17. Which of the following assumptions is embodied in the AFN equation? a. All balance sheet accounts are tied directly to sales. b. Accounts payable and accruals are tied directly to sales. c. Common stock and long-term debt are tied directly to sales. d. Fixed assets, but not current assets, are tied directly to sales. e. Last year’s total assets were not optimal for last year’s sales.

ANSWER: b 18. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)? a. A sharp increase in its forecasted sales b. A sharp reduction in its forecasted sales c. The company reduces its dividend payout ratio. d. The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35. e. The company discovers that it has excess capacity in its fixed assets.

ANSWER: a 19. The term “additional funds needed (AFN)” is generally defined as follows: a. funds that are obtained automatically from routine business transactions. b. funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock, to support operations. c. the amount of assets required per dollar of sales. d. the amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth. e. a forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.

ANSWER: b 20. The capital intensity ratio is generally defined as follows: a. sales divided by total assets, i.e., the total assets turnover ratio. b. the percentage of liabilities that increase spontaneously as a percentage of sales. c. the ratio of sales to current assets.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting d. the ratio of current assets to sales. e. the amount of assets required per dollar of sales, or A0*/S0.

ANSWER: e 21. Which of the following is NOT one of the steps taken in the financial planning process? a. Assumptions are made about future levels of sales, costs, and interest rates for use in the forecast. b. The entire financial plan is reexamined, assumptions are reviewed, and the management team considers how additional changes in operations might improve results. c. Projected ratios are calculated and analyzed. d. Develop a set of projected financial statements. e. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors.

ANSWER: e 22. Spontaneously generated funds are generally defined as follows: a. Assets required per dollar of sales. b. A forecasting approach in which the forecasted percentage of sales for each item is held constant. c. Funds that a firm must raise externally through borrowing or by selling new common or preferred stock. d. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include spontaneous increases in accounts payable and accruals. e. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm’s growth.

ANSWER: d 23. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? a. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. b. The company increases its dividend payout ratio. c. The company begins to pay employees monthly rather than weekly. d. The company’s profit margin increases. e. The company decides to stop taking discounts on purchased materials.

ANSWER: b 24. Which of the following statements is CORRECT? a. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management’s historical performance is evaluated. d. The capital intensity ratio gives us an idea of the physical condition of the firm’s fixed assets. e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy and economies of scale exist.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting 25. Which of the following statements is CORRECT? a. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or strategies for achieving its goals. The statement of corporate strategies sets forth detailed plans rather than broad approaches for achieving a firm's goals. b. A firm’s corporate purpose states the general philosophy of the business and provides managers with specific operational objectives. c. Operating plans provide management with detailed implementation guidance, consistent with the corporate strategy, to help meet the corporate objectives. These operating plans can be developed for any time horizon, but many companies use a four-year horizon. d. A firm’s mission statement defines its lines of business and geographic area of operations. e. The corporate scope is a condensed version of the entire set of strategic plans.

ANSWER: c 26. Which of the following statements is CORRECT? a. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase. b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets.

Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets. c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. d. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them. e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. ANSWER: d 27. Which of the following statements is CORRECT? a. Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income. b. The AFN equation for forecasting funds requirements requires only a forecast of the firm’s balance sheet.

Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet. c. Dividends are paid with cash taken from the accumulated retained earnings account; hence, dividend policy does not affect the AFN forecast. d. A negative AFN indicates that retained earnings and spontaneous capital are far more than sufficient to finance the additional assets needed. e. If assets and spontaneously generated liabilities are not projected to grow at the same rate as sales, then the AFN method will provide more accurate forecasts than the projected financial statement method.

ANSWER: d 28. Which of the following statements is CORRECT? a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero. b. If a firm’s assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm’s AFN to be negative.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm’s actual AFN must, mathematically, exceed the previously calculated AFN. d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. e. Dividend policy does not affect the requirement for external funds based on the AFN equation.

ANSWER: a 29. Which of the following statements is CORRECT? a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. c. Firms whose fixed assets are “lumpy” frequently have excess capacity, and this should be accounted for in the financial forecasting process. d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. e. Regression techniques cannot be used in situations where excess capacity or economies of scale exist.

ANSWER: c 30. Which of the following is a condensed version of a company’s strategic unit? a. Corporate scope b. Statement of corporate objectives c. Operating plan d. Corporate strategies e. Mission statement ANSWER: e 31. Which element of a strategic plan will define the geographic areas in which a firm will operate? a. Mission statement b. Corporate scope c. Territorial scope d. Financial plan e. Operating plan ANSWER: b 32. Which element of a strategic plan ties the entire planning process together? a. Operating plan b. Mission statement c. Financial plan d. Statement of corporate objectives e. Corporate scope ANSWER: c 33. Which element of a strategic plan defines the people responsible for each particular function?

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting a. Statement of corporate objectives b. Human resources strategies c. Corporate scope d. Operating plan e. Financial plan ANSWER: d 34. A firm’s retention ratio is a. equal to 1 minus the dividend payout ratio. b. the balance left in retained earnings after the preferred stock dividends are paid. c. equal to 1 plus the return on equity ratio. d. required to be no more than 50% of current year’s addition to retained earnings. e. equal to the dividend payout ratio.

ANSWER: a 35. The growth rate at which the firm’s AFN equals zero is a. the capital intensity ratio. b. the excess capacity ratio. c. equal to the spontaneously generated funds percentage. d. the sustainable growth rate. e. the retention rate.

ANSWER: d 36. While operating plans can be developed for any time horizon, most companies use a. a one-year horizon. b. a two-year horizon. c. current year data only. d. a five-year horizon. e. the current and previous year data only.

ANSWER: d 37. Last year Godinho Corp. had $400 million of sales, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity? a. $550.0 b. $520.0 c. $570.0 d. $625.0 e. $500.0 ANSWER: e 38. Kamath-Meier Corporation's CFO uses this equation, which was developed by regressing inventories on sales over the past 5 years, to forecast inventory requirements: Inventories = $22.0 + 0.125(Sales). The company expects sales of $600.0 million during the current year, and it expects sales to grow by 31% next year. What is the inventory forecast for next year? All dollars are in millions.

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting a. $135.9 b. $149.1 c. $143.1 d. $120.3 e. $103.4 ANSWER: d 39. Last year Wei Guan Inc. had $525 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity. In millions, by how much could Wei Guan's sales increase before it is required to increase its fixed assets? a. $336.40 b. $350.54 c. $251.60 d. $279.87 e. $282.69 ANSWER: e 40. Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only 90% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets? a. 10.11% b. 12.44% c. 9.22% d. 11.89% e. 11.11% ANSWER: e 41. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its Fixed Assets/Sales ratio was 40%. However, its fixed assets were used at only 80% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had, had it been operating at full capacity. What target Fixed Assets/Sales ratio should the company set? a. 29.4% b. 40.0% c. 32.0% d. 32.3% e. 31.0% ANSWER: c 42. Fairchild Garden Supply expects $580 million of sales this year, and it forecasts a 15% increase for next year. The CFO uses this equation to forecast inventory requirements at different levels of sales: Inventories = $30.2 + 0.25(Sales).

All dollars are in millions. The firm's cost of goods sold is expected to be 70% of sales. What is the projected inventory turnover ratio for the coming year? a. 4.17 times b. 4.20 times c. 3.15 times Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting d. 4.13 times e. 2.37 times ANSWER: e 43. Clayton Industries is planning its operations for next year. Ronnie Clayton, the CEO, wants you to forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

Last year's sales = S0 Sales growth rate = g Last year's total assets = A0* Last year's prof margin = PM

$350 30% $390 5%

Last yr's accounts payable Last yr's notes payable Last yr's accruals Target payout ratio

$40 $50 $30 60%

a. $86.0 b. $100.8 c. $70.4 d. $86.9 e. $75.6 ANSWER: d 44. Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year?

Last year's sales = S0 Sales growth rate = g Last year's total assets = A0* Last year's profit margin = PM

$200,000 40% $150,000 20.0%

Last year's accounts payable $50,000 Last year's notes payable $15,000 Last year's accruals $20,000 Target payout ratio 25.0%

a. -$10,100 b. -$8,500 c. -$10,000 d. -$10,200 e. -$7,800 ANSWER: c 45. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 70%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.

Last year's sales = S0 Sales growth rate = g Last year's total assets = A0* Last year's profit margin = PM

$300 40% $500 20%

Copyright Cengage Learning. Powered by Cognero.

Last year's accounts payable Last year's notes payable Last year's accruals Initial payout ratio New payout ratio

$50 $15 $20 10% 70% Page 9

Name:

Class:

Date:

Chapter 17 - Financial Planning and Forecasting a. $38.3 b. $50.4 c. $41.3 d. $60.5 e. $58.0 ANSWER: b 46. Last year, Emery Industries had $450 million of sales and $225 million of fixed assets, so its Fixed Assets/Sales ratio was 50%. However, its fixed assets were used at only 40% of capacity. If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated? a. $163.35 b. $135.00 c. $108.00 d. $136.35 e. $121.50 ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management 1. Multinational financial management requires that financial analysts consider the effects of changing currency values. a. True b. False ANSWER: True 2. Legal and economic differences among countries, although important, do NOT pose significant problems for most multinational corporations when they coordinate and control worldwide operations and subsidiaries. a. True b. False ANSWER: False 3. When the value of the U.S. dollar appreciates against another country's currency, we may purchase more of the foreign currency with the U.S. dollar. a. True b. False ANSWER: True 4. The United States and most other major industrialized nations currently operate under a system of floating exchange rates. a. True b. False ANSWER: True 5. Exchange rate quotations consist solely of direct quotations. a. True b. False ANSWER: False 6. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a third currency as a base. a. True b. False ANSWER: True 7. A Eurodollar is a U.S. dollar deposited in a bank outside the United States. a. True b. False ANSWER: True 8. LIBOR is an acronym for London Interbank Offered Rate, which is an average of interest rates offered by London banks to smaller U.S. corporations on all deposits. a. True b. False ANSWER: False 9. Exchange rate risk is the risk that the cash flows from a foreign project, when converted to the parent company's Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management currency, will be worth less than was originally projected because of exchange rate changes. a. True b. False ANSWER: True 10. Because political risk is seldom negotiable, it cannot be explicitly addressed in multinational corporate financial analysis. a. True b. False ANSWER: False 11. Individuals and corporations can buy or sell forward currencies to hedge their exchange rate exposure. Essentially, the process involves simultaneously selling the currency expected to appreciate in value and buying the currency expected to depreciate. a. True b. False ANSWER: False 12. If an investor can obtain more of a foreign currency for a dollar in the forward market than in the spot market, then the forward currency is said to be selling at a discount to the spot rate. a. True b. False ANSWER: True 13. If a dollar will buy fewer units of a foreign currency in the forward market than in the spot market, then the forward currency is said to be selling at a premium to the spot rate. a. True b. False ANSWER: True 14. A foreign currency will, on average, depreciate against the U.S. dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of the United States. a. True b. False ANSWER: True 15. The cash flows relevant for a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company plus the cash flows that must remain in the foreign country. a. True b. False ANSWER: False 16. The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky. a. True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management b. False ANSWER: True 17. When considering the risk of a foreign investment, a higher risk might arise from exchange rate risk and political risk while lower risk might result from international diversification. a. True b. False ANSWER: True 18. Which of the following are reasons why companies move into international operations? a. To take advantage of lower production costs in regions where labor costs are relatively low b. To develop new markets for the firm's products c. To better serve their primary customers d. Because important raw materials are located abroad e. All of the above ANSWER: e 19. Multinational financial management requires that a. the effects of changing currency values be included in financial analyses. b. legal and economic differences need not be considered in financial decisions because these differences are insignificant. c. political risk should be excluded from multinational corporate financial analyses. d. traditional U.S. and European financial models incorporating the existence of a competitive marketplace not be recast when analyzing projects in other parts of the world. e. cultural differences need not be accounted for when considering firm goals and employee management.

ANSWER: a 20. In Japan, 90-day securities have a 4% annualized return, and 180-day securities have a 5% annualized return. In the United States, 90-day securities have a 4% annualized return, and 180-day securities have an annualized return of 4.5%.

All securities are of equal risk, and Japanese securities are denominated in terms of the Japanese yen. Assuming that interest rate parity holds in all markets, which of the following statements is most CORRECT? a. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market. b. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 180-day forward market. c. The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market. d. The yen-dollar exchange rate in the 180-day forward market equals the yen-dollar exchange rate in the 90-day spot market. e. The relationship between spot and forward interest rates cannot be inferred.

ANSWER: a 21. If the inflation rate in the United States is greater than the inflation rate in Britain, other things held constant, the British pound will a. appreciate against the U.S. dollar. b. depreciate against the U.S. dollar. c. remain unchanged against the U.S. dollar.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management d. appreciate against other major currencies. e. appreciate against the dollar and other major currencies.

ANSWER: a 22. Which of the following statements is CORRECT? a. Any bond sold outside the country of the borrower is called a domestic bond. b. Foreign bonds and Eurobonds are two important types of domestic bonds. c. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. d. The term Eurobond applies only to foreign bonds denominated in U.S. currency. e. A Eurodollar is a euro dollar deposited in a bank outside the U.S. ANSWER: c 23. Currently, a U.S. trader notes that in the six-month forward market, the Japanese yen is selling at a premium (that is, you receive more dollars per yen in the forward market than you do in the spot market), while the British pound is selling at a discount. Which of the following statements is CORRECT? a. If interest rate parity holds, six-month interest rates should be the same in the U.S., Britain, and Japan. b. If interest rate parity holds among the three countries, the United States should have the highest six-month interest rates and Japan should have the lowest rates. c. If interest rate parity holds among the three countries, Britain should have the highest six-month interest rates and Japan should have the lowest rates. d. If interest rate parity holds among the three countries, Japan should have the highest six-month interest rates and Britain should have the lowest rates. e. If interest rate parity holds among the three countries, the United States should have the highest six-month interest rates and Britain should have the lowest rates.

ANSWER: c 24. Today in the spot market $1 = 1.82 Swiss francs and $1 = 130 Japanese yen. In the 90-day forward market, $1 = 1.84 Swiss francs (CHF) and $1 = 127 Japanese yen. Assume that interest rate parity holds worldwide. Which of the following statements is most CORRECT? a. Interest rates on 90-day risk-free U.S. securities are higher than the interest rates on 90-day risk-free Swiss securities. b. Interest rates on 90-day risk-free U.S. securities are higher than the interest rates on 90-day risk-free Japanese securities. c. Interest rates on 90-day risk-free U.S. securities equal the interest rates on 90-day risk-free Japanese securities. d. Since interest rate parity holds interest rates should be the same in all three countries. e. Interest rates on 90-day risk-free U.S. securities equal the interest rates on 90-day risk-free Swiss securities.

ANSWER: b 25. If one Swiss franc can purchase 0.78 U.S. dollar, how many Swiss francs (CHF) can one U.S. dollar buy? a. 1.1538 CHF b. 1.2821 CHF c. 1.0256 CHF d. 1.4103 CHF e. 1.0897 CHF Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management ANSWER: b 26. If one U.S. dollar buys 1.69 Canadian dollars, how many U.S. dollars can you purchase for one Canadian dollar (C$)? a. $0.7101 b. $0.5444 c. $0.7219 d. $0.6095 e. $0.5917 ANSWER: e 27. If one British pound can purchase $2.20 U.S. dollars, how many British pounds can one U.S. dollar buy? a. £ 0.5227 b. £ 0.4909 c. £ 0.4682 d. £ 0.4545 e. £ 0.3409 ANSWER: d 28. If one U.S. dollar buys 0.65 euro, how many dollars can you purchase for one euro? a. $1.5077 b. $1.3846 c. $1.5385 d. $1.9231 e. $1.3538 ANSWER: c 29. If one U.S. dollar sells for 0.40 British pound, how many dollars should one British pound sell for? a. $2.7750 b. $2.8250 c. $2.5250 d. $2.7500 e. $2.5000 ANSWER: e 30. Suppose 144 yen could be purchased in the foreign exchange market for one U.S. dollar today. If the yen depreciates by 15.0% tomorrow, how many yen could one U.S. dollar buy tomorrow? a. 158.9760 yen b. 173.8800 yen c. 203.6880 yen d. 165.6000 yen e. 150.6960 yen ANSWER: d 31. Suppose a foreign investor who holds tax-exempt Eurobonds paying 10.25% is considering investing in an equivalentCopyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management risk domestic bond in a country with a 28.00% withholding tax on interest paid to foreigners. If 10.25% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return? a. 14.38% b. 17.08% c. 13.24% d. 17.23% e. 14.24% ANSWER: e 32. Suppose DeGraw Corporation, a U.S. exporter, sold a solar heating station to a Japanese customer at a price of 134.0 million yen, when the exchange rate was 140.0 yen per dollar. In order to close the sale, DeGraw agreed to make the bill payable in yen, thus agreeing to take some exchange rate risk for the transaction. The terms were net 6 months. If the yen fell against the dollar such that one dollar would buy 154.4 yen when the invoice was paid, what dollar amount would DeGraw actually receive after it exchanged yen for U.S. dollars? a. $867,875.65 b. $676,943.01 c. $876,554.40 d. $911,269.43 e. $963,341.97 ANSWER: a 33. Suppose the exchange rate between U.S. dollars and Swiss francs is 1.41 CHF = $1.00, and the exchange rate between the U.S. dollar and the euro is $1.00 = 0.45 euro. What is the cross rate of Swiss francs to euros? (In other words, how many Swiss francs are needed to purchase one euro?) Do not round the intermediate calculations and round the final answer to four decimal places. a. 3.6347 CHF b. 3.7913 CHF c. 3.1333 CHF d. 2.5067 CHF e. 3.2273 CHF ANSWER: c 34. Suppose that currently, 1 British pound equals 1.98 U.S. dollars and 1 U.S. dollar equals 1.45 Swiss francs (CHF).

How many Swiss francs are needed to purchase 1 pound? a. 3.1007 CHF b. 2.8136 CHF c. 3.0146 CHF d. 3.0720 CHF e. 2.8710 CHF ANSWER: e 35. A currency trader observes the following quotes in the spot market: 1 U.S. dollar =

1.28

Japanese yen

Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management 1 British pound = 2.25 Swiss francs 1 British pound = 1.65 U.S. dollars Given this information, how many yen can be purchased for 1 Swiss franc? Do not round the intermediate calculations and round the final answer to four decimal places. a. 1.0701 yen b. 0.9105 yen c. 1.0607 yen d. 0.7322 yen e. 0.9387 yen ANSWER: e 36. A currency trader observes the following quotes in the spot market: 1 U.S. dollar = 10.875 Mexican pesos 1 British pound = 8.500 Danish krone 1 British pound = 1.65 U.S. dollars Given this information, how many Mexican pesos (Mex$) can be purchased for 1 Danish krone? a. 2.3432 Mex$ b. 2.0477 Mex$ c. 2.1955 Mex$ d. 2.0055 Mex$ e. 2.1110 Mex$ ANSWER: e 37. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold for the same amount of yen today but the current exchange rate is 125 yen per dollar, what would the car be selling for today in U.S. dollars? a. $14,406 b. $13,933 c. $10,863 d. $11,808 e. $12,280 ANSWER: d 38. Suppose one year ago, Hein Company had inventory in Britain valued at 225,000 pounds. The exchange rate for dollars to pounds was 1£ = 2.00 U.S. dollars. This year the exchange rate is 1£ = 1.82 U.S. dollars. The inventory in Britain is still valued at 225,000 pounds. What is the U.S. dollar gain or loss in inventory value as a result of the change in exchange rates? a. -$40,500.00 b. -$38,880.00 c. -$46,170.00 d. -$31,995.00 e. -$34,425.00 ANSWER: a 39. If the spot rate of the Israeli shekel is 5.51 shekels per dollar and the 180-day forward rate is 5.65 shekels per dollar, Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management then the forward rate for the Israeli shekel is selling at a(n) ______________ to the spot rate. a. 2.41% premium b. 3.07% premium c. 2.13% discount d. 2.54% discount e. 2.21% discount ANSWER: d 40. Suppose one British pound can purchase 1.76 U.S. dollars today in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 12.00% against the pound over the next 30 days. How many dollars will a pound buy in 30 days? a. $1.9515 b. $2.1289 c. $2.2866 d. $1.9712 e. $2.3852 ANSWER: d 41. Stover Corporation, a U.S. based importer, makes a purchase of crystal glassware from a firm in Switzerland for 39,960 Swiss francs (CHF), or $24,000, at the spot rate of 1.665 Swiss francs per dollar. The terms of the purchase are net 90 days, and the U.S. firm wants to cover this trade payable with a forward market hedge to eliminate its exchange rate risk. Suppose the firm completes a forward hedge at the 90-day forward rate of 1.682 Swiss francs. If the spot rate in 90 days is actually 1.656 Swiss francs, how much in U.S. dollars will the U.S. firm have saved or lost by hedging its exchange rate exposure? Do not round the intermediate calculations and round the final answer to the nearest cent. a. $417.76 b. $440.14 c. $373.00 d. $365.54 e. $414.03 ANSWER: c 42. Suppose a U.S. firm buys $200,000 worth of television tubes from a Mexican manufacturer for delivery in 60 days with payment to be made in 90 days (30 days after the goods are received). The rising U.S. deficit has caused the dollar to depreciate against the peso recently. The current exchange rate is 5.66 pesos per U.S. dollar. The 90-day forward rate is 5.45 pesos/dollar. The firm goes into the forward market today and buys enough Mexican pesos at the 90-day forward rate to completely cover its trade obligation. Assume the spot rate in 90 days is 5.30 Mexican pesos per U.S. dollar. How much in U.S. dollars did the firm save by eliminating its foreign exchange currency risk with its forward market hedge? Do not round the intermediate calculations and round the final answer to the nearest cent. a. $5,408.20 b. $5,878.48 c. $6,525.12 d. $4,702.79 e. $4,820.36 ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management 43. Suppose 90-day investments in Britain have a 6.00% annualized return and a 1.50% quarterly (90-day) return. In the U.S., 90-day investments of similar risk have a 4.00% annualized return and a 1.00% quarterly (90-day) return. In the 90day forward market, 1 British pound equals $1.55. If interest rate parity holds, what is the spot exchange rate ($/£)? Do not round the intermediate calculations and round the final answer to four decimal places. a. $1.5577 b. $1.5888 c. $1.9159 d. $1.9471 e. $1.7757 ANSWER: a 44. Suppose hockey skates sell in Canada for 113 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S. dollar. If purchasing power parity (PPP) holds, what is the price of hockey skates in the United States? a. $70.60 b. $97.08 c. $94.67 d. $69.80 e. $80.23 ANSWER: e 45. Suppose 6 months ago a Swiss investor bought a 6-month U.S. Treasury bill at a price of $9,708.74, with a maturity value of $10,000.00. The exchange rate at that time was 1.413 Swiss francs (CHF) per dollar. Today, at maturity, the exchange rate is 1.324 Swiss francs per dollar. What is the annualized rate of return to the Swiss investor? Do not round the intermediate calculations and round the final answer to two decimal places. a. –6.42% b. –6.98% c. –7.95% d. –6.00% e. –8.16% ANSWER: b 46. A product sells for $750 in the United States. The spot exchange rate is $1 to 1.54 Swiss francs (CHF). If purchasing power parity (PPP) holds, what is the price of the product in Switzerland? a. 1,016.40 b. 1,074.15 c. 1,258.95 d. 1,155.00 e. 958.65 ANSWER: d 47. A box of candy costs 28.80 Swiss francs (CHF) in Switzerland and $22.30 in the United States. Assuming that purchasing power parity (PPP) holds, how many Swiss francs are required to purchase one U.S. dollar? Do not round the intermediate calculations and round the final answer to four decimal places. a. 1.2398 CHF b. 1.5756 CHF Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management c. 1.2915 CHF d. 1.0461 CHF e. 1.5627 CHF ANSWER: c 48. One year ago, a U.S. investor converted dollars to yen and purchased 100 shares of stock in a Japanese company at a price of 3,150 yen per share. The stock's total purchase cost was 315,000 yen. At the time of purchase, in the currency market 1 yen equaled $0.00952. Today, the stock is selling at a price of 3,465 yen per share, and in the currency market $1 equals 110 yen. The stock does not pay a dividend. If the investor were to sell the stock today and convert the proceeds back to dollars, what would be his realized return on his initial dollar investment from holding the stock? a. 4.54% b. 5.04% c. 4.34% d. 4.99% e. 5.34% ANSWER: b 49. Suppose in the spot market 1 U.S. dollar equals 1.3000 Canadian dollars (C$). 6-month Canadian securities have an annualized return of 6.00% (and thus a 6-month periodic return of 3.00%). 6-month U.S. securities have an annualized return of 6.50% and a periodic return of 3.25%. If interest rate parity holds, what is the U.S. dollar-Canadian dollar exchange rate in the 180-day forward market? In other words, how many Canadian dollars are required to purchase one U.S. dollar in the 180-day forward market? Do not round the intermediate calculations and round the final answer to four decimal places. a. 1.4006 C$ b. 1.5951 C$ c. 1.3876 C$ d. 1.2969 C$ e. 1.5433 C$ ANSWER: d 50. Blenman Corporation, based in the United States, arranged a 2-year, $1,000,000 loan to fund a project in Mexico. The loan is denominated in Mexican pesos, carries a 9.50% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.10 pesos per dollar before the first payment came due. The loan was not hedged in the foreign exchange market. Thus, Blenman must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective annual interest rate will Blenman end up paying on the loan? Do not round the intermediate calculations and round the final answer to two decimal places. a. 20.36% b. 18.24% c. 25.45% d. 17.39% e. 21.21% ANSWER: e 51. If one Swiss franc can purchase 0.78 U.S. dollar, how many Swiss francs (CHF) can one U.S. dollar buy? a. 1.5385 CHF Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management b. 1.2821 CHF c. 1.5897 CHF d. 1.0769 CHF e. 1.5769 CHF ANSWER: b 52. If one British pound can purchase $2.15 U.S. dollars, how many British pounds can one U.S. dollar buy? a. £0.4047 b. £0.4279 c. £0.3535 d. £0.4651 e. £0.5488 ANSWER: d 53. If one U.S. dollar buys 1.52 Canadian dollars, how many U.S. dollars can you purchase for one Canadian dollar? a. $0.6711 b. $0.7500 c. $0.6974 d. $0.6184 e. $0.6579 ANSWER: e 54. If one U.S. dollar buys 0.69 euro, how many dollars can you purchase for one euro? a. $1.6087 b. $1.7391 c. $1.4493 d. $1.5217 e. $1.3043 ANSWER: c 55. If one U.S. dollar sells for 0.46 British pound, how many dollars should one British pound sell for? a. $1.8913 b. $1.9348 c. $2.1957 d. $2.5000 e. $2.1739 ANSWER: e 56. Suppose 144 yen could be purchased in the foreign exchange market for one U.S. dollar today. If the yen depreciates by 12.0% tomorrow, how many yen could one U.S. dollar buy tomorrow? a. 174.1824 yen b. 146.7648 yen c. 191.9232 yen d. 161.2800 yen Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management e. 170.9568 yen ANSWER: d 57. Suppose a foreign investor who holds tax-exempt Eurobonds paying 7.50% is considering investing in an equivalentrisk domestic bond in a country with a 28.00% withholding tax on interest paid to foreigners. If 7.50% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return? a. 9.27% b. 10.00% c. 11.56% d. 12.71% e. 10.42% ANSWER: e 58. Suppose DeGraw Corporation, a U.S. exporter, sold a solar heating station to a Japanese customer at a price of 135.0 million yen, when the exchange rate was 140.0 yen per dollar. In order to close the sale, DeGraw agreed to make the bill payable in yen, thus agreeing to take some exchange rate risk for the transaction. The terms were net six months. If the yen fell against the dollar such that one dollar would buy 154.4 yen when the invoice was paid, what dollar amount would DeGraw actually receive after it exchanged yen for U.S. dollars? a. $874,352.33 b. $690,738.34 c. $935,556.99 d. $778,173.58 e. $1,049,222.80 ANSWER: a 59. Suppose the exchange rate between U.S. dollars and Swiss francs (CHF) is 1.41 CHF = $1.00, and the exchange rate between the U.S. dollar and the euro is $1.00 = 0.45 euro. What is the cross rate of Swiss francs to euros? (In other words, how many Swiss francs are needed to purchase one euro?) Do not round the intermediate calculations and round the final answer to four decimal places. a. 2.6947 b. 3.2900 c. 3.1333 d. 2.4440 e. 3.0707 ANSWER: c 60. Suppose that currently, 1 British pound equals 1.98 U.S. dollars and 1 U.S. dollar equals 1.90 Swiss francs (CHF).

How many Swiss francs are needed to purchase 1 pound? a. 3.0096 CHF b. 4.3263 CHF c. 4.2134 CHF d. 3.4610 CHF e. 3.7620 CHF ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management 61. A currency trader observes the following quotes in the spot market: 1 U.S. dollar = 1.12 Japanese yen 1 British pound = 2.25 Swiss francs 1 British pound = 1.65 U.S. dollars Given this information, how many yen can be purchased for 1 Swiss franc (CHF)? Do not round the intermediate calculations and round the final answer to four decimal places. a. 0.6817 yen b. 1.0102 yen c. 0.9445 yen d. 0.8542 yen e. 0.8213 yen ANSWER: e 62. A currency trader observes the following quotes in the spot market: 1 U.S. dollar = 10.875 Mexican pesos 1 British pound = 9.250 Danish krone 1 British pound = 1.65 U.S. dollars Given this information, how many Mexican pesos can be purchased for 1 Danish krone? a. 2.3472 b. 2.1726 c. 2.1532 d. 1.5325 e. 1.9399 ANSWER: e 63. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold for the same amount of yen today but the current exchange rate is 134 yen per dollar, what would the car be selling for today in U.S. dollars? a. $11,125 b. $10,024 c. $12,447 d. $11,015 e. $9,473 ANSWER: d 64. Suppose one year ago, Hein Company had inventory in Britain valued at 242,000 pounds. The exchange rate for dollars to pounds was 1£ = 2.00 U.S. dollars. This year the exchange rate is 1£ = 1.82 U.S. dollars. The inventory in Britain is still valued at 242,000 pounds. What is the U.S. dollar gain or loss in inventory value as a result of the change in exchange rates? a. -$43,560.00 b. -$48,787.20 c. -$47,916.00 d. -$37,461.60 Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management e. -$54,014.40 ANSWER: a 65. If the spot rate of the Israeli shekel is 5.51 shekels per dollar, and the 180-day forward rate is 5.90 shekels per dollar, then the forward rate for the Israeli shekel is selling at a(n) _______ to the spot rate. a. 7.57% premium b. 7.72% premium c. 8.07% discount d. 7.08% discount e. 5.73% discount ANSWER: d 66. Suppose one British pound can purchase 1.75 U.S. dollars today in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 12.00% against the pound over the next 30 days. How many dollars will a pound buy in 30 days? a. $1.8424 b. $1.9992 c. $2.3912 d. $1.9600 e. $2.0580 ANSWER: d 67. Stover Corporation, a U.S. based importer, makes a purchase of crystal glassware from a firm in Switzerland for 39,960 Swiss francs (CHF), or $24,000, at the spot rate of 1.665 Swiss francs per dollar. The terms of the purchase are net 90 days, and the U.S. firm wants to cover this trade payable with a forward market hedge to eliminate its exchange rate risk. Suppose the firm completes a forward hedge at the 90-day forward rate of 1.682 Swiss francs. If the spot rate in 90 days is actually 1.637 Swiss francs, how much in U.S. dollars will the U.S. firm have saved or lost by hedging its exchange rate exposure? Do not round the intermediate calculations and round the final answer to the nearest cent. a. $528.99 b. $509.40 c. $653.08 d. $535.52 e. $489.81 ANSWER: c 68. Suppose a U.S. firm buys $200,000 worth of television tubes from a Mexican manufacturer for delivery in 60 days with payment to be made in 90 days (30 days after the goods are received). The rising U.S. deficit has caused the dollar to depreciate against the peso recently. The current exchange rate is 5.56 pesos per U.S. dollar. The 90-day forward rate is 5.45 pesos/dollar. The firm goes into the forward market today and buys enough Mexican pesos at the 90-day forward rate to completely cover its trade obligation. Assume the spot rate in 90 days is 5.30 Mexican pesos per U.S. dollar. How much in U.S. dollars did the firm save by eliminating its foreign exchange currency risk with its forward market hedge? Do not round the intermediate calculations and round the final answer to the nearest cent. a. $5,197.16 b. $5,774.62 c. $6,698.56 Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management d. $7,160.53 e. $6,871.80 ANSWER: b 69. Suppose 90-day investments in Britain have a 6.00% annualized return and a 1.50% quarterly (90-day) return. In the U.S., 90-day investments of similar risk have a 4.00% annualized return and a 1.00% quarterly (90-day) return. In the 90day forward market, 1 British pound equals $2.00. If interest rate parity holds, what is the spot exchange rate ($/£)? Do not round the intermediate calculations and round the final answer to four decimal places. a. $2.0099 b. $1.8893 c. $1.5275 d. $1.5476 e. $2.2310 ANSWER: a 70. Suppose hockey skates sell in Canada for 130 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S. dollar. If purchasing power parity (PPP) holds, what is the price of hockey skates in the United States? a. $114.45 b. $83.07 c. $72.92 d. $82.15 e. $92.30 ANSWER: e 71. Suppose six months ago a Swiss investor bought a six-month U.S. Treasury bill at a price of $9,708.74, with a maturity value of $10,000.00. The exchange rate at that time was 1.310 Swiss francs (CHF) per dollar. Today, at maturity, the exchange rate is 1.324 Swiss francs per dollar. What is the annualized rate of return to the Swiss investor? Do not round the intermediate calculations and round the final answer to two decimal places. a. 7.63% b. 8.20% c. 9.68% d. 6.97% e. 6.56% ANSWER: b 72. A product sells for $750 in the United States. The spot exchange rate is $1 to 1.54 Swiss francs (CHF). If purchasing power parity (PPP) holds, what is the price of the product in Switzerland? a. 1,432.20 b. 1,247.40 c. 877.80 d. 1,155.00 e. 1,420.65 ANSWER: d 73. A box of candy costs 28.80 Swiss francs (CHF) in Switzerland and $20.40 in the United States. Assuming that Copyright Cengage Learning. Powered by Cognero.

Page 15

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management purchasing power parity (PPP) holds, how many Swiss francs are required to purchase one U.S. dollar? Do not round the intermediate calculations and round the final answer to four decimal places. a. 1.5812 CHF b. 1.1576 CHF c. 1.4118 CHF d. 1.3271 CHF e. 1.0729 CHF ANSWER: c 74. One year ago, a U.S. investor converted dollars to yen and purchased 100 shares of stock in a Japanese company at a price of 3,150 yen per share. The stock's total purchase cost was 315,000 yen. At the time of purchase, in the currency market, 1 yen equaled $0.00952. Today, the stock is selling at a price of 3,465 yen per share, and in the currency market, $1 equals 145 yen. The stock does not pay a dividend. If the investor were to sell the stock today and convert the proceeds back to dollars, what would be his realized return on his initial dollar investment from holding the stock? a. –19.09% b. –20.31% c. –17.67% d. –16.66% e. –22.75% ANSWER: b 75. Suppose in the spot market 1 U.S. dollar equals 1.5250 Canadian dollars. Six-month Canadian securities have an annualized return of 6.00% (and, thus, a six-month periodic return of 3.00%). Six-month U.S. securities have an annualized return of 6.50% and a periodic return of 3.25%. If interest rate parity holds, what is the U.S. dollar-Canadian dollar exchange rate in the 180-day forward market? In other words, how many Canadian dollars are required to purchase one U.S. dollar in the 180-day forward market? Do not round the intermediate calculations and round the final answer to four decimal places. a. 1.4452 b. 1.6430 c. 1.8560 d. 1.5213 e. 1.3540 ANSWER: d 76. Blenman Corporation, based in the United States, arranged a two-year, $1,000,000 loan to fund a project in Mexico.

The loan is denominated in Mexican pesos, carries a 6.50% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.10 pesos per dollar before the first payment came due. The loan was not hedged in the foreign exchange market. Thus, Blenman must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective annual interest rate will Blenman end up paying on the loan? Do not round the intermediate calculations and round the final answer to two decimal places. a. 15.37% b. 16.79% c. 18.91% d. 18.03% e. 17.67% Copyright Cengage Learning. Powered by Cognero.

Page 16

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management ANSWER: e 77. In comparison to domestic firms, which of the following is an additional risk factor to consider when firms operate globally? a. Net present value of potential projects b. Political risk c. WACC in capital budgeting d. Creating shareholder wealth e. Dividend payment policies ANSWER: b 78. What would cause the appreciation or depreciation in the foreign exchange value of a floating currency? a. Market forces b. Government regulations c. Shipping of goods overseas d. Production capacity of factories in foreign countries e. Management strategies differing between domestic and global enterprises ANSWER: a 79. Purchasing power parity has also been called the a. power of one price. b. law of one customer. c. law of one price. d. rule of equal price. e. rule of identical goods.

ANSWER: c 80. The equation for purchasing power parity is a. price of good in the home country = price of good in the foreign country times spot rate. b. price of good in the home country = price of good in the home country times spot rate. c. price of good in the foreign country = price of good in the home country times spot rate. d. price of good in the home country = price of good in the foreign country times current exchange rate. e. price of good in the foreign country = price of good in the home country times current exchange rate.

ANSWER: a 81. Certificates representing ownership of foreign stock held in trust are called a. Eurobonds. b. Eurocredits. c. Certificates of deposit. d. American depository receipts. e. Eurodollars.

ANSWER: d 82. The process of sending cash flows from a foreign subsidiary back to a parent company is called Copyright Cengage Learning. Powered by Cognero.

Page 17

Name:

Class:

Date:

Chapter 18 - Multinational Financial Management a. financial statement reporting. b. buying American depository receipts. c. repatriation of earnings. d. depositing foreign earnings. e. depositing subsidiary cash flows.

ANSWER: c 83. Per the text, which of the following countries or geographic areas potentially have the greatest political risk to reduce the value of a company’s investment? a. United Kingdom b. Eastern Europe c. Switzerland d. Western Europe e. United States ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 18

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management True / False 1. One objective of risk management can be to reduce the volatility of a firm's cash flows. a. True b. False ANSWER: True 2. In theory, reducing the volatility of its cash flows will always increase a company's value. a. True b. False ANSWER: False 3. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses. a. True b. False ANSWER: False 4. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses. a. True b. False ANSWER: True 5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use three-month T-bills. a. True b. False ANSWER: False Multiple Choice 6. Which of the following is an example of a derivative security? a. Bonds b. Cryptocurrencies c. Swaps d. Common stock e. Preferred stock ANSWER: c 7. The value of a stock option depends on all of the following EXCEPT: a. exercise price. b. variability of the stock price. c. length of time until option expiration.

Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management d. risk-free rate of interest. e. bond price.

ANSWER: e 8. Which of the following statements concerning risk management is CORRECT? a. Risk management can reduce the volatility of cash flows, and this increases the probability of bankruptcy. b. Risk management makes sense for firms directly engaged in activities that involve commodities whose values can be hedged, but it doesn't make much sense for most other firms. c. Companies with volatile earnings pay more taxes than companies with more stable earnings due to the treatment of tax credits and the rules governing corporate loss carry-forwards. Therefore, our tax system encourages risk management to stabilize earnings. d. Risk management can increase the likelihood of higher cash flows and, therefore, increase the probability of financial distress. e. Proper risk management by firms can virtually eliminate all risk.

ANSWER: c 9. Which of the following is a way risk management can be used to increase the value of a firm? a. Risk management can decrease debt capacity. b. Risk management can make it difficult for a firm to maintain its optimal capital budget. c. Risk management can increase the expected costs of financial distress. d. Risk management can help firms minimize taxes. e. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

ANSWER: d 10. An option that gives the holder the right to sell a stock at a specified price at some time in the future is called a(n) a. call option. b. put option. c. out-of-the-money option. d. naked option. e. covered option.

ANSWER: b 11. An option that gives the holder the right to buy a stock at a specified price at some time in the future is called a(n) a. call option. b. put option. c. out-of-the-money option. d. naked option. e. covered option.

ANSWER: a 12. A call option whose underlying stock value is less than the corresponding exercise price is an example of a(n) a. straddle option. b. put option. c. out-of-the-money option.

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management d. naked option. e. covered option.

ANSWER: c 13. An investor who "writes" a call option without the stock in their portfolio to back it up is selling a(n) a. call option. b. put option. c. out-of-the-money option. d. naked option. e. covered option.

ANSWER: d 14. An investor who "writes" a call option against stock held in their portfolio is selling a(n) a. straddle option. b. put option. c. out-of-the-money option. d. naked option. e. covered option.

ANSWER: e 15. Deeble Construction Co.'s stock is trading at $30 a share. There are also call options on the company's stock, some with an exercise price of $25 and some with an exercise price of $35. All options expire in three months. Which of the following best describes the value of these options? a. If Deeble's stock price rose by $5, the exercise value of the options with the $25 exercise price would also increase by $5. b. The options with the $25 exercise price will sell for less than the options with the $35 exercise price. c. The options with the $25 exercise price have an exercise value greater than $5. d. The options with the $35 exercise price have an exercise value greater than $0. e. The options with the $25 exercise price will sell for $5.

ANSWER: a 16. Which of the following statements is most CORRECT? a. One advantage of forward contracts is that they are default-free. b. Futures contracts generally trade on an organized exchange and are marked to market daily. c. Goods are never delivered under forward contracts but are almost always delivered under futures contracts. d. Forward contracts are generally standardized instruments, whereas futures contracts are generally tailor-made for the two parties of the contract. e. Essentially there are no differences between forward and futures contracts, except that forward contracts are used only for financial assets while futures contracts are used only for commodities.

ANSWER: b 17. Which of the following statements regarding the background of derivatives is CORRECT? a. The appearance of speculators in the futures market increases risk. b. Natural hedges occur when two parties in the same industry enter into a derivative transaction.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management c. One of the first formal markets for derivatives involved futures markets for corn. d. The derivatives market has grown more rapidly than any other market in recent years. e. Nonsymmetric hedges can eliminate risk.

ANSWER: d 18. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates? a. Buying inverse floaters b. Entering into an interest rate swap where the bank receives a fixed payment stream and, in return, agrees to make payments that float with market interest rates c. Purchase principal-only (PO) strips that decline in value whenever interest rates rise. d. Enter into a short hedge where the bank agrees to sell interest rate futures. e. Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans.

ANSWER: d 19. Which of the following statements is CORRECT? a. Put options give investors the right to buy a stock at a certain exercise price before a specified date. b. Call options give investors the right to sell a stock at a certain exercise price before a specified date. c. Options typically sell for less than their exercise value. d. LEAPS are very short-term options that have begun trading on the exchanges in recent years. e. Option holders are not entitled to receive dividends unless they choose to exercise their option.

ANSWER: e 20. There are call options on the common stock of XYZ Corporation. Which of the following best describes the factors that affect call option values? a. The price of call options will rise if XYZ's stock price rises. b. The higher the strike price, the higher the call option price. c. Assuming the same strike price, a call option that expires in one month will sell for a higher price than one that expires in three months. d. The less volatile a stock's price, the more valuable a call option on the stock is. e. If the risk-free rate of interest increases, the value of call options will decrease.

ANSWER: a 21. Which of the following events is likely to decrease the value of call options on the common stock of GCC Company? a. An increase in GCC's stock price b. An increase in the exercise price of the option c. An increase in the amount of time until the option expires d. An increase in the risk-free rate e. GCC's stock price becomes more risky (higher variance) ANSWER: b 22. Which of the following statements regarding factors that affect call option prices is CORRECT? a. The longer the time until the call option expires, the smaller its value and the smaller its premium. b. An option on an extremely volatile stock is worth less than one on a very stable stock.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management c. The price of a call option increases as the risk-free rate increases. d. Two call options on the same stock will have the same value even if they have different strike prices. e. If you observe that a put option on a stock increases in value, then a call option on that same stock also increases in value.

ANSWER: c 23. Which of the following statements is CORRECT? a. An option's value is determined by its exercise value, which is the market price of the stock less its strike price. Thus, an option can't sell for more than its exercise value. b. As a stock's price increases, the premium portion of an option on that stock increases because the difference between the stock price and the fixed strike price increases. c. If the company is consistently profitable, its call options will always be in the money. d. The market value of an option depends in part on the option's length of time until expiration and on the variability of the underlying stock's price. e. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin becomes larger.

ANSWER: d 24. Warnes Motors' stock is trading at $20 a share. Three-month call options with an exercise price of $20 have a price of $1.50. Which of the following will occur if the stock price increases 10% to $22 a share? a. The price of the call option will increase by $2. b. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%. c. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%. d. The price of the call option will increase by more than $2. e. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.

ANSWER: b 25. A riskless hedge can best be defined as a. a situation in which aggregate risk can be reduced by derivatives transactions between two parties. b. a hedge in which an investor buys a stock and simultaneously sells a call option on that stock and ends up with a riskless position. c. standardized contracts that are traded on exchanges and are "marked to market" daily, but where physical delivery of the underlying asset is virtually never taken. d. two parties agree to exchange obligations to make specified payment streams. e. simultaneously buying and selling a call option with the same exercise price.

ANSWER: b 26. Which of the options trading sites is the oldest and the largest? a. Chicago Board of Trade b. NASDAQ c. New York Stock Exchange d. Chicago Mercantile Exchange Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management e. Chicago Board Options Exchange (CBOE) ANSWER: e 27. Which of the following exchange-traded options are tied to individual stocks and stock indexes? a. Future contracts b. Naked options c. Long-term equity anticipation securities (LEAPS) d. Stock options e. Binomial options ANSWER: c 28. Which of the following statements is CORRECT regarding the value of a call option? a. The lower the stock’s market price in relation to its strike price, the higher the call option price. b. Options prices increase as the expiration date is lengthened. c. The shorter the option period, the higher the option price. d. The higher the stock price, the higher the call option price. e. The lower the stock price, the lower the call option price.

ANSWER: b 29. Futures contracts that are sold to guard against price declines are called a. swaps. b. speculative hedges. c. long hedges. d. short hedges. e. perfect hedges.

ANSWER: d 30. A debt obligation derived from another debt obligation is called a(n) a. structured note. b. riskless hedge. c. inverse floater. d. currency swap. e. natural hedge.

ANSWER: a 31. A note in which the interest rate paid moves counter to market rates is called a(n) a. perfect hedge. b. long hedge. c. structured note. d. reverse floater. e. inverse floater.

ANSWER: e 32. In regard to risk management, liability risks refer to Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management a. risks that a company will have more liabilities than it can pay in the long term. b. risks that a company will have excess liabilities on their balance sheet. c. risks associated with destruction of productive assets. d. risks associated with product, service, or employee actions. e. risks associated with financial transactions.

ANSWER: d 33. A 6-month call option on Romer Technologies' stock has a strike price of $44.00 and sells in the market for $8.25.

Romer's current stock price is $48.00. What is the exercise value of the option? Do not round your intermediate calculations. a. $4.00 b. $3.52 c. $3.64 d. $3.12 e. $3.88 ANSWER: a 34. A 6-month call option on Meyers Inc.'s stock has a strike price of $47.00 and sells in the market for $8.00. Meyers' current stock price is $49.00. What is the option premium? Do not round your intermediate calculations. a. $5.10 b. $5.28 c. $6.00 d. $6.54 e. $5.34 ANSWER: c 35. A 6-month put option on Makler Corp.'s stock has a strike price of $49.00 and sells in the market for $8.50. Makler's current stock price is $40.00. What is the exercise value of the option? Do not round your intermediate calculations. a. $8.73 b. $9.54 c. $10.98 d. $8.01 e. $9.00 ANSWER: e 36. A 6-month put option on Smith Corp.'s stock has a strike price of $44.00 and sells in the market for $8.00. Smith's current stock price is $43.00. What is the option premium? Do not round your intermediate calculations. a. $8.61 b. $7.00 c. $6.02 d. $5.81 e. $5.46 ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management 37. Looking at The Wall Street Journal, you observe that the settlement price on a hypothetical 8-year, semiannual payment, 7% coupon Treasury note is 105-210. If the note has a $1,000 par value, what is the implied Treasury note rate? Do not round your intermediate calculations. a. 6.10% b. 6.04% c. 6.64% d. 4.94% e. 4.57% ANSWER: a 38. Lissa Co.'s stock price is currently $31.25. A 6-month call option on Lissa's stock has a strike price of $25.25 and has an expected volatility of 40% (i.e., expected standard deviation = 40%). The risk-free rate is 6%. According to the BlackScholes option pricing model, what is the value of the option? Do not round your intermediate calculations. a. $5.99 b. $5.69 c. $8.27 d. $7.59 e. $7.81 ANSWER: d 39. Suppose a hypothetical CBOT 8-year U.S., semiannual payment, 6% coupon Treasury note futures contract has a quoted price of 89-090. If the note has a $1,000 par value, what is the implied annual interest rate inherent in this futures contract? Do not round your intermediate calculations. a. 6.34% b. 9.79% c. 7.83% d. 7.12% e. 9.32% ANSWER: c 40. Suppose a hypothetical CBOT 7-year U.S., semiannual payment, 6% coupon Treasury note futures contract has a quoted price of 103-180. If the note has a $1,000 par value, what is the implied annual interest rate inherent in the futures contract? Do not round your intermediate calculations. a. 4.31% b. 6.46% c. 5.01% d. 5.38% e. 6.19% ANSWER: d 41. Suppose a hypothetical CBOT 12-year U.S., semiannual payment, 7% coupon Treasury note futures contract has a quoted price of 103-180. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 19 - Derivatives and Risk Management contract? (Assume a $1,000 par value, round the new interest rate to 4 decimal places when written as a decimal, and round the change in price up to the nearest whole dollar.) Do not round other intermediate calculations. a. −$76 b. −$72 c. −$100 d. −$88 e. −$80 ANSWER: e 42. Suppose a hypothetical CBOT 7-year U.S., semiannual payment, 6% coupon Treasury note futures contract has a quoted price of 88-300. If annual interest rates go down by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, round the new interest rate to 4 decimal places when written as a decimal, and round the change in price up to the nearest whole dollar.) Do not round other intermediate calculations. a. $43 b. $56 c. $51 d. $61 e. $59 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 1. The "preferred" feature of preferred stock means that it will normally provide a higher expected return than will common stock. a. True b. False ANSWER: False 2. Unlike with bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible. a. True b. False ANSWER: True 3. Operating leases with payment terms of 12 months or less would show no asset or liability on the balance sheet; however, the lease expense would be shown as an operating expense on the income statement. a. True b. False ANSWER: True 4. Accounting Standards Codification Topic 842 (ASC 842) eliminates off-balance-sheet leases except for operating leases with payment terms of 12 months or less. a. True b. False ANSWER: True 5. Accounting Standards Codification Topic 842 (ASC 842) classifies leases as either finance or operating leases. A lease is a finance lease if it meets any of five criteria listed in ASC 842. If the lease does not meet any of the five criteria, then the lease is classified as an operating lease. One of the five criteria is that the lease transfers ownership of the asset to the lessee by the end of the lease term. a. True b. False ANSWER: True 6. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False ANSWER: True 7. Historically, leasing was often referred to as off-balance-sheet financing because lease payments were shown as operating expenses on a firm's income statement, but leased assets and associated liabilities did not appear on the firm's balance sheet under certain conditions. a. True b. False ANSWER: True 8. Because the cash flows under both the lease and the borrow-and-purchase alternative are risky, they should be Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles discounted at a relatively high rate. Most analysts recommend using the company's weighted average cost of capital (WACC). a. True b. False ANSWER: False 9. A warrant is an option, and as such it cannot be used as a "sweetener." a. True b. False ANSWER: False 10. A warrant holder is not entitled to vote, but they do receive any cash dividends paid on the underlying stock. a. True b. False ANSWER: False 11. The sale of call options cannot give rise to the problem of dilution of stockholders' earnings, but the use of warrants can. a. True b. False ANSWER: True 12. A detachable warrant is a warrant that can be removed from the security with which it was issued and traded separately from it. Most traded warrants are originally attached to bonds or preferred stocks. a. True b. False ANSWER: True 13. The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False ANSWER: True 14. A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False ANSWER: False 15. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. a. True b. False ANSWER: True 16. Firms generally do not call their convertibles unless the conversion value is greater than the call price.

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles a. True b. False ANSWER: True 17. Preferred stock normally has no voting rights. However, most preferred issues stipulate that the preferred stockholders can elect a minority number of the directors if the preferred dividend is omitted. a. True b. False ANSWER: True 18. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy. a. True b. False ANSWER: False 19. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders. a. True b. False ANSWER: True 20. Preferred stock can provide a financing alternative for some firms when market conditions are such that the firms cannot issue either pure debt or common stock at any reasonable cost. a. True b. False ANSWER: True 21. Corporations that invest surplus funds in floating-rate preferred stock benefit from a relatively stable price and from the 50% tax exemption on preferred dividends received. a. True b. False ANSWER: True 22. Leasing is typically a financing decision rather than a capital budgeting decision. The decision to acquire the asset is a "done deal" before the lease analysis begins. Therefore, in a lease analysis, we are concerned simply with whether to finance the asset with a lease or with a loan. a. True b. False ANSWER: True 23. Assume that a piece of leased equipment has a relatively high expected residual value. From the lessee's viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles a. True b. False ANSWER: False 24. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee's a. equity cash flows. b. capital budgeting project cash flows. c. debt cash flows. d. pension fund cash flows. e. sales.

ANSWER: c 25. Which of the following statements is CORRECT? a. Preferred stock generally has a higher component cost of capital to the firm than does common stock. b. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm's common stock. c. From the issuer's point of view, preferred stock is less risky than bonds. d. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less. e. Unlike bonds, preferred stock cannot have a convertible feature.

ANSWER: c 26. Which of the following is CORRECT? a. If firms were to keep their leases off the balance sheet, their debt ratios would be higher than if the effects of their leases were reflected in their financial statements. b. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation. c. Accounting Standards Codification Topic 842 (ACS 842) requires that all leases must be reflected on the balance sheet, even operating leases with payment terms of 12 months or less. d. The lessee is the owner of the leased property, while the lessor is the party that uses the leased property. e. When a lease is "capitalized," the lease is reported on the firm's balance sheet. A "right-to-use" asset and a liability are recorded on the balance sheet equal to the present value of the lease payments.

ANSWER: e 27. Accounting Standards Codification Topic 842 (also known as ASC 842) requires that for an unqualified audit report, except for operating leases with terms of 12 months or less, all other leases must be included on the balance sheet by reporting the a. residual value as a fixed asset. b. residual value as a liability. c. present value of future lease payments as a "right-to-use" asset and showing this same amount as an offsetting liability. d. undiscounted sum of future lease payments as an asset and as an offsetting liability. e. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.

ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 28. When firms kept leases off their balance sheets, it tended to a. make the firms appear riskier than they actually were because their stated debt ratios were increased. b. make the firms appear less risky than they actually were because their stated debt ratios appeared to be lower. c. affect the firms' cash flows but not their degree of risk. d. have no effect on either cash flows or risk because the cash flows were already reflected in the income statement. e. affect the lessee's cash flows but only due to tax effects.

ANSWER: b 29. Which of the following statements about convertibles is CORRECT? a. The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt. b. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted. c. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt. d. At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price. e. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.

ANSWER: e 30. Which of the following statements is correct? a. Accounting Standards Codification Topic 842 (ASC 842) eliminates off-balance-sheet leases, so all operating and finance leases must be reported on the balance sheet. Thus, a lessee firm will report a “right-to-use” asset and a liability on its balance sheet equal to the present value of the lease payments. b. The discount rate used to determine the present value of the lease payments recorded on the balance sheet is the firm’s weighted average cost of capital (WACC) because the risk of a lease is similar to that of the firm’s average capital budgeting project. c. Under Accounting Standards Codification Topic 842 (ASC 842), there are three different lease classifications: finance leases, operating leases, and residual leases. d. A lessee with a finance lease will report both interest and amortization expenses on the income statement. The amortization expense would be considered an operating expense (similar to the treatment of depreciation), while the interest expense is a financing expense and shown below operating income on the income statement.

As a result of this treatment, lessees with finance leases will report higher earnings before interest, taxes, and depreciation and amortization (EBITDAs) than lessees with operating leases. e. The economic effects of buying or leasing an asset are not similar, and as a result the accounting treatment of the two (as shown on a firm’s financial statements) are quite different.

ANSWER: d 31. Which of the following statements is correct? a. The intent of the new leasing guidance (Accounting Standards Codification Topic 842 or ASC 842) is to consider the form of the lease transaction rather than its substance. b. The reporting changes required under ASC 842 will impact how leases are treated for U.S. federal income tax purposes.

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles c. Under ASC 842, a lessee with an operating lease with payment terms greater than 12 months must “capitalize” the lease and report it on the firm’s balance sheet. As a result, the lessee firm will report a “right-to-use” asset and a liability on its balance sheet equal to the present value of the lease payments. In addition, the lessee firm will report annual lease payments as a lease expense (an operating expense) on the income statement. d. Under ASC 842, there are four criteria that must be met to classify a lease as an operating lease. If just one of these criteria is not met, then the lease is classified as a finance lease. If the lease is classified as a finance lease, it remains off the balance sheet, and only the lease expense would be shown as an operating expense on the income statement. e. As a result of the new guidance under ASC 842, lessees with operating leases will report higher earnings before interest, taxes, depreciation, and amortization (EBITDAs) than lessees with finance leases.

ANSWER: c 32. Which of the following statements concerning warrants is CORRECT? a. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants are used but remains the same if convertibles are used. b. Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops. c. Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen. d. A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders. e. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.

ANSWER: c 33. Which of the following statements is CORRECT? a. Warrants have an option feature, but convertibles do not. b. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds. c. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt, even though investing in convertibles is riskier than investing in straight debt. d. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant. e. Warrants can sometimes be detached and traded separately from the security with which they were issued, but this is unusual.

ANSWER: c 34. Which of the following statements is CORRECT regarding preferred stock? a. From the standpoint of corporations, preferred stock is riskier than bonds. b. From an investor’s viewpoint, preferred stock is considered riskier than bonds. c. Preferred stock has voting rights just like common stock. d. Nonpayment of preferred dividends can force a company into bankruptcy. e. If preferred shareholders do not get their dividends, they can sue the company for payment.

ANSWER: b Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 35. The party that uses leased property instead of owning it is the a. lessee. b. buyer. c. lessor. d. landlord. e. investor.

ANSWER: a 36. The source of ASC 842 that provides guidance on leases is the a. SEC. b. IRS. c. FASB. d. Sarbanes-Oxley Act. e. NYSE. ANSWER: c 37. Which of the following statements is CORRECT regarding the estimated residual value of leased property? a. A large residual value on leased property means the lessor will own the property at the end of the lease. b. Large residual values on leased property will bias the decision against leasing. c. If the estimated residual value of leased property is expected to be large, it is better to own than to lease. d. Leases cannot occur with a zero residual value at the end of the lease. e. If the estimated residual value of leased property is expected to be large, it is better to lease than to own.

ANSWER: e 38. If bonds are sold with warrants, the initial market price of the bond will be equal to the a. straight-debt value of the bond less the value of the warrants. b. straight-debt value of the bond plus the value of the warrants. c. straight-debt value of the bond times the value of the warrants. d. coupon payment of the bond plus the value of the warrants. e. coupon payment of the bond less the value of the warrants.

ANSWER: b 39. Orient Airlines' common stock currently sells for $32, and its 9.0% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 23 shares of common stock at any time before 2028. What is the conversion value of the bond? Do not round your intermediate calculations. a. $699.20 b. $625.60 c. $772.80 d. $736.00 e. $662.40 ANSWER: d 40. Chocolate Factory's convertible debentures were issued at their $1,000.00 par value in 2024. At any time prior to maturity on February 1, 2044, a debenture holder can exchange a bond for 27 shares of common stock. What is the Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles conversion price of the common stock, Pc? Do not round your intermediate calculations. a. $37.04 b. $46.30 c. $38.89 d. $29.63 e. $31.48 ANSWER: a 41. Moniker Manufacturing's bonds were recently issued at their $1,000 par value. At any time prior to maturity (20 years from now), a bondholder can exchange a bond for a share of common stock at a conversion price of $50. What is the conversion ratio? Do not round your intermediate calculations. a. 21.00 b. 19.00 c. 20.00 d. 24.00 e. 25.00 ANSWER: c 42. Sutton Corporation, which has a zero tax rate due to tax loss carry-forwards, is considering a 5-year, $6,500,000 bank loan to finance service equipment. The loan has an interest rate of 10.8% and would be amortized over 5 years, with 5 end-of-year payments. Sutton can also lease the equipment for 5 end-of-year payments of $1,740,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment. Do not round your intermediate calculations. a. -$10,854 b. -$11,841 c. -$9,867 d. -$10,361 e. -$7,401 ANSWER: c 43. Ballentine Inc., which has a zero tax rate due to tax loss carry-forwards, is considering a 6-year, $5,100,000 bank loan in order to buy a new piece of equipment. The loan will be amortized over 6 years with end-of-year payments and has an interest rate of 9.9%. Alternatively, Ballentine can also lease the equipment for an end-of-year payment of $1,300,000. By how much does the lease payment exceed the loan payment? Do not round your intermediate calculations. a. $165,540 b. $99,324 c. $125,810 d. $152,297 e. $132,432 ANSWER: e 44. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools are eligible for 100% bonus depreciation, so they will be fully depreciated at the time of purchase. The tools will be obsolete and worthless after 3 years. The firm can borrow $4,800,000, the after-tax cost of the manufacturing tools, at 9.8% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,200,000 each and lease them.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles The loan obtained from the bank is a 3-year loan, amortized in 3 equal installments at the end of each year. The firm's tax rate is 25%. Annual maintenance costs associated with ownership are estimated at $240,000 payable at the end of the year, but this cost would be borne by the lessor if the equipment were leased. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) Do not round your intermediate calculations. a. $773 b. $967 c. $870 d. $1,208 e. $1,160 ANSWER: b 45. Warren Corporation's stock sells for $37.00 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond would have 90 warrants attached to it, each exercisable into one share of stock at an exercise price of $53.00. The firm's straight bonds yield 11.2%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $37.00. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par? Do not round your intermediate calculations. a. 8.02% b. 8.91% c. 7.13% d. 8.46% e. 9.36% ANSWER: b 46. Curry Corporation is setting the terms on a new issue of bonds with warrants. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 18 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $13.80. A similar straightdebt issue would require a 9.6% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000? Do not round your intermediate calculations. a. 6.35% b. 5.99% c. 7.41% d. 7.05% e. 5.29% ANSWER: d 47. Upstate Water Company just sold a bond with 52 warrants attached. The bonds have a 20-year maturity and an annual coupon of 11.6%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 14%. What is the implied value of each warrant? Do not round your intermediate calculations. a. $3.06 b. $3.82 c. $2.45 d. $3.36 e. $2.75 ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 48. Curran Contracting is issuing new 25-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry an 11.8% annual interest rate. However, with the warrants attached, the bonds will pay a 9.0% annual coupon. There are 32 warrants attached to each bond, which have a par value of $1,000. What is the implied value of each warrant? Do not round your intermediate calculations. a. $8.70 b. $6.96 c. $8.35 d. $8.00 e. $5.57 ANSWER: b 49. Herbert Engineering is issuing new 20-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry an 11.4% annual interest rate. However, with the warrants attached the bonds will pay a 7.0% annual coupon. There are 30 warrants attached to each bond, which has a par value of $1,000. What is the value of the straightdebt portion of the bonds? Do not round your intermediate calculations. a. $592.73 b. $658.58 c. $493.94 d. $823.23 e. $526.87 ANSWER: b 50. Thomson Engineering is issuing new 22-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry an 11.7% annual interest rate. However, with the warrants attached the bonds will pay an 8.0% annual coupon. There are 30 warrants attached to each bond, which have a par value of $1,000. What is the value of the straightdebt portion of the bonds? Do not round your intermediate calculations. a. $889.36 b. $640.34 c. $818.21 d. $711.48 e. $569.19 ANSWER: d 51. Herring Inc. is considering issuing 17-year, 9.0% semiannual coupon, $1,000 face value convertible bonds at a price of $1,000 each. Each bond would be convertible into 25 shares of common stock. If the bonds were not convertible, investors would require an annual nominal yield of 11.8%. What is the straight-debt value of each bond at the time of issue? Do not round your intermediate calculations. a. $915.98 b. $756.68 c. $597.38 d. $796.50 e. $836.33 ANSWER: d 52. Cannon Manufacturing is considering issuing 15-year, 7.2% annual coupon, $1,000 face value convertible bonds at a price of $1,000 each. Each bond would be convertible into 30 shares of common stock. If the bonds were not convertible, Copyright Cengage Learning. Powered by Cognero.

Page 10

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles investors would require an annual yield of 11.8%. The stock's current price is $30.00, its expected dividend is $3.54, and its expected growth rate is 5.9%. The bonds are noncallable for 10 years. What is the bond's conversion value in Year 5? Do not round your intermediate calculations. a. $1,438.48 b. $1,498.42 c. $1,198.73 d. $1,258.67 e. $899.05 ANSWER: c 53. Ellis Enterprises is considering whether to lease or buy some necessary equipment it needs for a project that will last the next 3 years. The equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at the time of purchase. If the firm buys the equipment, it will borrow $5,100,000, the after-tax cost of the equipment, at 8.0% interest.

The firm's tax rate is 25%, and the firm's before-tax cost of debt is 8.0%. Annual maintenance costs associated with ownership are estimated to be $340,000. What is the annual end-of-year lease payment (in thousands of dollars) for a 3year lease that would make the firm indifferent between buying or leasing the equipment? (Suggestion: Delete 3 zeros from dollars and work in thousands.) Do not round your intermediate calculations. a. $2,596 b. $2,163 c. $2,884 d. $3,461 e. $3,317 ANSWER: c 54. Carolina Trucking Company (CTC) is evaluating a potential lease for a truck with a 4-year life with an after-tax cost of $32,000. The truck is eligible for 100% bonus depreciation, so it will be fully depreciated at the time of purchase. If the firm borrows and buys the truck, the loan rate would be 9.6%, and the loan would be amortized over the truck's 4-year life. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which it will be sold at an estimated residual value of $13,400. If CTC buys the truck, it would purchase a maintenance contract that costs $2,500 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. CTC's tax rate is 25%. What is the net advantage to leasing (NAL)? Do not round your intermediate calculations. a. $7,577 b. $6,856 c. $6,134 d. $7,216 e. $8,660 ANSWER: d 55. Bev's Beverages is negotiating a lease on a new piece of equipment with an after-tax cost of $74,000 if purchased. The equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at the time of purchase. The equipment will be used for 3 years and then sold because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $25,000. A maintenance contract on the equipment would cost $2,600 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $18,400 per year, payable at the beginning of each year. The lease would include maintenance. The firm's tax rate is 20%, and it could obtain a loan amortized over 3 years for the after-tax cost of the equipment at a before-tax cost of 8.8%. If there is a positive net advantage to leasing (NAL), then the firm will lease the equipment. Otherwise, the firm will buy it. What is Copyright Cengage Learning. Powered by Cognero.

Page 11

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles the NAL? Do not round your intermediate calculations. a. $22,212 b. $18,880 c. $25,543 d. $16,659 e. $19,990 ANSWER: a 56. Emerson Electrical Engineering Inc. is issuing new 20-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry a 12.0% interest rate. However, with the warrants attached, the bonds will pay a 9.0% annual coupon. There are 24 warrants attached to each bond, which have a par value of $1,000. The exercise price of the warrants is $30.00, and the expected stock price 10 years from now (when the warrants may be exercised) is $55.17. What is the investor's expected overall pre-tax rate of return for this bond-with-warrants issue? Do not round your intermediate calculations. a. 9.89% b. 9.30% c. 11.63% d. 14.54% e. 13.96% ANSWER: c 57. Atlas Anglers Inc. is considering issuing a 17-year convertible bond that will be priced at its $1,000 par value. The bonds have a 7.3% annual coupon rate, and each bond can be converted into 25 shares of common stock. The stock currently sells at $35.00 a share, has an expected dividend in the coming year of $3.50, and has an expected constant growth rate of 5.5%. What is the estimated floor price of the convertible at the end of Year 3 if the required rate of return on a similar straight-debt issue is 8.0%? Do not round your intermediate calculations. a. $1,027.46 b. $1,284.33 c. $1,181.58 d. $924.72 e. $873.34 ANSWER: a 58. Valdes Enterprises is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have a 7.8% annual coupon, and each bond could be converted into 33 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.5%. The stock currently sells for $38.00 a share, has an expected dividend in the coming year of $3.00, and has an expected constant growth rate of 6.4%. What is the estimated floor price of the convertible at the end of Year 4? Do not round your intermediate calculations. a. $1,928.61 b. $1,366.10 c. $2,008.97 d. $1,607.18 e. $1,767.90 ANSWER: d 59. Quaid Co.'s common stock sells for $33.00, pays a dividend of $2.20, and has an expected long-term growth rate of Copyright Cengage Learning. Powered by Cognero.

Page 12

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 7.0%. The firm's straight-debt bonds yield an 11.00% return. Quaid is planning a convertible bond issue. The bonds will have a 20-year maturity, pay a 9.00% annual coupon, have a par value of $1,000, and a conversion ratio of 25 shares per bond. The bonds will sell for $1,000 and will be callable after 10 years. Assuming that the bonds will be converted at Year 10, when they become callable, what will be the expected return on the convertible when it is issued? Do not round your intermediate calculations. a. 14.34% b. 14.96% c. 12.47% d. 11.85% e. 9.35% ANSWER: c Multiple Part: The next 4 problems must be kept together; all use the data in Exhibit 20.1.

Exhibit 20.1 The following data apply to Saunders Corporation's convertible bonds: Years to maturity 14 Stock price Par value $1,000 Conversion price Annual coupon 6.70% Straight-debt yield

$33.00 $41.00 12.00%

60. Refer to Exhibit 20.1. What is the bond's conversion ratio? a. 28.05 b. 24.39 c. 25.61 d. 23.17 e. 26.83 ANSWER: b 61. Refer to Exhibit 20.1. What is the bond's initial conversion value when issued? a. $724.39 b. $643.90 c. $845.12 d. $965.85 e. $804.88 ANSWER: e 62. Refer to Exhibit 20.1. What is the bond's straight-debt value at the time of issue? a. $681.14 b. $778.45 c. $616.27 d. $648.71 e. $518.97 ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 13

Name:

Class:

Date:

Chapter 20 - Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 63. Refer to Exhibit 20.1. What is the minimum price (or "floor" price) at which the Saunders' bonds should sell? a. $648.71 b. $925.61 c. $643.90 d. $845.12 e. $804.88 ANSWER: e

Copyright Cengage Learning. Powered by Cognero.

Page 14

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions True / False 1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values. a. True b. False ANSWER: True 2. Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency. a. True b. False ANSWER: True 3. Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth. a. True b. False ANSWER: False 4. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine. a. True b. False ANSWER: False 5. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price. a. True b. False ANSWER: False 6. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy. a. True b. False ANSWER: True 7. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in the terms of merger agreements. a. True b. False ANSWER: True 8. Since the primary rationale for any operating merger is synergy, in planning such mergers the development of accurate pro forma cash flows is the single most important task. a. True b. False Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions ANSWER: True 9. Borrowing funds on terms that would require immediate repayment of all loans if the firm is acquired, selling off at bargain prices the assets that originally made the firm a desirable target, and granting huge "golden parachutes" that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as "poison pills." a. True b. False ANSWER: True 10. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources to achieve a specific objective, usually limited in scope. a. True b. False ANSWER: True 11. Leveraged buyouts (LBOs) occur when a firm's managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying shares in the company using large amounts of borrowed money. a. True b. False ANSWER: True 12. A spin-off is a type of divestiture in which the assets of a division are sold to another firm. a. True b. False ANSWER: False 13. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers. a. True b. False ANSWER: True 14. The primary reason given by managers for most mergers is the acquisition of more assets to increase sales and market share. a. True b. False ANSWER: False 15. Since managers' central goal is to maximize stock price, managers' personal incentives do not interfere with mergers that would benefit the target firm's stockholders. a. True b. False ANSWER: False 16. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions a. True b. False ANSWER: True 17. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship. a. True b. False ANSWER: True 18. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive. a. True b. False ANSWER: True 19. Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team. a. True b. False ANSWER: False 20. Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified. a. True b. False ANSWER: True 21. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain, and the discount rate can only be determined after the merger is consummated. a. True b. False ANSWER: False 22. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently. a. True b. False ANSWER: True 23. The rate used to discount projected merger cash flows should be the overall cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm. a. True b. False ANSWER: False Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions 24. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger. a. True b. False ANSWER: False 25. The value of the target firm is calculated by discounting residual cash flows that belong to the acquiring firm's shareholders at the target's cost of equity, reflecting any changes to its capital structure resulting from the merger. a. True b. False ANSWER: True Multiple Choice 26. Which of the following types of mergers is designed to make a company less vulnerable to a takeover? a. Synergistic merger b. Defensive merger c. Diversification merger d. Management proposed merger e. Breakup value merger ANSWER: b 27. Purchasing stock for a corporate raider under a guaranteed buy-back agreement is called a. finding a white squire. b. issuing a golden parachute. c. seeking a white knight. d. setting up a poison pill. e. parking stock.

ANSWER: e 28. Pro forma financial statements that show incremental cash flows and the cost of capital to project all future cash flows are both needed to analyze a proposed merger under the a. bid price method. b. market multiple analysis. c. equity residual method. d. discounted cash flow analysis. e. pro forma cash flow method.

ANSWER: d 29. Which of the following statements is most CORRECT? a. A conglomerate merger is one where a firm combines with another firm in the same industry. b. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm. c. Defensive mergers are designed to make a company less vulnerable to a takeover.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions d. The equity residual method values a target firm by discounting residual cash flows at the acquiring firm's overall cost of capital, reflecting the combined firm's post-merger capital structure. e. A financial merger occurs when the operations of the firms involved are integrated in the hope of achieving synergistic benefits.

ANSWER: c 30. Which of the following statements is most CORRECT? a. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers. b. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed. c. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger. d. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, research of U.S. firms suggests that, in most cases, diversification through mergers does not increase the firm's value. e. Research of U.S. firms suggests that managers' personal motivations have had little, if any, impact on firms' decisions to merge.

ANSWER: d 31. Which of the following statements is most CORRECT? a. The high value of the U.S. dollar relative to Japanese and European currencies in the 1980s made U.S. companies comparatively inexpensive to foreign buyers, spurring many mergers. b. During the 1980s, the Reagan and Bush administrations tried to foster greater competition, and they were adamant about preventing the loss of competition; thus, most large mergers were disallowed. c. The expansion of the junk bond market made debt more freely available for large acquisitions and LBOs in the 1980s, and, thus, it resulted in an increased level of merger activity. d. Increased nationalization of business and a desire to scale down and focus on producing in one's home country have virtually halted cross-border mergers today. e. Because strategic alliances and joint ventures are easy to form and enable firms to compete better in the global economy than would mergers, merger activity has virtually come to a halt in the 21st century.

ANSWER: c 32. Which of the following statements is most CORRECT? a. The acquiring firm's required rate of return in most horizontal mergers will not be affected because the two firms will have similar betas. b. The goal of merger valuation is to value the target firm's total capital at the target firm's weighted average cost of capital because a firm is acquired from all of its investors—both shareholders and creditors. c. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis. d. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms. e. The primary rationale for most operating mergers is synergy.

ANSWER: e Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions 33. Which of the following statements is most CORRECT? a. Leveraged buyouts (LBOs) occur when a firm issues equity and uses the proceeds to take a firm public. b. In a typical LBO, bondholders do well but shareholders see their value decline. c. Firms are forbidden by law to sell any assets during the first five years following a leveraged buyout. d. Not all target firms are acquired by publicly traded corporations. In recent years, an increasing number of firms have been acquired by private equity firms. Private equity firms raise capital from wealthy individuals and look for opportunities to make profitable investments. e. In an LBO, sometimes the acquiring group plans to run the acquired company for a number of years, boost its sales and profits, and then take it public again as a stronger company. In other instances, the LBO firm plans to sell off divisions to other firms that can gain synergies. In either case, the acquiring group expects to make a substantial profit from the LBO, but the inherent risks are small due to the heavy use of venture capital and very little debt.

ANSWER: d 34. Which of the following statements is most CORRECT? a. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger. b. A defensive merger is one where the firm's managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover. c. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition. d. In a liquidation, the firm's existing stockholders are given new stock representing separate ownership rights in the division that was divested. The division establishes its own board of directors and officers, and it becomes a separate company. e. If there are no synergistic benefits to be gained from a merger, the acquiring company will stop its plans for the merger. However, if synergistic gains are large, plans for the merger will continue. In fact, the greater the synergistic gains, the smaller the gap between the target's current price and the maximum the acquiring company could pay because of the acquiring company's upper hand in the merger.

ANSWER: b 35. Studies have found that diversified firms are worth __________ the sum of their individual parts. a. the same as b. more than c. twice as much as d. less than e. ten times more than ANSWER: d 36. Typically, the larger the company, a. the higher the salaries of its top officers. b. the lower the salaries of its top officers. c. there is no difference in the salaries of its top officers. d. the more investment the top officers have in the company. e. the less investment the top officers have in the company.

ANSWER: a Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions 37. When a merger occurs between companies in the same industry and no customer or supplier relationship exists, it is known as a a. hostile takeover. b. conglomerate merger. c. congeneric merger. d. vertical merger. e. horizontal merger.

ANSWER: c 38. Compared to previous years, most recent mergers take place to a. eliminate competition. b. execute leveraged buyouts. c. offer top officers a golden parachute. d. gain economies of scale or scope. e. consolidate industries.

ANSWER: d 39. Junk bonds are best defined as bonds a. below investment grade of BBB/Baa. b. that pay very low interest rates. c. issued by small unknown companies. d. that usually default. e. that have less than a one-year duration.

ANSWER: a 40. Which of the following types of mergers occur between companies in totally different industries? a. Horizontal mergers b. Vertical mergers c. Congeneric mergers d. Hostile takeovers e. Conglomerate mergers ANSWER: e 41. Which type of merger is most likely to be considered anticompetitive by the Department of Justice? a. Vertical mergers b. Congeneric mergers c. Conglomerate mergers d. Friendly mergers e. Hostile takeovers ANSWER: a 42. Historical views of mergers have found that on average, a. shareholders of acquiring firms capture a large benefit of a merger’s benefit. b. most mergers do not add any benefit to the acquiring or target companies.

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions c. top officers of acquiring firms capture a large portion of a merger’s benefit. d. shareholders of target firms capture a large portion of a merger’s benefit. e. benefits of mergers are evenly split between the acquiring and the target companies.

ANSWER: d 43. Simpson Inc. is considering a vertical merger with The Lachey Company. Simpson currently has a required return of 9.00%, while Lachey's required return is 16.00%. The market risk premium is 5.20% and the risk-free rate is 5%. Assume the market is in equilibrium. If Simpson is going to make up 67% of the new firm (and Lachey will comprise the remaining 33%), what will be the beta of the new merged firm? There will be no additional infusion of debt in the merger.

Do not round your intermediate calculations. a. 1.03 b. 0.91 c. 1.21 d. 1.15 e. 1.27 ANSWER: c 44. Gekko Properties is considering purchasing Teldar Properties. Gekko's analysts project that the merger will result in incremental after-tax cash flows of $2 million, $4 million, $5 million, and $10 million over the next four years. The horizon value of the firm's operations, as of Year 4, is expected to be $105 million. Assume all cash flows occur at the end of the year. The acquisition would be made immediately, if it is undertaken. Teldar's post-merger beta is estimated to be 2.0, and its post-merger tax rate would be 25.00%. The risk-free rate is 6.00%, and the market risk premium is 5.50%.

What is the value of Teldar to Gekko Properties? Do not round intermediate calculations. a. $78,800,293 b. $69,123,064 c. $78,109,063 d. $53,915,990 e. $71,196,756 ANSWER: b 45. At the beginning of the year, Ham Inc.'s management is considering making an offer to buy Egg Corporation. Egg's projected operating income (EBIT) for the current year is $26.0 million, but Ham believes that if the two firms were merged, it could consolidate some operations, reduce Egg's expenses, and raise its EBIT to $40.0 million. Neither company uses any debt, and they both pay income taxes at a 25% rate. Ham has a better reputation among investors, who regard it as better managed and less risky, so Ham's stock has a P/E ratio of 17 versus a P/E of 10 for Egg. Since Ham's management will be running the entire enterprise after the merger, investors will value the resulting corporation based on Ham's P/E. Based on expected market values, how much synergy should the merger create? Do not round your intermediate calculations. a. $189.0 million b. $239.4 million c. $252.0 million d. $289.8 million e. $264.6 million ANSWER: c 46. At the beginning of the year Giant Inc.'s management is considering making an offer to buy Micro Corporation.

Copyright Cengage Learning. Powered by Cognero.

Page 8

Name:

Class:

Date:

Chapter 21 - Mergers and Acquisitions Micro's projected operating income (EBIT) for the current year is $32.0 million, but Giant believes that if the two firms were merged, it could consolidate some operations, reduce Micro's expenses, and raise its EBIT to $35.0 million. Neither company uses any debt, and they both pay income taxes at a 35% rate. Giant has a better reputation among investors, who regard it as very well managed and not very risky, so its stock has a P/E ratio of 11 versus a P/E of 10 for Micro. Since Giant's management would be running the entire enterprise after a merger, investors would value the resulting corporation based on Giant's P/E. If Micro has 10 million shares outstanding, by how much should the merger increase its share price, assuming all of the synergy will go to its stockholders? Do not round your intermediate calculations. a. $3.66 b. $4.14 c. $5.12 d. $4.63 e. $4.88 ANSWER: e 47. Anacott Steel is acquiring Terafly Incorporated. Terafly is expected to provide Anacott with operating cash flows of $12, $21, $16, and $9 million over the next four years, respectively. In addition, the horizon value of all remaining cash flows at the end of Year 4 is estimated at $18 million. The merger will cost Anacott $45 million today. If the value of the merger is estimated at $8.00 per share and Anacott has 1,000,000 shares outstanding, what equity discount rate must the firm be using to value this acquisition? a. 12.81% b. 11.80% c. 16.55% d. 14.39% e. 15.68% ANSWER: d

Copyright Cengage Learning. Powered by Cognero.

Page 9

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets 1. What does the term “fintech” refer to? a. Financial intermediaries b. Cutting-edge financial products and services c. Government regulations of technology d. Accounting systems e. Financial institutions ANSWER: b 2. What technology enabled the electronic transfer of money in the 19th century? a. Telegraph b. ATM machine c. Bitcoin d. Telephone e. Internet ANSWER: a 3. What led to the explosive growth of fintech? a. Slow economic growth b. High interest rates c. Rapid advancements in digital technology d. Tighter regulations e. Use of cash and checks ANSWER: c 4. What enabled online bill payment and money transfers in the 1990s? a. Ethereum b. Internet c. Cloud computing d. Mainframe computers e. Customer demand ANSWER: b 5. What allowed early bitcoin mining? a. Cloud computing b. Lower bitcoin prices c. Using regular computers d. Access to banking data e. Use of renewable energy resources ANSWER: c 6. How does distributed data storage enhance blockchain security? a. By encrypting data b. By hiding IP addresses c. By multiplying the difficulty of hacking the system using multiple nodes Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets d. By blocking malware e. By not allowing duplicate copies of the data ANSWER: c 7. How does blockchain prevent data tampering by hackers? a. Encryption protocols used by hackers b. Hackers could access credential checks c. Using complex passwords d. Firewall protections exploited by hackers e. Hackers could typically access one node, but the system’s consensus mechanism requires a majority of nodes before data is altered ANSWER: e 8. In which type of blockchain can any user add data? a. Private blockchains b. Public blockchains c. Permissionless blockchains d. Corporate blockchains e. Permissioned blockchains ANSWER: c 9. Which is an advantage of using bitcoins for transactions? a. Availability of credit b. Deposit insurance c. Reversible payments d. Faster transaction speed e. Zero fees ANSWER: d 10. Which of the following contributes to the volatility of the market value of Bitcoin? a. Government bans b. Technical glitches c. Speculation and investor attitudes d. Incorrect pricing data e. Cash is still used for purchasing goods and services ANSWER: c 11. How can crypto volatility be hedged? a. With collateralized debt b. Through arbitrage c. Using futures contracts d. By trading options e. By eliminating cash for international transactions ANSWER: c Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets 12. Why do institutional investors have a reluctancy to enter the bitcoin futures market? a. Government bailout policies b. Deposit insurance protection does not apply to the market. c. Confidence in short-term volatility d. A perceived lack of liquidity. e. Distrust in bitcoin versus cash ANSWER: d 13. How could exchange-traded funds (ETFs) based on bitcoin futures approval aid crypto adoption? a. By guaranteeing bitcoin prices b. Through promoting smart contracts in traditional tradeable securities c. By attracting institutional investors to cryptocurrencies through traditional markets d. From tax incentives for cryptocurrency miners e. By avoiding price manipulation ANSWER: c 14. What are smart contracts used for on the blockchain? a. Hiring lawyers b. Security regulations c. Storing personal data d. Automating transactions without intermediaries e. Guarantee secure transactions ANSWER: d 15. What are initial coin offerings (ICOs)? a. A type of blockchain b. An equity offering c. A process similar to initial public offerings (IPOs) d. An options market e. An international currency option ANSWER: c 16. How are the terms of smart contracts executed? a. Court judgment typically increases the enforceability of smart contracts. b. Regulatory oversight makes contracts enforceable by forcing them to be executed. c. Smart contracts are programmed to execute a transaction automatically on the blockchain. d. Private arbitration contributes to execution and enforcement. e. Smart contracts are executed by intermediaries.

ANSWER: c 17. Stablecoins attempt to maintain price stability a. through government regulations. b. with blockchain algorithms.

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets c. with collateral asset reserves. d. by controlling supply and demand. e. by oversight of international trading markets.

ANSWER: c 18. What is a limitation of chatbots in banking? a. Weak data security b. Difficulty understanding dialogues c. High costs d. Lack of availability e. Answering questions in a timely manner ANSWER: b 19. Neobanks attract customers from traditional banks through a. physical office locations. b. higher interest rates. c. old-fashioned practices. d. strong political ties. e. not charging fees.

ANSWER: b 20. What is a limitation in peer-to-peer (P2P) lending? a. Low borrower returns on P2P lending versus traditional lending b. Lack of sufficient credit checks to bolster confidence c. Lenders cannot resell the loans or withdraw money from the platform d. High default risk amongst the P2P lending community e. Use of AI algorithms to match lenders and borrowers ANSWER: c 21. How could improvements in sentiment analysis benefit investment strategies? a. By predicting market crashes b. By assessing investor feelings c. By identifying accounting fraud d. By analyzing financial ratios e. By using spreadsheets more effectively ANSWER: b 22. How do robo-advisors assess client risk and return profiles? a. By conducting personal interviews b. By reviewing financial statements c. By using algorithmic models d. By reading news reports e. By word of mouth Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets ANSWER: c 23. What technology do insurers use for more efficient damage assessments and claims processing? a. ATMs b. Drones c. Mobile apps d. Websites e. Traditional spreadsheets ANSWER: b 24. How can insurtech increase efficiency in pricing policies? a. By analyzing consumer data b. By using mobile apps c. By employing more staff d. By opening local offices e. By relying more on spreadsheet analysis ANSWER: a 25. How can embedded finance integrate financial services? a. By using cloud computing b. By employing blockchain technology c. By incorporating them into nonfinancial platforms d. By developing robo-advisors e. By heavily advertising their services ANSWER: c 26. What can AI algorithms do to help detect insurance fraud? a. Conducting customer surveys b. Analyzing claims data c. Reviewing financial statements d. Monitoring news reports e. Reviewing relevant ratios ANSWER: b 27. What AI-related analytics tool optimizes insurance premium pricing? a. Amortization calculators b. Spreadsheet analysis c. Financial ratio analysis d. Inventory management systems e. Algorithms to identify insurance fraud and money laundering schemes ANSWER: e 28. What regulatory issue arises from fintech companies collecting large amounts of personal data? a. Money laundering Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets b. Insider trading c. Privacy and security concerns d. Accounting fraud e. Fraud schemes ANSWER: c 29. Why is regulating cryptocurrencies challenging for government agencies? a. Lack of technological skills b. Conflicting political interests c. No standard definition exists d. Too many new startups e. Lack of public support for oversight ANSWER: c 30. Which regulator proposed national bank charters for fintech companies? a. Federal Reserve b. Securities and Exchange Commission (SEC) c. Office of the Comptroller of the Currency (OCC) d. Financial Industry Regulatory Authority (FINRA) e. Internal Revenue Service (IRS) ANSWER: c 31. Which U.S. legislation aims to clarify fintech regulations? a. Digital Accountability and Transparency Act (DATA) b. Gramm–Leach–Bliley Act (GLBA) c. Responsible Financial Innovation Act (RFIA) d. PATRIOT Act e. Sarbanes-Oxley Act (SOX) ANSWER: c 32. How have some nations addressed crypto's anonymity risks? a. By taxing transactions b. Through identity verification c. With outright bans d. By regulating exchanges e. By calling for investigations ANSWER: c 33. Within fintech lending, which agency proposed oversight rules for nonbank companies that provide financial services and pose risks to customers? a. Federal Reserve b. Securities and Exchange Commission (SEC) c. Consumer Financial Protection Bureau (CFPB) d. Financial Industry Regulatory Authority (FINRA) Copyright Cengage Learning. Powered by Cognero.

Page 6

Name:

Class:

Date:

Chapter 22 - Fintech in Financial Markets e. Internal Revenue Service (IRS) ANSWER: c 34. Assume that a cryptocurrency is deemed to be a commodity. Which agency would most likely be tasked with regulating it? a. Federal Reserve b. Securities and Exchange Commission (SEC) c. Commodity Futures Trading Commission (CFTC) d. Financial Industry Regulatory Authority (FINRA) e. Internal Revenue Service (IRS) ANSWER: c 35. What European Union regulation aims to improve fintech privacy and security? a. Basel III rules b. BREXIT agreement c. General Data Protection Regulation (GDPR) and Payment Services Directive (PSD2) d. Stability and Growth Pact e. International Monetary Fund (IMF) ANSWER: c 36. What act provides the framework for securing confidential customer data in the United States? a. PATRIOT Act b. Telecommunications Act c. Gramm–Leach–Bliley Act d. Riegle–Neal Act e. Dodd-Frank Act ANSWER: c 37. Which of these aims to provide more clarity regarding which governmental agencies will provide regulatory oversight for cryptocurrency and blockchain-derived assets? a. Dodd–Frank Act b. Responsible Financial Innovation Act c. Gramm–Leach–Bliley Act d. Sarbanes-Oxley Act e. Digital Accountability and Transparency Act ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 7

Name:

Class:

Date:

Web Appendix 5A Continuous Compounding and Discounting 1. If you receive $15,000 today and can invest it at a 6.75% annual rate compounded continuously, what will be your ending value after 20 years? a. $45,710.49 b. $56,125.54 c. $57,861.38 d. $47,446.33 e. $72,326.73 ANSWER: c 2. In six years' time, you are scheduled to receive money from a trust established by your grandparents. When the trust matures, there will be $100,000 in the account. If the account earns 9.50% compounded continuously, how much is in the account today? a. $68,994.10 b. $43,545.46 c. $46,373.09 d. $56,552.54 e. $64,469.90 ANSWER: d 3. Assume one bank offers you a nominal annual interest rate of 6.00% compounded daily, while another bank offers you continuous compounding at a 5.90% nominal annual rate. You decide to deposit $1,350 with each bank. Exactly two years later you withdraw your funds from both banks. What is the difference in your withdrawal amounts between the two banks? Assume 365 days in a year. Do not round your intermediate calculations. a. $2.27 b. $3.78 c. $3.03 d. $2.57 e. $2.87 ANSWER: c 4. You have $5,436.60 in an account that pays 9.10% interest, compounded continuously. If you deposited some funds 11 years ago, how much was your original deposit? Round your answer to the nearest dollar. a. $1,638 b. $1,998 c. $2,318 d. $2,178 e. $1,578 ANSWER: b 5. How much should you be willing to pay for an account today that will have a value of $1,000 in 23 years under continuous compounding if the nominal rate is 10.90%? a. $72.55 b. $81.51 c. $66.03 d. $97.81 Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 5A Continuous Compounding and Discounting e. $83.14 ANSWER: b 6. You need a down payment of $20,000 in order to purchase your first home four years from today. You currently have $14,014 to invest. In order to achieve your goal, what nominal interest rate, compounded continuously, must you earn on this investment? Do not round your intermediate calculations. a. 9.43% b. 8.89% c. 9.25% d. 7.56% e. 9.78% ANSWER: b 7. You place $1,000 in an account that pays 7.00% interest compounded continuously. You plan to hold the account for exactly 3 years. Simultaneously, in another account you deposit money that earns 8.20% compounded semiannually. If the accounts are to have the same amount at the end of the three years, how much of an initial deposit do you need to make now in the account that pays 8.20% interest compounded semiannually? Do not round your intermediate calculations. a. $843.37 b. $920.92 c. $969.39 d. $727.04 e. $891.84 ANSWER: c 8. For a 10-year deposit, what annual rate payable semiannually will produce the same effective rate as 9.00% compounded continuously? Do not round your intermediate calculations. a. 10.86% b. 9.21% c. 7.09% d. 11.14% e. 10.22% ANSWER: b

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 7A Zero Coupon Bonds 1. Which of the following statements is CORRECT? a. If interest rates increase, a 10-year zero coupon bond's price will drop by a greater percentage than will a 10year, 8% coupon bond. b. One nice thing about zero coupon bonds is that individual investors do not have to pay any taxes on a zero coupon bond until it matures, even if they are not holding the bonds as part of a tax-deferred account. c. If a bond with a sinking fund provision has a yield to maturity greater than its coupon rate, the issuing company would prefer to comply with the sinking fund by calling the bonds in at par rather than buying the bonds back in the open market. d. Because of the IRS's tax treatment of zero coupon bonds, pension funds and other tax-exempt entities rarely, if ever, invest in zero coupon bonds. e. Interest must be paid on a zero coupon bond's accrued value, but while the first year's interest is taxable at the ordinary income tax rate, subsequent years are taxed at the long-term capital gains rate (since they are received after more than a year).

ANSWER: a 2. Consider each of the following bonds: Bond A: 8-year maturity with a 7% annual coupon.

Bond B: 10-year maturity with a 9% annual coupon.

Bond C: 12-year maturity with a zero coupon.

Each bond has a face value of $1,000 and a yield to maturity of 8%. Which of the following statements is NOT correct? a. Bond A sells at a discount, while Bond B sells at a premium. b. If the yield to maturity on each bond falls to 7%, Bond C will have the largest percentage increase in its price. c. Bond C has the most reinvestment risk. d. Bond C has the most price risk. e. If the yield to maturity is constant, the price of Bond A will continue to increase over its life until it finally sells at par.

ANSWER: c 3. McGwire Company's pension fund projects that most of its employees will take advantage of an early retirement program the company plans to offer in five years. Anticipating the need to fund these pensions, the firm bought zero coupon U.S. Treasury Trust Certificates maturing in five years. When these instruments were originally issued, they were 12% coupon, 30-year U.S. Treasury bonds. The stripped Treasuries are currently priced to yield 7.00%. Their total maturity value is $6,000,000. What is their total cost (price) to McGwire today? Do not round your intermediate calculations. a. $3,550,671 b. $3,807,346 c. $4,705,709 d. $3,379,554 e. $4,277,917 ANSWER: e 4. At the beginning of the year, you purchased a five-year zero coupon bond with a yield to maturity of 6.40% and a face value of $1,000. Your tax rate is 30.00%. What is the total tax that you will have to pay on the bond during the first year? Do not round your intermediate calculations. a. $14.36 Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 7A Zero Coupon Bonds b. $12.39 c. $14.08 d. $11.40 e. $17.32 ANSWER: c 5. You just purchased a 12-year, $1,000 face value, zero coupon bond with a yield to maturity of 9.00%. If your tax rate is 26.00%, how much in taxes will you have to pay at the end of the first year of holding the bond? Do not round your intermediate calculations. a. $7.74 b. $6.91 c. $9.65 d. $7.07 e. $8.32 ANSWER: e 6. S. Claus & Co. is planning a zero coupon bond issue that has a par value of $1,000 and matures in two years. The bonds will be sold today at a price of $960.00. If the firm's marginal tax rate is 40.00%, what is the annual after-tax cost of debt to the company on this issue? Do not round your intermediate calculations. a. 0.93% b. 1.01% c. 1.24% d. 1.08% e. 1.45% ANSWER: c 7. A 17-year, $1,000 face value, zero coupon bond has a yield to maturity of 8%. What is the amount of tax an investor in the 33% tax bracket will pay the first year of the bond? Do not round your intermediate calculations. a. $6.49 b. $5.35 c. $7.14 d. $6.28 e. $6.35 ANSWER: c 8. On January 1st Julie bought a seven-year, zero coupon bond with a face value of $1,000 and a yield to maturity of 5.00%. Assume that Julie's tax rate is 25.00%. How much tax will Julie have to pay on the bond the first year she owns it? Do not round your intermediate calculations. a. $11.10 b. $7.20 c. $7.55 d. $8.88 e. $8.35 ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 7A Zero Coupon Bonds 9. U.S. Delay Corporation, a subsidiary of the Postal Service, must decide whether to issue zero coupon bonds or quarterly payment bonds to fund construction of new facilities. The $1,000.00 par value quarterly payment bonds would sell at $795.54, have a 5.75% coupon rate, and mature in 10 years. At what price would the zero coupon bonds with a maturity of 10 years have to sell to earn the same effective annual rate as the quarterly payment bonds? Do not round your intermediate calculations. a. $499.93 b. $404.11 c. $416.61 d. $337.45 e. $487.43 ANSWER: c 10. Recycler Battery Corporation (RBC) issued zero coupon bonds 5 years ago at a price of $214.50 per bond. RBC's zeros had a 20-year original maturity, with a $1,000.00 par value. The bonds were callable 10 years after the issue date at a price 8% over their accrued value on the call date. If the bonds sell for $310.00 in the market today, what annual rate of return should an investor who buys the bonds today expect to earn on them? a. 9.26% b. 8.45% c. 7.55% d. 9.83% e. 8.12% ANSWER: e 11. Vogril Company issued 20-year, zero coupon bonds with an expected yield to maturity of 6.30%. The bonds have a par value of $1,000 and were sold for $294.67 each. What is the expected interest expense on these bonds for Year 8? Do not round your intermediate calculations. a. $23.06 b. $34.17 c. $31.89 d. $28.47 e. $26.76 ANSWER: d 12. A 2-year, zero coupon Treasury bond with a maturity value of $1,000.00 has a price of $875.0736. A one-year, zero coupon Treasury bond with a maturity value of $1,000.00 has a price of $939.8496. If the pure expectations theory is correct, for what price should one-year, zero coupon Treasury bonds sell one year from now? Do not round your intermediate calculations. a. $754.17 b. $1,042.81 c. $1,080.05 d. $996.25 e. $931.08 ANSWER: e 13. A four-year, zero coupon Treasury bond sells at a price of $762.8952. A three-year, zero coupon Treasury bond sells at a price of $827.8491. Assuming the expectations theory is correct, what does the market believe the price of one-year, Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Web Appendix 7A Zero Coupon Bonds zero coupon bonds will be in three years? Do not round your intermediate calculations. a. $810.95 b. $1,096.63 c. $866.25 d. $1,068.99 e. $921.54 ANSWER: e 14. Assume that the State of Florida sold tax-exempt, zero coupon bonds with a $1,000.00 maturity value 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 4.60%, compounded semiannually. The bonds are now callable at a premium of 4.00% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today? Do not round your intermediate calculations. a. 6.68% b. 4.33% c. 5.48% d. 5.59% e. 5.09% ANSWER: c 15. Assume that the City of Tampa sold an issue of $1,000.00 maturity value, tax-exempt (muni), zero coupon bonds 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 5.20% but with semiannual compounding. The bonds are now callable at a premium of 10.00% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today? a. 6.27% b. 6.49% c. 7.15% d. 7.29% e. 6.42% ANSWER: d 16. Schiffauer Electronics plans to issue 10-year, zero coupon bonds with a par value of $1,000.00 and a yield to maturity of 6.25%. The company has a tax rate of 30.00%. How much extra in taxes would the company pay (or save) the second year (at t = 2) if it goes ahead and issues the bonds? Do not round your intermediate calculations. a. $11.19 b. $11.73 c. $11.95 d. $11.52 e. $10.87 ANSWER: e Exhibit 7A.1 Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in 3 years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1000, it will mature in 3 years, and it will sell in the market for $795.00. The firm's marginal tax rate is 40.00%.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Web Appendix 7A Zero Coupon Bonds 17. Refer to Exhibit 7A.1. What is the expected after-tax cost of this debt issue? Do not round your intermediate calculations. a. 3.58% b. 4.20% c. 4.01% d. 4.77% e. 4.91% ANSWER: d 18. Refer to Exhibit 7A.1. What is the nominal dollar value of the interest tax savings to the firm in the third year of the issue? Do not round your intermediate calculations. a. $25.91 b. $31.80 c. $29.45 d. $36.52 e. $25.33 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Web Appendix 7C Bankruptcy and Reorganization 1. Chapter 7 of the Bankruptcy Act is designed to do all of the following EXCEPT: a. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm. b. Allow insolvent debtors to discharge all of their obligations and start over unhampered by a burden of prior debt. c. Provide for an equitable distribution of the assets among the creditors. d. Detail the procedures to be followed when a firm is liquidated. e. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.

ANSWER: e 2. Which of the following statements is most CORRECT? a. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time. b. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws. c. All bankruptcy petitions are filed by creditors seeking to protect their claims on firms in financial distress.

Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm's management. d. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act. e. "Restructuring" a firm's debt can involve forgiving a certain portion of the debt but does not involve changing the debt's maturity or its contractual interest rate.

ANSWER: d 3. Which of the following statements is most CORRECT? a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan. b. The basic doctrine of fairness states that all debt holders must be treated equally. c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the "public interest" is not a relevant concern. d. While the firm is in bankruptcy, the existing management is always allowed to remain in control of the firm, though the court monitors its actions closely. e. To a large extent, the decision to dissolve a firm through liquidation or to keep it alive through reorganization depends upon the value of the firm if it is rehabilitated versus its value if its assets are sold off individually.

ANSWER: e 4. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1. Trustees' costs to administer and operate the firm 2. Common stockholders 3. General, or unsecured, creditors Secured creditors who have claim to the proceeds from the sale of a specific property 4. pledged for a mortgage 5. Taxes due to federal and state governments a. 1, 4, 3, 5, 2 b. 5, 4, 1, 3, 2 Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 7C Bankruptcy and Reorganization c. 4, 1, 5, 3, 2 d. 5, 1, 4, 2, 3 e. 1, 5, 4, 3, 2 ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 8A Calculating Beta Coefficients 1. Which of the following statements is CORRECT? a. The CAPM is an ex ante model, which means that all of the variables should be historical values that can reasonably be projected into the future. b. The beta coefficient used in the SML equation should reflect the expected volatility of a given stock's return versus the return on the market during some future period. c. The general equation: Y = a + bX + e, is the standard form of a simple linear regression where b = beta, and X equals the independent return on an individual security being compared to Y, the return on the market, which is the dependent variable. d. The rise-over-run method is not a legitimate method of estimating beta because it measures changes in an individual security's return regressed against time. e. The Security Market Line (SML) shows the relationship between risk as measured by beta and the required rate of return for all securities.

ANSWER: b 2. Given the following returns on Stock J and the "market" during the last three years, what is the beta coefficient of Stock J? (Hint: Think rise over run.)

Year Stock J Market 1 –8.67% –8.70% 2 13.43% 13.40% 3 19.83% 19.80% a. 0.95 b. 1.13 c. 1.00 d. 1.07 e. 1.03 ANSWER: c 3. Stock X and the "market" have had the following rates of returns over the past four years.

Year Stock X Market 1 12.00% 13.86% 2 5.00% 1.58% 3 11.00% 14.51% 4 –7.00% –3.44% 35% of your portfolio is invested in Stock X, and the remaining 65% is invested in Stock Y. The risk-free rate is 5.40%, and the market risk premium is also 5.40%. You estimate that 13.08% is the required rate of return on your portfolio.

What is the beta of Stock Y? a. 1.61 b. 1.70 c. 1.82 d. 1.34 e. 1.72 ANSWER: b 4. Hanratty Inc.'s stock and the stock market have generated the following returns over the past five years: Year

Hanratty

Market (r M)

Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 8A Calculating Beta Coefficients 1 2 3 4 5

13.00% 18.00% –5.00% 23.00% 6.00%

9.00% 15.00% –2.00% 19.00% 12.00%

What is the estimated beta of Hanratty Inc.'s stock? a. 1.59459 b. 0.89297 c. 1.27567 d. 1.53080 e. 1.21189 ANSWER: c 5. Below are the returns for the past five years for Stock S and for the overall market: Year 1 2 3 4 5

Stock S 12.00% 34.00% –29.00% –11.00% 45.00%

Market (r M) 8.00% 28.00% −20.00% −4.00% 30.00%

What is the estimated beta of Stock S? a. 1.43198 b. 1.14558 c. 1.86157 d. 1.50358 e. 1.00239 ANSWER: a 6. Given the following returns on Stock Q and "the market" during the last three years, what is the difference in the calculated beta coefficient of Stock Q when Year 1 and Year 2 data are used as compared to Year 2 and Year 3 data?

(Hint: Think rise over run.)

Year 1 2 3

Stock Q 7.48% –3.60% 21.69%

Market 7.57% 13.13% 16.53%

a. 9.43 b. 10.28 c. 7.83 d. 9.90 e. 8.21 ANSWER: a Exhibit 8A.1 Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 8A Calculating Beta Coefficients You have been asked to use a CAPM analysis to choose between Stocks R and S, with your choice being the one whose expected rate of return exceeds its required return by the widest margin. The risk-free rate is 6.00%, and the required return on an average stock (or the "market") is 10.00%. Your security analyst tells you that Stock S's expected rate of return is equal to 12.00%, while Stock R's expected rate of return is equal to 15.00%. The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock. The following past rates of return are to be used to calculate the two stocks' beta coefficients, which are then to be used to determine the stocks' required rates of return: Year Stock R Stock S Market 1 –18.57% –11.69% –9.00% 2 16.45% 10.41% 8.00% 3 39.11% 24.71% 19.00% Note: The averages of the historical returns are not needed, and they are generally not equal to the expected future returns.

7. Refer to Exhibit 8A.1. Calculate both stocks' betas. What is the difference between the betas? That is, what is the value of betaR − betaS? (Hint: The graphical method of calculating the rise over run, or (Y2 − Y1) divided by (X2 − X1) may aid you.) a. 0.81 b. 0.80 c. 0.76 d. 0.57 e. 0.86 ANSWER: c 8. Refer to Exhibit 8A.1. Set up the SML equation and use it to calculate both stocks' required rates of return, and compare those required returns with the expected returns given above. You should invest in the stock whose expected return exceeds its required return by the widest margin. What is the widest positive margin, or greatest excess return (expected return − required return)? a. 0.84% b. 0.71% c. 0.66% d. 0.62% e. 0.80% ANSWER: e

Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Web Appendix 12C Using the CAPM to Estimate the Risk Adjusted Cost of Capital 1. Sunshine Inc. has two equally sized divisions. Division A has a beta of 0.8, and Division B has a beta of 1.2. The company is 100% equity financed. The risk-free rate is 6%, and the market risk premium is 5%. Sunshine assigns different hurdle rates to each division based on each division's market risk. Which of the following statements is CORRECT? a. Sunshine's composite WACC is 10%. b. Division B has a lower WACC than Division A. c. If the same WACC is used for each division, the firm would select too many Division A projects and reject too many Division B projects. d. If the same WACC is used for each division, the firm would select too many Division B projects and reject too many Division A projects. e. Sunshine's composite WACC is 12%.

ANSWER: d 2. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true? a. If an asset's beta is larger than the firm's beta, then the required return on the asset is less than the required return on the firm. b. If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm. c. If the beta of the asset is greater than the firm's beta prior to the addition of that asset, then the firm's beta after the purchase of the asset will be smaller than the original firm's beta. d. If the beta of an asset is larger than the firm's beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase. e. None of the statements is true.

ANSWER: d 3. Using the Security Market Line (SML) concept in capital budgeting, which of the following statements is CORRECT? a. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is greater than the beta of the firm's average project. b. If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta. c. If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted. d. If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted. e. None of the statements is correct.

ANSWER: a 4. Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.65 and will generate an expected return of 5.00%. The firm currently has a required return of 12.5% and a beta of 1.25. The investment, if undertaken, will double the firm's total assets. If rRF is 7.00% and the market risk premium is 7.00% should the firm undertake the investment? a. Yes; the beta of the asset will reduce the risk of the firm. b. No; the expected return of the asset is less than the firm's required return, which is 10.75%. c. No; the expected return of the asset (5.00%) is less than the required return (9.86%). d. No; the risk of the asset (beta) will increase the firm's beta.

Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 12C Using the CAPM to Estimate the Risk Adjusted Cost of Capital e. Yes; the expected return of the asset (5.00%) exceeds the required return (4.50%).

ANSWER: c 5. Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 18.00%; the risk-free rate is 0.25%; and the market risk premium is 7.00%. You are considering a new project that has 50.00% more beta risk than your firm's assets currently have, that is, its beta is 50.00% larger than the firm's existing beta. The expected return on the new project is 18.00%. Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement. a. No; a 50.00% increase in beta risk gives a risk-adjusted required return of 24.00%. b. Yes; its expected return is greater than the firm's WACC. c. No; the project's risk-adjusted required return is 8.88% above its expected return. d. Yes; the project's risk-adjusted required return is less than its expected return. e. No; the project's risk-adjusted required return is 9.88% above its expected return.

ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 12D Techniques for Measuring Beta Risk 1. Which of the following methods involves calculating an average beta for comparable firms and using that beta to determine a project's beta? a. Risk premium method b. Pure play method c. Accounting beta method d. CAPM method e. Discounted cash flow model ANSWER: b 2. Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pure-play firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0.8, and Division B has a beta of 1.5. The two divisions are the same size. The risk-free rate is 5.00%, and the market risk premium is 6.40%. Assume that Northern is 100% equity financed. What is the overall composite WACC for Northern Conglomerate? Do not round your intermediate calculations. a. 9.27% b. 15.45% c. 12.36% d. 14.21% e. 10.51% ANSWER: c 3. Interstate Transport has a target capital structure of 50% debt and 50% common equity. The firm is considering a new independent project that has a return of 14% and is not related to transportation. However, a pure-play proxy firm has been identified that has a beta of 1.38. Both firms have a marginal tax rate of 25%, and Interstate's before-tax cost of debt is 12%. The risk-free rate is 10%, and the market risk premium is 5%. The firm should: a. Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return. b. Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt. c. Accept the project; its return is greater than the firm's required rate of return on the project of 12.95%. d. Reject the project; its return is less than the firm's required rate of return on the project of 16.9%. e. Reject the project; its return is only 14%.

ANSWER: c

Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage 1. A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new production method which will entail an increase in fixed costs but a decrease in variable costs and will result in a degree of operating leverage of 1.500. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish this? Do not round intermediate calculations. a. $5,457,894.74 b. $4,250,000.00 c. $4,473,684.21 d. $3,578,947.37 e. $4,697,368.42 ANSWER: c 2. Your firm's EPS last year was $1.00. You expect sales to increase by 22.50% during the coming year. If your firm has a degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS? Do not round intermediate calculations. a. $1.55 b. $1.98 c. $2.42 d. $1.94 e. $1.92 ANSWER: b 3. Which of the following statements is CORRECT? a. An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage. b. An increase in interest expense will reduce the company's degree of financial leverage. c. If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. d. If a firm's degree of operating leverage increases, its degree of financial leverage must also have increased. e. If the company has no debt outstanding, then its degree of total leverage equals its degree of financial leverage.

ANSWER: c 4. The Quick Company expects its sales to increase by 50% in the coming year. The firm's current EPS is $1.50. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach? Do not round intermediate calculations. a. $4.02 b. $4.94 c. $3.58 d. $4.90 e. $4.06 ANSWER: a 5. Alvarez Technologies has sales of $3,000,000. The company's fixed operating costs total $500,000, and its variable costs equal 53.50% of sales, so the company's current operating income is $895,000. The company's interest expense is Copyright Cengage Learning. Powered by Cognero.

Page 1

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage $500,000. What is the company's degree of total leverage (DTL)? a. 3.1785 b. 4.3792 c. 3.2491 d. 3.5316 e. 2.6487 ANSWER: d 6. Which of the following statements is CORRECT? a. The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales. b. The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL). c. Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage. d. For a given change in sales, the corresponding percentage change in net income could be more or less than the percentage change in operating income. e. The degree of total leverage (DTL) is equal to the DFL divided by the degree of operating leverage (DOL).

ANSWER: a 7. Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 6.250, and a degree of financial leverage of 1.875. If sales decline by 20% next year, then what will be the firm's expected EBIT in one year? Do not round intermediate calculations. a. $706,667 b. $666,667 c. $640,000 d. $726,667 e. $720,000 ANSWER: b 8. The degree of operating leverage has which of the following characteristics? a. The closer the firm is operating to the breakeven quantity, the smaller the DOL. b. A change in quantity demanded will produce the same percentage change in EBIT as an identical change in price per unit of output, other things held constant. c. The DOL is not a fixed number for a given firm but will depend upon the time zero values of the economic variables Q (Quantity), P (Price), and V (Volume). d. The DOL relates the change in net income to the change in operating income. e. If the firm has no debt, the DOL will equal 1.

ANSWER: c 9. Maxvill Motors has annual sales of $14,300. Its variable costs equal 60% of its sales, and its fixed costs equal $1,000. If the company's sales increase 10%, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)? a. 12.60% Copyright Cengage Learning. Powered by Cognero.

Page 2

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage b. 12.12% c. 14.06% d. 11.88% e. 10.06% ANSWER: b 10. Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85.00% of sales, and its fixed costs are $500,000.

Therefore, the company's operating income (EBIT) equals $1,000,000. The company estimates that if its sales were to increase 1.50%, its net income and EPS would increase 17.50%. What is the company's interest expense? Do not round intermediate calculations. a. $810,429 b. $923,714 c. $871,429 d. $784,286 e. $897,571 ANSWER: c 11. PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10%.

Sales for the year totaled $3,500,000, and variable costs were 60% of sales. Net income was equal to $600,000, and the company's tax rate was 24%. If PQR's degree of total leverage is equal to 1.24, what is its degree of operating leverage? Do not round intermediate calculations. a. 1.2504 b. 0.9274 c. 1.2921 d. 1.2400 e. 1.0420 ANSWER: e 12. Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.50. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.50, what is this year's expected EBIT with the increase in sales? a. $114,000 b. $108,300 c. $107,160 d. $121,980 e. $123,120 ANSWER: a 13. Bell Brothers has $3,000,000 in sales. Fixed costs are estimated to be $100,000, and variable costs are equal to 50.00% of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 5.00%. If Bell Brothers' sales were to increase by 20.00%, how much of a percentage increase would you expect in the company's net income? Do not round intermediate calculations. a. 27.56% b. 22.22% Copyright Cengage Learning. Powered by Cognero.

Page 3

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage c. 18.89% d. 27.33% e. 23.56% ANSWER: b 14. Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately 27.50% of sales, and its fixed costs amount to 50.00% of revenues at its current output level. Although fixed costs are based on revenues at the current output level, the cost level is fixed. What is Monroe's degree of operating leverage in sales dollars? a. 3.8344 b. 3.1578 c. 2.8356 d. 2.4811 e. 3.2222 ANSWER: e 15. A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a YTM of 11.40%. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 11.40% and is equal to the coupon rate)? Do not round intermediate calculations. a. $14,619,883 b. $13,304,094 c. $17,982,456 d. $15,789,474 e. $15,643,275 ANSWER: a 16. The use of financial leverage by the firm has a potential impact on which of the following?

(1) (2) (3) (4) (5)

The risk associated with the firm.

The return experienced by the shareholder.

The variability of net income.

The degree of operating leverage.

The degree of financial leverage. a. 1, 3, 5 b. 1, 2, 5 c. 2, 3, 5 d. 2, 3, 4, 5 e. 1, 2, 3, 5 ANSWER: e 17. Assume that a firm has a degree of financial leverage of 1.50. If sales increase by 20%, the firm will experience a 60% increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase? Do not round intermediate calculations.

Copyright Cengage Learning. Powered by Cognero.

Page 4

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage a. $63,571 b. $58,571 c. $71,429 d. $77,143 e. $80,714 ANSWER: c 18. Which of the following is a key benefit of using the degree of leverage concept in financial analysis? a. It allows decision makers a relatively clear assessment of the consequences of alternative actions. b. It establishes the optimal capital structure for the firm. c. It shows how a given change in leverage will affect sales. d. It identifies, with certainty, the future net income based upon sales projections about the future. e. None of the above statements is correct.

ANSWER: a 19. If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is CORRECT? a. The percentage change in operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income. b. The percentage change in EBIT will equal the percentage change in net income. c. The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt. d. The percentage change in operating income will be less than the percentage change in net income. e. Since debt is used, the degree of operating leverage must be greater than 1.

ANSWER: d 20. Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and also permit sales to increase to $96,000,000. What is Stromburg's degree of operating leverage at the new projected sales level? a. 5.1247 b. 4.0235 c. 4.2353 d. 4.8706 e. 4.1082 ANSWER: c 21. Lincoln Lodging Inc. estimates that if its sales increase 10.00%, then its net income will increase 22.50%. The company's EBIT equals $2.4 million, and its interest expense is $400,000. The company's operating costs include fixed and variable costs. What is the level of the company's fixed operating costs? Do not round your intermediate calculations. a. $2,562,000 b. $2,247,000 c. $1,995,000 d. $2,100,000 Copyright Cengage Learning. Powered by Cognero.

Page 5

Name:

Class:

Date:

Web Appendix 14A Degree of Leverage e. $1,953,000 ANSWER: d 22. The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 15.00% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage? Do not round intermediate calculations. a. 3.5000 b. 3.7000 c. 2.8333 d. 3.3333 e. 3.1667 ANSWER: d 23. Company D has a 50% debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales and the same degree of operating leverage. Which of the following statements is most CORRECT? a. If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net income. b. If sales increase 10% for both companies, then Company D will have a larger percentage increase in its operating income (EBIT). c. If EBIT increases 10% for both companies, then Company D's net income will rise by more than 10%, while Company E's net income will rise by less than 10%. d. Company E has a higher degree of financial leverage. e. The two companies have the same degree of total leverage.

ANSWER: a

Copyright Cengage Learning. Powered by Cognero.

Page 6